10 - The different wallets and their risks
Crypto.com recently released a hype commercial starring Matt Damon promoting the digital assets. At the end Matt closes the commercial with an epic quote: “... fortune favors the brave.” Bravery and stupidity are sides of the same coin. The way the coin lands is dependent on how successful a person is. Most of the time, success in any situation is dependent on the person’s understanding of risk. The brave individual has a deeper understanding of risk. They know when to take it and when not to. Digital asset investing is fraught with risk especially when considering where to hold your assets. Understanding these risks will help any investor avoid some of the most common digital asset investing pitfalls.
Outsourcing Risk
During the start of our wallet discussion in Wallets don’t hold crypto they hold keys, we briefly alluded to the fact that using an exchange means giving up full control of your digital assets. The obvious issues are that sending, trading, or even logging into your account is up to the exchange’s discretion. These are both real issues but there are some less obvious risks that everyone using an exchange should be aware of.
First, exchanges are often not FDIC insured. FDIC stands for the Federal Deposit Insurance Corporation which is the agency that was created in 1933 (during the great depression) to help stop bank runs. It provides insurance up to $250,000 worth of an individual's bank deposits. If you deposit money into a digital asset exchange and the exchange goes out of business, your money will be gone. Coinbase and other larger exchanges do provide deposit insurance to US customers, but this insurance ONLY covers the US dollars held on the exchange, not digital assets.
The second risk is how your digital assets are managed. Exchanges control billions of dollars worth of digital assets that if stolen, cannot be reclaimed. Remember when sending a transaction you must sign it with your private key. Once a transaction has been transmitted to a blockchain, there is no reversing it unless the recipient sends the funds back. All blockchain transactions are final which makes digital assets a highly appealing target for hackers. In fact, in recent years millions of dollars worth of assets have been stolen from exchanges and cannot be recovered.
You might be thinking that the second risk can be mitigated by insurance. Unfortunately, insurance is hard to come by in space. In fact Coinbase, the most well capitalized exchange, can only insure a fraction of their almost $9 billion dollar customer digital asset balance. As of 2019, their insurance covered a mere $255 million worth of customer’s funds. Insurance doesn’t scale with asset price increases, so it is doubtful that insurance coverage over its customers' assets has increased substantially.
Hot Storage
Instead of using an exchange, you can opt to assume a different set of risks by creating and using a wallet. Last week we discussed downloading wallet software and generating a price key. In the early days of the industry, wallet software and these phrases were exclusively stored on computers; but they can really be stored anywhere digital information can be stored, including on your phone or even on a piece of paper. Where you store this information dictates what risk you assume. During the current crypto market bull run, many people have entered the blockchain space if not through an exchange like Coinbase then through a wallet application in their web browser or on a mobile phone.
Web based wallets, also known as wallet browser extensions, sit in the upper right hand corner of your web browser. Examples of web based wallets are Metamask and Phantom and have the advantage of being easy to access. With a single click of a button, your assets are easily accessible to you. The private key and other sensitive information are stored in an encrypted file on your computer. What this means is that if you set up a wallet in your Chrome browser on one computer and decided you also wanted to have access to that wallet on another computer, you would need to enter your secret phrase on the new device even if you are logged into the same Google Chrome account.
The convenience of the web based wallet makes them appealing, but their convenience comes at a cost: limited functionality. There is only so much that an application stored in a web browser can do.
Mobile based wallets are another handy wallet solution. Mobile wallets look just like a stock trading or bank account application. Private keys are stored in a similar manner as on your web browser, but the encrypted copy of is stored on your phone. If you lose it, someone steals it, or you get a new phone, your wallet will be gone. There is no worse feeling than realizing you forgot to transfer your wallet from one phone to another.
Cold Storage
Where to store your private keys (aka what wallet should I use?) has been a debate since the start of the industry. If you think about the ways we have discussed keys being stored, they all have one thing in common-- your desktop, phone, or web browser are all connected to the internet. The problem with this is that an internet connection is not only the entry point for you to experience the amazing world of the web--it is also an entry point for anyone on the web to access your device. On the off chance that you are exposed to some malicious software or someone attempts to attack your device and they find your private keys, there will be no stopping them moving your assets. For this reason, many advanced crypto users store this sensitive data on something called a cold storage device.
The name cold store describes the act of storing information on a device that is not connected to the internet. Hot storage on the other hand would be the opposite. Most of the time, cold storage devices look like a USB and they store your private key information. The device itself uses software that when plugged into your computer will allow you to sign transactions. Keeping your private key offline is another level of protection for keeping your keys safe from unknown cyber attacks. Some well known cold storage devices are Ledger and Trezor and both are highly secure ways to store your private keys.
Bravery
Being brave means understanding risk and how to assume it. There is no risk free investment especially within digital assets. If you plan on holding your own assets you will need to understand the risks. Holding them on an exchange outsources the risk which you pay the exchange a premium to do. Holding your assets on a web browser, mobile device, or desktop wallet means that you are taking on the risk. Assuming this risk provides you the benefit of autonomy and flexibility. If you are very concerned about storing your assets, you can always go so far as to store your private keys on a cold storage device.
Each one of these solutions will appeal to different people depending on what risks they want to take. Next week we move back into some of the technicalities surrounding how blockchains work.