A cold wallet is used to store cryptocurrency. This is a digital wallet that securely stores private keys. This is offline storage and not tied to the Internet.
This is also called a hardware wallet.
Digital assets like this are stored on physical devices to prevent hackers from gaining access. These are flash drive like devices that can be connected to any computer.
Those involved in cryptocurrency call this cold storage to denote the difference between a hot wallet, one that is connected to the Internet or accessible online.
The benefit to using a cold wallet is that no transactions can occur without first connecting it. It is not a good option for those looking to trade cryptocurrency. Those who HODL often utilize cold wallets since they are not going to sell for years.
Many long term Bitcoin and Ethereum investors have their assets in cold wallets. opting to avoid exchanges.
This is in keeping with the idea: not your keys, not your crypto.
How Cold Wallets Work
No cryptocurrency is stored in a cold wallet.
When coins (or tokens) are moved to a new wallet, the transaction is recorded on the blockchain. This is a ledger often called distributed ledger technology (DLT). Individual nodes are run, often unrelated to each other. This is where the concept of decentralization is prevalent.
Unlike a bank which controls the ledger and backs it up, a blockchain ledger is run on different servers simultaneously. Since they are not connected to each other, each is carrying a mirrored version. The block producers are the ones responsible for adjusting balances as transactions are added. They also arrive at consensus to eliminate the double spend problem.
Access requires both a public and private key. The private key is only known to the wallet holder and a cold storage device contains that. This is what allows the user access to the contents of the wallet.
Another layer of security is added by having a PIN tied to the device. This must be entered to open up the contents on the USB stick. Once that occurs transactions can occur.
The PIN along with the private key provided from the cold wallet allows the coins to be moved out.
Risk Mitigation
People use cold wallets to mitigate the risk associated with cryptocurrency.
The original design set forth by Satoshi Nakamoto with the introduction of the bitcoin network eliminated the counterparty risk. This is the risk that people bear when dealing with financial institutions who are actually the custodians of the assets.
In 2022, cryptocurrency investors learned the risk that existed when dealing with an exchange such as FTX. When this entity entered into bankruptcy, the crypto owners were in limbo.
Decentralized exchanges (DEX) can provide protection that centralized exchanges (CEX) cannot since they do not have the counterparty risk. DEX are not exempt from hackers often using phishing software.
Traditional finance, aka TradFi, is built upon financial intermediaries. This provides these corporations with enormous power over people's financial affairs. They have the ability to close accounts. There were also numerous cases of fraud.
Cryptocurrency puts the responsibility for the security of assets on the owner. This eliminates the counterparty risk associated with the intermediary. It also removes them from the equation completely.
Customers are drawn to the convenience that comes from financial service providers offer. Cold wallets value security over convenience.