If you are to achieve true financial self-sovereignty, it is critical to understand how to properly secure your bitcoin.
The first concept to understand is a so-called “wallet”, which enables you to store, send and receive bitcoin. Another way to think about it is as digital wallet or bank account for your bitcoin.
Technically speaking, and to be more accurate, wallets are software that store public and private keys which enable you to manage your bitcoin.
Different Types of Wallets
When it comes to wallets, there are two main kinds:
- hot wallets; and
- cold wallets.
The difference, quite simply, is that hot wallets are connected to the internet and cold wallets are not. This has important security implications, discussed further below.
Homing in on hot wallets, they can be further categorised between:
In both cases, these are applications that sit on either your desktop or mobile device and are therefore “hot” in the sense that they are connected to the internet.
Another critical distinction to be made is between:
- non-custodial wallets – only the wallet’s owner holds the private keys and access to the funds; and
- custodial wallets – hold the private keys on behalf of the wallet’s owner, which makes them less secure as users need to trust the wallet provider.
Cold wallets are all non-custodial because the owner holds the private keys required to access the bitcoin. By contrast, hot wallets can be either custodial or non-custodial.
When to Choose a Hot Wallet or Cold Wallet
Hot wallets tend to be the most frequently used by beginners because they are simple to use and easy to set up. These days, they have intuitive user interfaces meaning that ordinary users don’t need to be technical.
Hot wallets are most often employed by users who spend their bitcoin frequently or have small amounts for periodic purchases. Since they are connected to the internet, hot wallets are inherently less secure and prone to cyber attacks in which your bitcoin could be stolen.
Best practice therefore suggests that you shouldn’t have much bitcoin stored in a hot wallet, beyond your immediate needs.
Remember: “Not your keys, not your coins”. This means that if your bitcoin is sitting on an exchange, it is technically an “IOU” since it is a custodial wallet. If the exchange goes down, your bitcoin will in all probability disappear too.
Cold wallets, which aren’t connected to the internet, are by contrast more secure since they are far less prone to hacks and cyber attacks, as you are only online when conducting transactions.
If you are building up your bitcoin stack, best practice is therefore for the vast majority to be stored in a cold wallet for long-term investment. This is “cold storage” as Bitcoiners tend to refer to it.
Most cold wallets are hardware wallets which typically resemble a USB device. This stores the wallet’s private keys, making them de facto unreachable to hackers or other malicious parties. There are various manufacturers, some of which use open source software, as opposed to proprietary software. Ledger is an example of the latter, whereas ColdCard is an example of the former.
While cold wallets provide a superior storage solution in terms of security, the main drawback is that they are impractical for everyday usage as it is more cumbersome to send bitcoin from a cold wallet.