Cryptocurrency wallets store your crypto funds and keep them safe through the use of private keys. They come in two main forms, cold wallets and hot wallets. The different types of cryptocurrency wallet have various uses depending on your needs and level of experience. 

Unlike a normal wallet, which holds actual cash, crypto wallets technically don’t hold your crypto. Your digital assets still exist on the blockchain, but they can only be accessed through your private keys. 

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What Are Cryptocurrency Wallets and How Do They Work?

Imagine your crypto wallet is a safe, so then your private keys are the code used to open it and gain access to what is inside. 

In this blog we explore what cryptocurrency wallets are, how they keep your crypto safe on the blockchain, and the key differences between hot wallets and cold wallets. 

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The Different Types of Crypto Wallet

There are two key types of cryptocurrency wallet:

• Cold wallets/Hardware wallets 
• Hot wallets/Software wallets

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Cold Wallets for Crypto

Cold wallets - also known as hardware wallets - store your private keys on a thumb drive device that is only connected to a computer and the internet when you want to access your crypto. Until this time, the device is kept in a secure, secret location known only to the owner. 

Because they’re offline, many people consider them the most secure option for safely storing cryptocurrency.

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Hot Wallets for Crypto

With hot wallets your private keys are stored in an app or piece of software often installed on your smartphone or computer. 

Hot wallets - also known as software wallets because they’re always connected to the internet - should be protected by two-step encryption. 

Software wallets are like your online banking app and they make sending, receiving and exchanging cryptocurrencies such as Bitcoin, Ethereum and Solana, quick and convenient. 

They do this through the use of wallet addresses. 

These are a long list of letters and numbers also known as a hexadecimal address or public key, which can be shared with various contacts much like an email address. 

Wallet addresses make the transferring of cryptocurrencies, NFTs and other digital assets quick and easy. 

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Custodial and Non-Custodial Hot Wallets

Hot wallets and software wallets typically come in one of two different forms - custodial and non-custodial. 

Custodial hot wallets entrust your private keys to a third party such as a cryptocurrency exchange. And as the name suggests, the third party takes custody of the private keys for you. 

This effectively gives them full control over the stored cryptocurrencies - they take responsibility for managing your wallet’s private key, signing transactions, and protecting your digital assets.

Because they undertake all this responsibility they are a popular option for people new to cryptocurrency. For example, your Cryptology account comes with a secure custodial software wallet. Other examples of custodial wallets include BitGo and Free Wallet.

In contrast, non-custodial crypto wallets give you full control over your private keys. This means it’s your responsibility to keep them safe and secure.

Also known as self-custody wallets, it is you - the crypto owner - who’s responsible for managing your funds and digital assets, you have to manage your own private key, handle transactions and keep your crypto secure. 

Non-custodial wallets provide you with a seed phrase. Upon creating the wallet, you must write down a set of 12 to 24 randomly generated words - this set of words is known as a ‘recovery’, ‘seed’, or ‘mnemonic’ phrase. 

It is your responsibility to keep this seed phrase safe, and that’s why it’s often recommended you keep two copies in separate locations, in case one is lost or stolen. This seed phrase generates the public and private keys to access your cryptocurrency. 

The seed phrase also acts as a backup or recovery mechanism in case you lose access to your original device - you can download the app or software onto a different device and thanks to your seed phrase you will be able to access your crypto.

Anyone with the seed phrase will be able to gain control of the funds held in the connected wallet. That’s why it’s so important to keep your seed phrase secure and not share it with anyone.  

MetaMask is a popular example of a non-custodial software wallet. MetaMask has the capability to securely connect its users to various different blockchains, blockchain-based applications and the wider world of Web3 while also securely storing cryptocurrency and digital assets.

Almost all cold wallets are non-custodial. Popular hardware wallets include Ledger, Trezor and KeepKey. 

These physical crypto wallet devices resemble thumb drives and USB sticks. Because they keep your private keys offline they are regarded as the safest solution for storing cryptocurrency and digital assets. 

Any form of crypto wallet that is online and connected to the internet is arguably less secure than wallets that are offline. 

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Why are Crypto Wallets Important?

The world of crypto is still very new. And both critics and fans sometimes refer to it as the Wild West, due to a lack of regulation, formal processes and the intense volatility of the market.

Unfortunately, as with every innovative new industry, there are downsides to be aware of. And just like the Wild West had cowboys, outlaws and wanted men, in crypto there are bad actors, hacks and rug pulls that can and do occur.

From Sam Bankman-Fried and the FTX collapse, to scam tokens and wallet drainers, unfortunately there are thieves and scammers out there keen to gain access to your hard-earned crypto.

This is why crypto security and cryptocurrency wallets are so important.

You may have heard the phrase - “Not your keys, not your coins” - this refers to the fact that you need to own the private keys associated with your funds in order to truly keep them safe. 

It also emphasizes the significance of responsibility. Generally speaking, the more responsibility you take for your crypto, the safer you can make it. Keeping the majority of your funds in secure hot and cold wallets is a crucial precaution to take.

If you’re trading cryptocurrencies like Bitcoin, Ethereum and other altcoins on a regular basis, try to only keep the amounts of crypto on exchanges that you need for trading.

If you’re investing and holding - or HODLING - your crypto funds, that’s when your cold and hot wallets come into use. Choose carefully between opting for a hardware or software wallet, and make sure your choice serves your operational needs as well as security. 

And if you have significant amounts of crypto, it can be beneficial to split them across several hardware or software wallets, to further spread risk.

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Hot and Cold Wallet Risk Management

Your wallet safety is crucial, as crypto is a frequent high-value target for hackers. It’s best to employ several safeguards including:

1. Encrypting the wallet with a strong password.
2. Using two-factor authentication for exchanges.
3. Keeping crypto in a few different wallets.
4. And storing any large amounts of crypto offline.

Hot wallets, AKA software wallets are online and connected to the internet, providing easy access for quick transactions but at a potential security risk. 

Alternatively, cold wallets AKA hardware wallets are offline storage solutions, making them more secure but less convenient for frequent trading and investing. 

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Cryptocurrency Wallets - The Window into Web3

As we’ve learnt, different types of cryptocurrency wallet help keep your digital assets safe in various ways.

Both hot wallets and cold wallets are crucial to secure your cryptocurrencies. Also known as software and hardware wallets, they both serve different purposes depending on:

• The user’s goals.
• Reasons for use.
• Level of experience.
• Amount of crypto.

Hot or cold wallets are used to secure users’ private keys, rather than the crypto itself, which exists on the blockchain. Each has different methods and significant security implications. It’s vital to understand the key areas of differentiation:

A hot wallet is a piece of software you install on your laptop, smartphone or tablet to store your private keys, which then allow you to access your cryptocurrencies.

A cold wallet is a type of crypto wallet that never interacts with any smart contracts and is rarely connected to the internet.

Cryptocurrency wallets also serve as a window into the wider world of Web3. As well as control your own private keys for safe access to your crypto, hot wallets allow you to: 

• Manage all your digital assets in a secure place.
• Send and receive cryptocurrency to and from anywhere in the world.
• Browse decentralized finance applications or dApps.
• Shop at stores that accept crypto as payment.

As crypto wallets develop they offer more functionality, including DeFi services like crypto staking, airdrop hunting and yield farming. 

However, there is a lot of debate in the crypto space about how the overall user experience needs to improve, in order to make crypto and the broader world of Web3 more accessible to the less tech-savvy users. 

A considerable part of this includes the design, user interface and capabilities of cryptocurrency hot wallets. Because these wallets act as a primary portal between people and digital assets, they dictate how people interact with crypto and Web3 and are a key barrier to onboarding new users. 

Many in the community feel moving away from long, hexadecimal ‘public key’ wallet addresses, and towards user names will simplify the experience and help improve mass adoption of crypto and decentralized finance.

But we will have to wait and see what innovations come and how the industry develops. 

Check out our other educational blog content on the world of blockchain and cryptocurrencies!