What is a cold wallet?

Fact-checked by Eric Rose (Head of Digital Asset Execution)

A cold wallet, also known as offline storage or cold storage, is a type of cryptocurrency wallet that remains disconnected from the internet, giving users or institutions full control over their private keys. This separation from online networks makes cold wallets one of the most secure ways to store digital assets.

Cold wallets are used to store private keys – secret codes that prove ownership of cryptocurrency – in an offline environment. To do this, private keys are transferred from a device with internet access to one that is permanently offline. By keeping these keys offline, cold crypto wallets mitigate the risk of hacking, theft, or unauthorized access.

There are various types of cold wallets that offer varying levels of security. For businesses and financial institutions, cold wallets offer a secure way to hold digital assets in the long term and form a core part of crypto custody solutions.

Types of cold wallets

Different types of cold storage include:

• Hardware wallets
• Offline software wallets
• Paper wallets
• Metal wallets, and
• Sound wallets.

Each of these cold wallets offers unique features and benefits.

Hardware wallets

Hardware wallets are physical devices specifically designed to store cryptocurrency private keys offline. They are one of the most popular cold storage options.

Hardware wallets connect to a computer or smartphone via USB or Bluetooth and are paired with a companion app to facilitate blockchain transactions. Through these apps, users can sign transactions which are then transmitted to the blockchain without exposing the private keys to any online threats. Some hardware wallets support multi-sig, which can further enhance security for business use-cases.

For added security, many modern hardware wallets are equipped with cameras that scan QR codes, further reducing the risk of data compromise when connecting to a computer. This feature ensures that private keys remain secure even when using the device with a USB connection.

Many hardware wallets also include a built-in screen and buttons that allow users to confirm transactions directly through the device. This ensures private keys never leave the protected hardware environment, providing an extra layer of security.

One of the main benefits of hardware wallets is that they can protect private keys from loss or physical damage. During setup, the device generates a recovery (seed) phrase that can be used to restore access to an account on a new hardware wallet if the original is lost or damaged. These wallets also incorporate PIN codes and advanced encryption chips to protect against unauthorized access or hacking attempts.

Offline software wallets

Offline software wallets, sometimes called air-gapped wallets, are software programs installed on computers that are never connected to the internet. They can be thought of as a DIY approach to hardware wallets, requiring more technical expertise to set up and use securely. For that reason, they’re only recommended for advanced users.

Sending cryptocurrency from an offline wallet involves:

1. Creating an unsigned transaction on an online computer
2. Transferring the transaction to the offline computer via QR code or USB
3. Using the offline wallet to sign the transaction
4. Moving the signed transaction back to the online computer via USB or QR code
5. Broadcasting the transaction to the blockchain.

This method, while secure, can be time-consuming and impractical for frequent transactions.

Paper wallets

Paper wallets are one of the simplest methods of storing cryptocurrency offline. These involve holding a physical document containing the private key written either in text form or printed as a QR code.

To create a paper wallet, the private key is generated offline (through a hardware wallet or a computer with no internet connection) and written on the paper.

Paper wallets come with certain risks:

• They are highly susceptible to physical damage, theft or loss.
• Unlike hardware wallets, paper wallets lack recovery options. If the paper is destroyed, access to the funds is permanently lost.
• Using a paper wallet to send cryptocurrency typically requires importing the private key into a software wallet, which temporarily exposes it to online risks.

Because of the above limitations, paper wallets are generally considered an outdated form of cold storage. Many modern wallet generators no longer recommend paper wallets due to the ease of making mistakes.

Metal wallets

Metal wallets, also known as metal backups, are a more enhanced version of paper wallets. This form of cold storage involves engraving a private key or seed phrase on a metal plate or assembling pre-engraved components to form the backup. Compared to paper wallets, metal wallets provide additional durability that’s resistant to fire, water, and general wear and tear.

Commercial metal wallets range from stamped steel plates to individual metal tiles that can be arranged to form the key. Like paper wallets, the private key or seed phrase should be generated in an offline environment to maintain security.

Note that metal wallets are often just a seed phrase backup rather than a standalone wallet that signs transactions. In other words, they are used to store recovery information and don’t actually connect to the blockchain.

Sound wallets

Sound wallets are a less common form of cold storage. These involve encoding private keys as sound files which are then stored on USBs, CDs, or vinyl records. The idea is to create a storage method that’s less likely to be recognized as holding valuable information.

Creating a sound wallet involves using specialized software to convert the private key into an audio file. To retrieve the key, the file needs to be decoded using advanced tools like spectroscopes.

This method is innovative but also has limitations, including the risk of physical damage, potential audio degradation over time, and the need for specialized equipment to access the keys. Sound wallets also don’t offer any significant advantage compared to more conventional options like hardware or metal wallets.

How does a cold wallet differ from hot wallets in crypto security?

The key difference between cold wallets and hot wallets is that hot wallets are connected to the internet. While this makes them convenient for frequent transactions, it also exposes them to cyber threats.

Hot wallets

Hot wallets store private keys on devices or servers connected to the internet. Examples include mobile apps, browser extensions, and exchange wallets. Exchange wallets are typically custodial, meaning a user relies on the exchange’s security measures to protect their private keys. Others, such as mobile or desktop apps, are non-custodial.

Because hot wallets are connected to the internet, they make transactions quick and easy. However, the online connection also makes them more vulnerable to hacking, phishing, and malware.

Cold wallets

Cold wallets, on the other hand, store private keys in isolated offline environments like hardware devices, metal wallets, or air-gapped computers. Since they’re not connected to the internet, cold wallets are virtually immune to online attacks, making them suitable for storing large amounts of cryptocurrency over the long term.

However, using a cold wallet requires extra steps to complete a transaction, such as connecting the device or importing the private key, which makes them less convenient for day-to-day use. While they’re still capable of conducting quick transactions, they require additional steps compared to hot wallets.

Why do businesses use cold wallets for digital asset protection?

Cold wallets provide businesses and digital assets custody providers with a secure and long-term storage solution for digital assets.

For businesses handling cryptocurrencies, keeping their digital assets secure is a top priority. Because cold wallets store private keys offline and away from internet-connected devices, they help reduce the risk of hacking. Unlike hot wallets, which can be vulnerable to malware, phishing, or other cyberattacks, cold wallets protect a business’s digital assets from online threats.

Additionally, many cold wallets include security features like PIN codes, encryption, and specialized chips designed to safeguard sensitive data. These security measures provide businesses with an added layer of protection to keep private keys secure. Many financial institutions use cold storage to meet regulatory requirements for safeguarding client assets.

Cold wallets are also ideal for businesses planning to hold digital assets for the long term. They are designed for extended storage and can protect assets from online risks as well as physical damage. For example, hardware wallets can withstand years of use while metal wallets resist extreme conditions like fire or water damage.

This durability makes cold wallets a suitable option for businesses looking to safeguard their cryptocurrency holdings over the long term.

What are the risks of using a cold wallet for digital assets?

While cold wallets provide a secure way to store digital assets, they also come with certain risks and limitations.

One of the main drawbacks of cold storage is that accessing funds requires manual steps. Unlike hot wallets, which allow online transactions to be executed quickly, cold wallets require private keys to first be retrieved from offline storage. This can be inconvenient when making frequent trades.

Depending on the type of cold wallet used, there’s also a risk of physical damage, loss, or theft. For example, hardware wallets can be damaged by water and fire or lost if not securely stored. Paper wallets are even more fragile and can easily be destroyed. If the recovery seed phrase is lost or not stored properly, a business may lose access to their funds permanently.

Setting up a cold wallet can also be complicated compared to hot wallets. The process involves several steps that, if not properly followed, could compromise the security of the wallet. If the seed phrase is generated in a compromised environment, cold storage loses its benefits.

Cold wallet vs. hot wallets: which is better for financial institutions?

For financial institutions, the choice between hot and cold wallets depends on their security requirements and transaction frequency.

Hot wallets, which are connected to the internet, provide more convenience and accessibility, making them ideal for frequent trades. They allow financial institutions to quickly store, send, and receive tokens from anywhere. However, the constant online presence of hot wallets makes them more vulnerable to cyberattacks and increases the risk of unauthorized access.

On the other hand, cold wallets provide a higher level of security. Since they’re offline, they’re much less susceptible to online threats and attacks. This makes them a potentially safer option for long-term storage or holding large amounts of digital assets. However, they require manual intervention to access, making them less convenient for regular transactions.

Large entities often employ a layered approach, using hot wallets for operational liquidity and cold wallets for long-term storage.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.