Fundamentals: Consensus Mechanisms

12/22/22 • 3 min

Accounting For Crypto Assets

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Fundamentals: Securing Crypto Assets

Now that we have a better grasp of how wallets function for crypto assets, we need to understand the inextricable link between decentralization, self-custody, and security. In the world of blockchain and cryptocurrency, no bank holds and secures your funds. You are the bank. As a result, you rely on varied levels of security based on the context of the usage of funds.

A real-world example of this concept is the difference between a wallet you carry in your pocket and a bank vault. Obviously, the money kept in a wallet is less secure than money stored in a bank vault, but the sacrificed security of funds is offset by increased convenience. To reduce the risk, a nominal amount of a person’s total wealth is carried in their pocket. The same principle applies to crypto assets.

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Fundamentals: Exchange & Hot Wallets

Exchange wallets are funds held on centralized exchanges (CEXs). If a taxpayer purchases crypto assets on a CEX like Coinbase or Kraken, then the assets are in the exchange’s wallet. When investors leave funds on exchanges, they are relying on a third party to secure their assets. Exchanges have been hacked and bad actors inside an exchange have stolen and mismanaged funds; in the strange case of the Quadriga Ex exchange founder who suddenly died under suspicious circumstances, the private keys to $190 million of users’ funds vanished.

Relying on exchanges to secure funds is only for active traders and those comfortable with the security vs. convenience tradeoff that this provides.

Hot wallets are the next step up in security after exchange wallets because they allow the user better control over the protective measures they implement. The user can create complex passwords and cybersecurity features to reduce the chances of their funds being compromised.

These wallets are “hot” because they live on your computer, generally as an app or as a plugin to a web browser. As they require an internet connection to use, malware, keyloggers, and other common hacking tools can be used to gain access to this type of wallet.

Hot wallets are only as good as the security measures put in place to protect them. As a result, they should only be used with small balances of cryptocurrencies to reduce risk exposure.