What is a Hot Wallet?
Once an investor decides to buy or extract a digital currency, he must then determine where and how to store the tokens. Unlike traditional currencies, there are no dedicated banks or traditional physical wallets that can be used to secure cryptocurrency holdings. Cryptocurrency wallets are commonly used tools for storing and protecting these assets, and they come in many different forms and varieties. One of the most popular is the so-called “hot wallet”. At its most basic level, the distinction between a warm wallet and a cold wallet is that hot wallets are connected to the Internet, unlike cold wallets.
Key points to remember
- An active wallet is usually software that allows cryptocurrency users to store, send and receive tokens.
- Hot wallets are linked to public and private keys which help facilitate transactions and act as a security measure.
- Because hot wallets are connected to the Internet, they tend to be a little more vulnerable to hacking and theft than cold storage methods.
Understanding a Hot Wallet
There are different reasons why an investor may want their cryptocurrency holdings to be connected or disconnected from the Internet, and it is therefore not uncommon for cryptocurrency enthusiasts to hold multiple wallets, some hot and some cold.
Probably the biggest advantage of an active wallet is that it can be used to facilitate basic transactions. People who actually want to make purchases with their cryptocurrency assets might choose to use a hot wallet, for example, since the assets in that wallet will be transferable over the Internet. In contrast, warm wallets are slightly more likely than cold storage techniques to face security and hacking issues. This is not to say that a warm wallet is necessarily a dangerous way to store your cryptocurrencies. Rather, it is a comparison between a warm wallet, which can access (and theoretically be accessed by) other parts of the Internet, and a form of cold storage, which is completely removed from the Internet ecosystem.
How a Hot Wallet works
An active wallet is software that allows a cryptocurrency owner to receive and send tokens. Although they are called “wallets”, the name is somewhat misleading: hot wallets do not actually store cryptocurrency like traditional wallets do. They simply help facilitate changes to the transaction records that are stored on the ledger of the decentralized blockchain for the cryptocurrency in question.
For the cryptocurrency user, the two most important pieces of information related to a cryptocurrency wallet are public and private cryptographic keys. Public keys are similar to account usernames: they identify the wallet to allow the user to receive tokens without revealing their identity. Private keys are more like identification numbers in that they allow the user to access the wallet to check balances, initiate transactions, etc. Without one of these keys, the wallet is effectively useless.
Security and warm wallets
What is used to determine the safety and security of a hot wallet? Much depends on the user himself. Elements of an active wallet connected to the Internet are vulnerable to attack because public and private keys are stored online. Savvy cryptocurrency investors will only keep a small portion of their holdings in their hot wallet, perhaps even just what they plan to spend in the near future. The remaining assets are likely to remain in a cold room until needed for specific transactions. In this case, the investor can keep an eye on the overall security, betting that hackers will not break into a hot wallet for a small number of coins or tokens.
Some investors choose to keep their cryptocurrencies in accounts linked to popular exchanges like Bitstamp or Poloniex. These companies, which hold your funds within their own infrastructure, can be seen as hot wallet service providers. This means that if an attacker accesses the Poloniex servers and infiltrates their customer accounts, you risk suffering a loss. Since most of the major digital currency exchanges allow users to transfer between various fiat currencies and cryptocurrencies, it is common for most users to hold a small amount of multiple currencies in their accounts. Again, moderation is the key; maintain a high balance and you risk attracting the attention of pirates or losing a substantial part of your assets in the event of theft.
Other types of hot wallets
There are a variety of hot wallets available, many of which are free to download. Investors should consider all of their options before committing to a particular type of portfolio. Some of them offer different types of user interface experience, and there are wallets specially designed to be used in partnership with particular applications or even with certain cryptocurrencies. It is also useful to research the team behind the development of an active portfolio before downloading and using this service. Developers have different degrees of expertise, different commitments to security and privacy, and different priorities in mind when creating their portfolios. Developers will also adopt different strategies to update their products; it is best to find an active wallet provider who is ready to continue updating their product as the hacking efforts change and adapt. It is also a good idea to make sure that the wallet you decide to use is fully compatible with any digital currency swaps that you also use.
There are also hot software portfolios. These are downloadable applications that are not linked to specific exchanges. You keep control of your private keys, so that the cryptocurrency assets in the active wallet remain under your control. However, your money remains vulnerable to hacking, because a malicious person or group who accesses your computer could theoretically also empty your wallet via the software application.
Some cryptocurrency users prefer to keep their digital assets in a physical “wallet”, most often a device that looks like a USB drive. These are generally not examples of hot wallets; they are only accessible by being connected directly to a computer and do not require an Internet connection for a user to be able to access their cryptocurrency funds.