Comprehensive Analysis of Cryptocurrency Wallets

Forwarded original title: Complete analysis of cryptocurrency wallets》Principles of hot and cold wallets, custody differences, and the advantages and disadvantages of multi-signatures

What is a Cold Wallet?

A cold wallet (also known as an offline wallet) typically relies on unconnected computers, mobile devices, or specialized products from manufacturers. It uses a physical method to store private keys offline, and only authorizes transactions when needed to reduce the risk of private key theft by hackers.

Due to its complex operations, it is often used by long-term HODLers or users who focus on asset security. However, it is important to note that if your mnemonic phrase is leaked, or if you authorize a malicious contract, your wallet assets may still be lost. Therefore, operational security must still be maintained.

Compared to the advantages of hot wallets

Wallets held by users on exchanges (usually hot wallets) are convenient for transactions, but in terms of security, because users do not own the private keys but authorize the exchange to hold them.

If the exchange is unfortunately hacked or manipulated internally, the assets in the account may be lost entirely, as previously rumored with the FTX exchange, where a large amount of user assets were transferred without authorization. Additionally, most cryptocurrency exchanges do not provide traditional institutional SIPC financial insurance, although some platforms offer insurance funds when hacked, but users still need to be very cautious about the risk.

Disadvantages of Cold Wallets

Less convenient

However, cold wallets are not without flaws; their setup and transaction processes are relatively complex. Each use requires connecting to other devices and takes additional time, which is inconvenient for frequent traders.

High hardware costs

Common cold wallets on the market today are often priced between $100 to $200, compared to free hot wallets, which have a higher initial cost. It is also essential to ensure that the cold wallet vendor is trustworthy, as purchasing a second-hand or maliciously modified product could potentially expose your private keys.

Physical damage risk

Cold wallets may also face physical security risks (such as computer loss, damage, etc.), therefore, they need to be properly stored.

What is a Hot Wallet?

A hot wallet, as the name implies, is the opposite of a cold wallet; it is an online wallet that can be stored on a mobile phone, computer, or website. Unlike cold wallets, which require purchasing and setup costs often exceeding thousands of dollars, hot wallets are characterized by their convenience and ease of access because all operations are centralized on the internet. This eliminates the need for cumbersome connections of cold wallet mediums to the internet for every transaction. Due to their high usability, hot wallets are particularly popular among general investors.

Drawbacks of Hot Wallets

However, hot wallets operate online, creating wallet addresses and private keys in a connected state. This exposure of private keys on the maliciously fraught internet means that users must constantly guard against hacker attacks and phishing risks.

Hot wallets can be further divided into two types: “browser extension wallets” and “mobile app wallets.” Among browser extension wallets, the Ethereum wallet MetaMask is very popular. The most popular wallet services on mobile phones include imToken, Trust, and Cipher, among others. Mobile wallets, with their straightforward interface design, are particularly suitable for beginners.

Custodial Wallets vs. Non-Custodial Wallets

Custodial wallets are managed by a third party. In these wallets, the third-party platform can manage the assets inside a user’s wallet, meaning the ultimate control over the assets remains with the third party rather than the user. Common centralized exchanges set up such accounts as custodial wallets.

Non-custodial wallets, on the other hand, allow users to fully control their private keys and assets. In these wallets, users can directly manage and protect their private keys without relying on any intermediary or third-party service. Common non-custodial wallets include MetaMask and Trust Wallet.

Advantages and Disadvantages of Custodial Wallets

The main advantage of custodial wallets is their convenience. If users find the process of buying and selling cryptocurrencies complex, third parties offering custodial wallets usually provide platforms for trading cryptocurrencies, allowing users to directly buy and sell them.

However, the disadvantages of custodial wallets are particularly evident. Firstly, the third party holds the user’s private keys and assets, which could pose the risk of the third party absconding with these assets. Therefore, choosing a reliable third party is crucial. Additionally, third parties often require users to undergo identity verification (KYC) to register for a custodial wallet, which may raise concerns about privacy breaches for some people.

Advantages and Disadvantages of Non-Custodial Wallets

The advantages of non-custodial wallets address the shortcomings of custodial wallets:

Complete Control: Users have control over their private keys and assets, avoiding the centralized risks associated with custodial wallets.

Privacy: Users do not need to disclose excessive personal information to a third party.

Flexibility: Users can interact with various blockchains and decentralized applications (DApps).

The disadvantages of non-custodial wallets include operational complexity and security risks. Compared to the convenience of custodial wallets, the transaction process in non-custodial wallets appears much more complex.

In terms of security risks, users must safeguard their wallet’s private keys themselves. If the private key is compromised, the assets in the wallet are highly susceptible to theft. Lastly, when interacting with DApps using non-custodial wallets, users need to be cautious about whether the websites are malicious and whether the smart contracts they are signing are malevolent. These are security risks that users must be aware of themselves.

What is a multi-signature wallet?

Although cold wallets are secure, they rely on users not losing them. This may not be user-friendly for beginners or those prone to errors. Ethereum co-founder Vitalik Buterin also expressed earlier, “Compared to hardware wallets or paper records, I prefer social recovery and multi-signature wallets.”

As the name suggests, multi-signature allows multiple users to jointly perform digital signatures to control wallet assets. For example, imagine a safe with two locks and two keys. One key is held by person A, and the other is managed by person B. The only way to open this safe is if both individuals provide their keys simultaneously; it cannot be opened with just one key.

Comparison of Single-signature and Multi-signature Wallets

Typically, our cryptocurrency assets are stored in standard single-key addresses, meaning that anyone with the corresponding private key can control the funds at that address. While this is more convenient for management than multi-signature, it poses a greater security risk. For instance, we often hear about criminals obtaining user private keys through phishing sites or contract vulnerabilities.

At this point, multi-signature wallets offer a solution by allowing multiple people to jointly manage an address. Funds can only be moved with the agreement of more than half of the managers, reducing the risk of asset theft.

Advantages and Appropriate Scenarios for Multi-signature Wallets

Increasing Security with Multisignature Wallets

Utilizing multisignature wallets, users can significantly mitigate the security issues caused by the loss or theft of private keys. This is because even if one of the private keys is compromised, the funds remain secure.

For instance, if Andy sets up a 2/3 multisignature wallet and stores each private key on different devices (such as a mobile phone, laptop, and desktop computer), even if a thief obtains the private key from his phone, they cannot steal the wallet’s funds using that single key alone. Furthermore, if Andy loses one of the private keys without malicious interference, he can still access his wallet using the other two keys.

It is worth mentioning that a 2/3 multisignature wallet requires at least two of the three private keys to access the wallet. Similarly, a 3/5 wallet requires at least three of the five private keys.

Facilitating Corporate Arbitration

Creating a 2/3 multisignature wallet can allow two parties to manage transactions through a third-party arbitrator, serving as a mutually trusted mediator to prevent trust issues. For example, if A deposits payment into the wallet and B provides the agreed products or services, they can both use their respective private keys to sign off and complete the transaction.

However, in case of a dispute, the arbitrator C can intervene and, based on his judgment, provide his signature to the correct party (A or B) to successfully move the funds.

Corporate Decision Making

Company boards can use this method to more securely control corporate funds. For example, by setting up a 3/5 multisignature wallet, each board member would have their own private key. In this scenario, no single board member can misuse the funds; access to the funds requires the agreement of a majority of the board members.

Multi-factor Authentication Prevents Erroneous Transactions

In traditional bank transfers, if an account number is entered incorrectly or other oversights occur, the funds are returned to the original address. However, transactions on the blockchain are irreversible. Once cryptocurrency is sent to the wrong address, the asset may be lost forever or require significant time and money to be retrieved through exchanges.

Thus, when a user initiates a transaction, other private key holders can prevent the erroneous transaction by refusing to sign it if they spot a mistake. The more people involved in the signing verification process, the lower the likelihood of an erroneous transaction.

Disadvantages of Multi-signature Wallets

Despite the solutions multi-signature wallets offer for the issues above, they still have risks and limitations due to real-world complexities and human nature.

Risk of Private Key Loss

Using this technology, especially with a 2/2 multi-signature wallet, if one of the private keys is lost, access to the funds is also lost. Therefore, it’s strongly recommended to use at least a 2/3 setting or higher for greater security.

Also, when considering where to store private keys, it’s best to consider diversifying the risk. For example, if all private keys are stored in one room and a fire or other accident occurs, you may permanently lose the ability to operate the wallet.

Decreased Operational Convenience

Due to the increased process of multi-signature verification, the convenience of multi-signature wallets is significantly reduced compared to single-signature wallets. If there’s an urgent transaction or frequent daily transactions that require the consent of a majority of private key holders, the time taken to complete transactions could be considerably extended.

Therefore, the main users of multi-signature wallets are still institutions with large amounts of funds under joint management. Compared to the broader individual user base, the adoption rate is relatively narrow.

Risk of Malicious Human Operation

Although having multiple people hold private keys can reduce the risk of illegal operations, if malicious individuals obtain more than half of the private keys, you cannot stop them from operating the wallet. However, this involves complex social dynamics, and it’s a reminder that no matter the security technology, risks still exist.

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1. This article is reproduced from [blocktempo], the original title is “Complete Analysis of Cryptocurrency Wallets” Principles of Hot and Cold Wallets, Differences in Custody, Advantages and Disadvantages of Multi-Signature”, the copyright belongs to the original author [Dieter], if you have any objection to the reprint, please contact Gate Learn Team, the team will handle it as soon as possible according to relevant procedures.

2. Disclaimer: The views and opinions expressed in this article represent only the author’s personal views and do not constitute any investment advice.

3. Other language versions of the article are translated by the Gate Learn team, not mentioned in Gate.io, the translated article may not be reproduced, distributed or plagiarized.