Imagine that two people use Bitcoin.
One manages their funds from an app installed on their phone... The other uses a system that keeps their private keys isolated from the device they use to access the Internet.
Both can receive BTC, check their balances, and authorize transfers.
BUT THERE IS A FUNDAMENTAL DIFFERENCE IN HOW THEY PROTECT THEIR PRIVATE KEYS.
To understand it, we need to know two concepts: HOT WALLET AND COLD WALLET.
WHAT IS A HOT WALLET?
A hot wallet is one that manages the keys needed to sign transactions in an environment connected to the Internet or one that can regularly connect to it.
Let's imagine Ana uses a self-custody app on her phone.
When she wants to send bitcoins, the app can prepare the transaction and generate the digital signature using the keys it manages on that same device.
It's a practical system for frequent transactions.
But there's something important...
THE DEVICE THAT USES THE INTERNET ALSO HAS ACCESS TO THE CRYPTOGRAPHIC MATERIAL NEEDED TO SIGN.
So, if an attacker manages to sufficiently compromise the phone or the app, they could obtain the keys or trigger unauthorized transactions...
This doesn't mean that any infection will allow someone to steal bitcoins, but it does mean there's an exposure surface we need to consider.
SO WHAT IS A COLD WALLET?
A cold wallet uses a system that keeps private keys isolated from the environment connected to the Internet.
And pay attention, because this is one of the most important differences.
IT DOESN'T SIMPLY MEAN HAVING AN APP THAT'S DISCONNECTED.
The goal is to prevent private keys from being exposed to systems that communicate with the Internet...
Let's see how it works.
Let's imagine Ana uses a connected computer to check her bitcoins.
But her private keys are protected on another device, designed to perform signing operations.
The computer can check balances and prepare transactions.
However, IT DOESN'T HAVE THE PRIVATE KEYS TO SIGN THEM.
AND HOW DOES IT RECEIVE BITCOINS IF THE DEVICE THAT PROTECTS THE KEYS IS TURNED OFF?
Very simple... Ana gives Bruno a receiving address.
Bruno sends 2 BTC to that address.
The transaction is broadcast to Bitcoin and can be confirmed even if Ana's device remains turned off.
Why? Because receiving bitcoins doesn't require using the private key.
THE BTC ARE NOT TRANSFERRED INTO THE DEVICE. THE TRANSACTION IS RECORDED ON BITCOIN.
BUT NOW FOR THE INTERESTING PART... WHAT HAPPENS WHEN ANA WANTS TO SPEND THOSE BTC?
The connected computer prepares the transfer information... But it can't authorize it on its own because it doesn't have the private keys.
Then it needs to send the details of that transaction to the device that can sign it.
And how are they sent?.. It depends on the system being used.
Some allow information to be exchanged using QR codes or memory cards, without physically connecting the signing device to the computer... Others use a USB connection.
BUT IF WE CONNECT IT VIA USB, DOESN'T IT STOP BEING A COLD WALLET?
Not necessarily.
CONNECTING TO A COMPUTER IS NOT THE SAME AS HANDING OVER THE PRIVATE KEYS.
In a hardware wallet designed to isolate the keys, the computer sends the information needed to sign... The device verifies and signs the transaction internally.
Then it returns the digital signature.
THE PRIVATE KEY REMAINS INSIDE THE DEVICE.
The computer receives the information needed to transmit the signed transaction to Bitcoin, but it does not receive the secret used to authorize it.
This allows the device to communicate physically with a connected computer without needing direct Internet access to sign.
However, that connection is not risk-free either. Security depends on the device's design, its software, and the verification of the transaction.
Later, we'll learn specifically how these tools work.
SO DO ALL COLD WALLETS NEED TO CONNECT AT SOME POINT?.. No.
There are systems completely isolated from networks, known as air-gapped, that exchange the information needed to sign without establishing a network connection or a direct link to the connected computer.
Others use specialized devices that communicate by cable but keep their private keys protected.
That's why we shouldn't confuse two things:
ONE THING IS HOW THE DEVICES COMMUNICATE. ANOTHER IS WHETHER THE PRIVATE KEYS ARE EXPOSED TO THE CONNECTED ENVIRONMENT...
DOES THAT MEAN A COLD WALLET IS IMPOSSIBLE TO COMPROMISE? No...
Cold storage reduces certain risks, especially those related to exposing private keys.
But it doesn't eliminate all dangers... A user could reveal their secret recovery information, use a tampered device, or sign a transaction without properly verifying its destination.
PROTECTING A PRIVATE KEY DOES NOT GUARANTEE THAT EVERY TRANSACTION WE AUTHORIZE IS SAFE.
WHICH ONE SHOULD WE USE?
It depends on our needs.
A hot wallet can be practical for frequent payments and amounts intended for everyday use.
A cold wallet can be a good choice for protecting funds over extended periods.
We can also use both systems.
But remember: HOT AND COLD DO NOT MEAN THE SAME THING AS CUSTODIAL AND SELF-CUSTODY.
A platform can hold its customers' funds in cold storage and still control the private keys.
That difference also deserves its own explanation...
SO... WHAT HAVE WE LEARNED?
A hot wallet uses signing keys in an environment that is connected or usually connected.
And a cold wallet aims to keep those keys isolated from that environment, even when it needs to exchange information to authorize a transaction.
THE DIFFERENCE IS NOT WHETHER WE SEE THE INTERNET ON A SCREEN, OR WHETHER WE USE A USB CABLE. IT'S HOW THE PRIVATE KEYS ARE PROTECTED AND WHAT ENVIRONMENT THEY ARE EXPOSED TO.
But now a question comes up...
HOW EXACTLY DOES A DEVICE SIGN TRANSACTIONS WITHOUT HANDING ITS PRIVATE KEYS OVER TO THE COMPUTER?
That brings us to the next section: WHAT IS A HARDWARE WALLET AND HOW DOES IT PROTECT PRIVATE KEYS?
👽 BECAUSE IT'S NOT ENOUGH TO KNOW WHERE YOUR BITCOINS ARE... THE KEY IS TO UNDERSTAND HOW THE SECRET THAT ALLOWS YOU TO SPEND THEM IS PROTECTED...