What Are Bitcoin Hot Wallets and Cold Storage?
When talking about bitcoin exchange platforms, two terms you will encounter along the way are cold storage and hot wallet. Both cold storage and the hot wallet are security measures put in place by exchange platforms to safeguard user funds from any mishap:
- Cold storage refers to bitcoins kept offline. You could compare this principle to banks moving customer funds into a vault rather than keeping it at the bank teller desk. In the case of bitcoin cold storage, though, there are other layers of security in place. Examples of cold storage include bitcoins kept on a USB drive or a dedicated hardware wallet.
As you may have guessed by now, most bitcoin wallets are stored on servers connected to the Internet. Cold storage wallets are kept entirely offline at all times, which also protects from harm in case a hacker would attempt to breach the platform.
Bitcoin exchange platforms protect the majority of — or, in some cases, all — customers from harm. However, there has to be sufficient bitcoin liquidity (amount of funds available at all times) within the exchange at all times as well, as there are always users who want to make a bitcoin withdrawal. And a proper exchange will process that withdrawal request immediately, rather than delaying it by several hours.
- Hot wallet refers to the method by which every bitcoin exchange keeps a certain liquidity just in case there is a massive influx of withdrawal requests. You may think of this liquidity as similar to the cash reserve that any bank must hold so that customers can access their funds at any point in time. This hot wallet provides liquidity of digital currency at all times. Unlike cold storage, a hot wallet is a bitcoin wallet connected to the Internet 24/7.
Good business practice for a bitcoin exchange means it never stores too many funds in a hot wallet. Even if it stores only 1 percent of the total amount of bitcoins circulating on the exchange, that can quickly add up to several hundreds or thousands of BTC. And if the platform were to be breached, the loss of funds would be quite catastrophic.
On top of that, most bitcoin exchange platforms will not process large bitcoin withdrawals from their hot wallet either, but rather move funds from cold storage to the intended recipient. Every platform has its own internal limits for doing so, making it hard to judge what is quantifiable as a large amount (but as mentioned earlier, you should never store too many BTC on an exchange wallet to begin with).