Hot wallets connect directly to the internet, which makes transactions faster, but also means hackers at least theoretically have openings for attack.
To prevent this, providers and users can each take actions to further secure their hot wallets. For instance, users can prevent a single point of failure by splitting up the keys to their wallet, storing them in different locations, and requiring multiple keys to sign any given transaction.
In that scenario, even if a hacker was able to compromise one key, it might not be enough for them to do any actual harm.
Moreover, depending on the provider, users can add policies and permissions to their account, limiting who can move funds, how frequently, how much per day, which addresses can receive them, etc. Those kind of controls can limit the amount of damage a bad actor – whether internal or external – can do to your balance sheet.
Hot wallets also tend to be very useful for retail aggregators and platforms, since their customers make frequent transactions. These companies will often keep some portion of their funds in hot wallets for liquidity and the rest in cold storage for safekeeping and periodic rebalancing.
Best for: Preserving speed and liquidity of funds.
Cold wallets are kept separate from the internet, meaning hackers have no clear way to get to them.
That said, storing assets in this manner slows down transaction times, since keys have to be handled offline and used on “air-gapped” devices (ie, not connected to the internet) to sign transactions securely.
Best for: Achieving maximum security.
For digital assets, the definition of “custody” has become increasingly stretched. Today, many providers claim to offer custody, but really just give users a way to store digital assets on their own.
This differs from the more classic definition of a custodian. In the traditional finance world, that term generally refers to an entity that holds the assets on your behalf and protects them against loss, theft, or misuse.
By contrast, the term “custody” tends to get thrown around more loosely in crypto. Many digital asset “custodians” actually just offer hot wallets, meaning they’re providing you a way to hold assets yourself through a software solution.
Regardless of how one prefers to define a “custodian” in general, a “qualified custodian” comes with a much sharper, more specific definition – one crafted by regulators.
In simple terms, a qualified custodian holds clients’ funds in a segregated manner and meets rigorous regulatory standards aimed at protecting client funds from loss, theft, or misuse. It applies only to specific types of regulated entities, like state trusts, which operate with a fiduciary duty to their clients.
These aspects of qualified custody especially matter for digital assets. Many investors know the saying, “Not your keys, not your crypto” – a concept that presents an investor with two choices:
Hold the keys yourself, but take responsibility for your own security
Hold your keys with a custodian, and trust that they will act appropriately on your behalf
This is why working with a qualified custodian – rather than a mere “custodian” – matters. You need to be able to trust your custodian, and a qualified custodian has a fiduciary responsibility to look out for your best interests.
The measures a qualified custodian can offer – cold storage, proven security technology, redundant human processes, segregated accounts, backup keys, insurance against loss or theft, fiduciary responsibility, etc. – only become more important as your holdings grow.
Generally speaking, you can divide wallets up according to two dimensions: who holds the keys and where are those keys created and stored?
Visually, the matrix looks like this:
This gives us three main wallet types, with self-managed hot wallets and custodian-managed cold wallets being the most popular with institutional investors and retail platforms.
For simplicity, BitGo uses the following terms to describe these wallets on this site and beyond:
The number of keys
If one chooses to store their keys with a custodian, they need to understand how those keys get stored – especially since different custodians take different approaches, and they’re not all equally effective.
First, a user needs to know how many keys will exist for their wallet. If only one, they face a potential single point of failure. If that key is lost, stolen, etc, they could be permanently locked out of their wallet and lose access to their funds.
Many of the hacks in the crypto world have penetrated either: A) hot wallets protected by only a single key or B) hot wallets that had multiple keys, but were kept in the same place.
By contrast, users need to focus on reducing this single point of failure. It’s much safer to use wallets that come with multiple keys, then store them in different places (eg, you hold onto Key X, your custodian holds onto Key Y, etc).
That means a potential attacker would have to compromise multiple locations instead of just one in order to gain control over your wallet.
Signing a transaction
Second, a user needs to understand how many keys are needed to sign a transaction – ie, to move funds on the blockchain.
In a “2-of-2” setup, for instance, two keys exist and a user would need access to both of them to sign anything. Unfortunately, that means the loss of either key could be devastating. It might prevent an attacker from accessing your funds – but it would also prevent you from accessing them, too. Even misplacing one of the keys could be disastrous.
A “2-of-3” setup, meanwhile, provides a backup key that can prove essential in business continuity and disaster recovery situations.
If an attacker compromises one key, for example, they won’t be able to access your wallet (since they need two keys and only have one) – but it also doesn’t lock you out, since there are still two uncompromised keys remaining.
The same logic applies to the scenario where a key gets lost instead of outright stolen. If that occurs, you’ll likewise retain enough keys to move your funds to safety.
Remember, too, that some providers will let you add policies and permissions to your account (like view-only access, velocity controls, whitelisted addresses, etc). That means – even if someone assembles enough keys in the first place – they may still get prevented from moving funds, or only allowed to do so only in a limited fashion. That gives you an extra layer of protection.
Third, users should understand whether they can access a key recovery service. Imagine a hot wallet where the user controls two of the three keys. To increase their security, they should store them in different places (so one hack doesn’t wipe out two keys at once), as discussed.
To do this, some users choose to work with an independent Key Recovery Service, which protects the backup key in an offline location.
In this hypothetical setup, all three keys live in different places: one with the user, one with the custodian, and one with the Key Recovery Service.
Users also need to understand the underlying technology that protects their keys, wherever those keys might live. Two of the better known solutions on the market are Multi-Signature (Multi-Sig) and Multi-Party Computation (MPC), each of which can be applied to hot and cold wallets alike.
With Multi-Sig, each wallet comes with multiple keys and – most commonly – requires two of them to sign any transaction (ie, a 2-of-3 setup). By preventing single points of failure, it offers the best protection against loss or theft. Multi-sig wallets have an outstanding track record of safety.
They also provide greater accountability. Because Multi-sig wallets produce multiple signatures on the blockchain, one can tell exactly which keys were used. That transparency can come in handy if there’s confusion about who signed a transaction. For instance, if a custodian tried to combine their key and the backup key to move funds without client permission, that would be easy to identify and prove.
Because Multi-sig wallets typically come with backup keys, too, they offer an advantage in disaster recovery. The loss or theft of one key doesn’t have to be catastrophic.
Multi-sig wallets require greater engineering time and expertise to build, however. Hence, many providers don’t offer them simply because they lack the resources to do so.
MPC wallets have become popular with providers since they can be spun up with less development work. Instead of using multiple keys, they rely on a single key, which then gets split up into multiple “key shares.” The idea is to mimic Multi-sig without as much effort.
There are, however, downsides to this approach. With only a single signature on the blockchain, MPC-powered transactions lose something in terms of accountability and transparency since you can’t tell which key shares were used to sign a given transaction.
Also, some MPC providers don’t include backup keys for their wallets, and there have been cases where funds have been irretrievably locked when one of the key shares got lost.
This drive for speed by some providers has led them to cut other corners, as well (though, in fairness, this derives less from MPC technology itself and more the way it’s been implemented).
Many MPC providers only offer hot wallets, which work better for some use cases than others and come with a distinct set of risks compared to cold, custodial wallets.
Many have also opted to reuse existing technology from the financial services world to sign their crypto transactions, instead of relying on tools purpose-built for crypto’s unique features and needs.
Finally, some MPC providers don’t open-source their cryptography. That process of battle-testing can be lengthy and difficult. Instead, they effectively ask customers to “take their word” that there are no vulnerabilities lurking undetected in their software.
TSS is a form of MPC that solves issues with other implementations on the market, while speeding up development time and lowering gas fees in the process.
For certain blockchains, Multi-sig can be particularly time-consuming to build upon. And while it does provide excellent security, the fact that each transaction contains more underlying data means blockchain fees (eg, ETH gas fees) can be somewhat higher.
TSS helps fix this without the drawbacks one sees in other MPC solutions. Specifically, TSS comes with a system of ledgers and audits to improve accountability, includes backup keys, works for cold storage, relies upon purpose-built technology, and has been battle-tested.
Choosing a wallet isn’t an “either/or” proposition. Many investors will hold both hot and cold wallets, and divide their funds between the two as desired.
For instance, a common setup is to keep a percentage of one’s holdings in a hot wallet for easy liquidity and the bulk in cold storage for safe-keeping, rebalancing between the two as needed.
Some advanced users will also incorporate self-managed cold wallets into their setup, too, adding in even further diversification and/or to satisfy certain regulatory requirements.
BitGo offers all three of the wallet types mentioned above: hot, custodial, and self-managed cold. These are powered by either Multi-sig or TSS technology (depending on the blockchain) and all come with backup keys.
BitGo also offers qualified custody (our custodial wallets) through our regulated trust entities.
By contrast, many other providers offer either hot or custodial wallets – but not both. For those that do offer true custodial, cold storage, they may or may not be qualified custodians.
Then, of course, one needs to weigh the underlying technology, available policies and permissions, company track records, and pricing into the decision – not to mention the options the custodian offers for you to deploy your funds and put them to work (ie, trading, borrowing and lending, staking, DeFi, etc).
To learn more about BitGo’s wallet and custody solutions, please click below to schedule time with our team.