Protecting digital wallets: Risks and security measures

What is a digital wallet

In the digital age, digital wallets are becoming increasingly popular, but there are risks associated with their use. In this article, we will discuss the risks associated with hot and cold wallets. A digital wallet is an online payment tool or software application that serves as an electronic version of a physical wallet. Also known as an electronic wallet, e-wallet or mobile wallet, it allows users to securely store digital versions of their payment methods - credit and debit cards, gift cards, cryptocurrencies, etc.

With regard to cryptocurrencies, their holders use digital wallets, which can vary in design and operation, with implications for security and risk. In this case, proof of ownership of the cryptocurrencies is based on knowledge of the private key stored in the wallet. If a wallet (and, therefore, a private key) is lost, then the cryptocurrencies "stored" in it are unrecoverable.

Cold wallet or hot wallet

There are two types of digital wallets - "cold" and "hot" - which differ in terms of how they are stored and transferred. Hot wallets are connected to the internet, while cold wallets are kept offline. In addition to storing private keys, wallets can also be used to carry out peer-to-peer transactions. Cold wallets can be very simple, such as a piece of paper kept in a safe place or an encrypted file on a USB stick. As a rule, exchanges use cold wallets to store the majority of their assets and keep only a small amount in a hot wallet for short-term transactions. Hot wallets allow for faster transfer of digital assets in peer-to-peer transactions. In reality, there is no significant difference between the technologies used in hot and cold wallets, and a hot wallet can become cold once disconnected from the internet, and vice versa.

Custodial and non-custodial wallets

Digital wallets can be managed by users, or their management can be delegated to a third-party custodian (also known as a "wallet provider"), which is usually an exchange, but may also be another company. When private keys are held by a third-party wallet provider, users no longer retain control over their crypto assets and, although the risk of losing the wallet is reduced, the risk of cyberattacks, data breaches and the freezing of transactions or accounts may increase.

Risks associated with digital wallets

"Hot" or "cold" digital wallets present different risks associated with each type. Hot wallets are vulnerable to cyberattacks and greater operational risks, as users depend on third parties to manage their private keys. In the case of cold wallets, the risk of loss or physical damage is higher, but the cyber risk is eliminated until the user decides to use the wallet.

In entities with storage and transfer functions, protecting and safeguarding funds is particularly important. In the event of the bankruptcy of wallet providers, the risk of client assets being commingled with those of the service provider is high, and users' funds may be exposed. Financial regulations protecting clients' funds in the event of the bankruptcy of wallet providers are necessary to ensure the safety of users' funds.