Why you need a Tiered Crypto Wallet System for DeFi

There’s so much to learn in the world of crypto, especially when it comes to setting up.

When you learn about the overwhelming choice of crypto wallets available you might wonder: 

“Which type of crypto wallet should I use?”

If simply buying and holding, the answer would be “the most secure type.”

But you’re not just buying and holding. You’re jumping into DeFi and staking, lending, transacting, and moving your assets all over the blockchain.

Therefore, the question that should be asked:

“Which types of crypto wallets do I need, and how should I use each?”

The answer is; you need more than one type of wallet. You need a tiered crypto wallet system because you are going to use different types of wallets for different situations.

Let’s explore why you need a tiered crypto wallet system, and then set one up.

Why do I need more than one type of crypto wallet for DeFi? 

You trade convenience for security when choosing between the many different types of crypto wallets.

Hot wallets (i.e. those connected to the internet) allow you to log in and send transactions from almost anywhere with just a few clicks. While this is remarkably convenient, it comes at the cost of security; because a wallet that connects to the internet is more vulnerable to cyber attack.

Cold wallets by design cannot connect to the internet, which makes them more secure but less convenient. When using a cold wallet, you’ll need your laptop/phone and your cold wallet to transact. Transactions will take longer as you require a few extra steps when compared to a hot wallet.

Since there is no “holy grail” crypto wallet that provides both high security and seamless convenience, you need different wallets for different situations.

And that’s where the tiered crypto wallet system comes in.

The tiers are different types of wallets, relating to convenience and security. At one end is high convenience and high risk, and at the other you have low convenience but low risk.

The tiered crypto wallet system below is designed for you as a DeFi participant. It is intended neither for speculators who buy and hold, nor for day traders who rely on centralized crypto exchanges.

The Tiered Crypto Wallet System for DeFi

You’ll need a hot wallet, a cold wallet. And depending on how much crypto you hold; you might need a deep freeze wallet.

← Hot wallet —— Cold wallet —— Deep freeze wallet → 

At one end you have your hot wallet which is high convenience but low security. At the other you have your deep freeze wallet with low convenience by extreme security. Lets explore each type of wallet, and how you should use each for DeFi

A Hot Wallet: an everyday spending account 

Hot wallets are high in convenience, but low in security.

Think of your hot wallet as akin to an everyday debit card that you carry in your physical wallet. 

You don’t (or at least, shouldn’t) have your life savings sitting in your everyday debit card account, therefore you’re comfortable carrying it around with you. If you lose your card, you simply call your bank and have a new one issued. If someone steals your card they can use contact-less payment to spend your money. But contactless payment has a limit, and since you don’t hold your life savings in this account, the risk of theft isn’t huge.

Using the same logic, you should only carry enough crypto in your hot wallet so that if something goes wrong you aren’t ruined.

Think of your hot wallet as your convenience wallet used for small, fast transactions. Use it to pay for goods and services that accept crypto, for your businesses operational costs, or for those urgent transactions like a hyped up NFT drop that will sell out before you get home to access your cold wallet.

Your hot wallet could be a crypto exchange (like Coinbase), a software wallet on your desktop (like MetaMask), or an app-based wallet on your phone (e.g. MetaMask’s mobile app or Rainbow wallet). 

Related: The most convenient hot cryptocurrency wallets

You can also choose between a custodial hot wallet (i.e. you trust a 3rd party with your crypto) or self-custody hot wallet (i.e. you control your crypto). A self-custody wallet gives you more control therefore removing 3rd party security risk at the cost of convenience (you have to manage your private keys). If you’re only holding small amounts in your hot wallet, a self-custody wallet may be unnecessary.

How to use your hot wallet:

  • The goal is to maximize convenience, and since you’ll only hold small amounts of crypto in this wallet, choosing a custodial wallet is OK.
  • Only keep the same amount in your hot wallet as you would feel comfortable keeping in your back pocket in the real world. 
  • Hot wallets have extra security risks, so be sure to read up on these hot wallet security best practices and at the very least; secure your device, use strong passwords, and 2FA everything.
  • Use your hot wallet for everyday payments: sending payments to people who know your identity (e.g. freelancers or friends), and to pay businesses that accept crypto.
  • Fund your hot wallet using a crypto exchange, not your main cold wallet (see next section) as you don’t want these wallets connected.

A Cold Wallet: Your Main DeFi Wallet

Cold wallets offer a medium level of convenience with a high level of security.

Your cold wallet resembles the bank account where you hold most of your savings. The main difference is that your bank is the custodian of your fiat currency, whereas you are the custodian of your cryptocurrency when you use a cold wallet.

Since you are reading this very article, you probably do not fully trust banks with large amounts of money. But once upon a time you did. Pre-crypto, you felt that your life savings were safer in a bank verus hidden in a shoebox under your bed. After all, banks are harder to break into and rob.

So don’t hide most of your crypto assets in a hot wallet because that’s like stuffing your life savings in a shoebox under your bed. Store most of your crypto in a secure cold wallet instead.

The only exception here is when you hold a considerable amount of crypto (let’s say seven figures or more). In this case you’ll want to diversify risk by using multiple cold wallets, or a deep freeze crypto wallet (see the next tier below)

Your cold wallet, as part of your tiered system, should rest in a hardware wallet like the Ledger which looks like a small USB device. Paper wallets are also cold wallets but since they eliminate all convenience we’ll ignore them in this case.

Related: the best crypto hardware wallets

Cold wallets are much, much safer than hot wallets, but the price of security is convenience. You cannot simply log into your cold wallet from any device like you can with a hot wallet. 

The process goes something like this. Your cold wallet must be physically present, your laptop/phone must have a software program installed (called a ‘bridge’), and sending crypto requires you to double check and verify every transaction. Finally, since cold wallets are self-custody you’ll be responsible for managing and keeping (i.e. not losing) your private keys.

Cold wallets are secure, but not invincible. It is absolutely vital to read up on these cold wallet security best practices before setting yours up.

How to use your cold wallet:

  • Hardware wallets are secure, but not invincible. Your crypto is at risk of absolute loss if you lose your private keys or fall victim to a sophisticated scam, so follow these cold wallet security best practices.
  • You should be safe to keep most of your crypto in a hardware wallet. For larger amounts consider spreading your crypto across multiple hardware wallets to diversify risk, or use a deep freeze wallet (see next section)
  • Make your hardware wallet user experience slightly more convenient by connecting it to a self-custody hardware wallet (e.g. MetaMask). 
  • Use your hardware wallet for DeFi: staking, borrowing, lending and liquidity pooling.
  • NEVER send crypto from your cold wallet to someone who knows your identity otherwise you risk doxxing yourself. Instead, only send crypto from your exchange or your hot wallet to those who know your identity.

(Optional) A Deep Freeze Wallet: Your Crypto Treasury

A deep freeze wallet offers terrible convenience but extreme security.

You can think of a deep freeze wallet as a physical safety deposit box in Switzerland which is used for privately holding large amounts of wealth, but is inconvenient to access. 

Just like Swiss banks, a deep freeze wallet only makes sense if you have truly mammoth crypto reserves, want to eliminate as much risk as possible, and do not care for convenience at all.

A deep freeze wallet can take many different shapes and forms, but the main idea is that when the wallet is created, neither the wallet or the tech used to set it up has ever connected to the internet. That is:

  • The device used to create the wallet have never connected to the internet 
  • The wallet is created offline (via something called air-gapping
  • Transactions are signed within an offline system 

If the above 3 boxes are ticked, there is zero chance that the wallet’s private keys are exposed to malicious entry via cyber threat.

The wallet will still have some type of access phrase, password, pin, or codeword. This access phrase should be encrypted – meaning even if it lands in the wrong hands, it cannot be used without solving the encryption. And if this encrypted passcode isn’t memorized, but is instead noted or written down, it must physically be stored somewhere difficult to access, like a safety deposit box in a bank. Maybe even a real Swiss bank, perhaps?

Creating a deep freeze wallet system requires specific technical knowledge, so if setting this up yourself, be prepared to invest time acquiring this knowledge yourself. 

If the technicalities worry you, invest time into finding a trustworthy custodian that offers such a service, like Coinbase Custody. Given the amount of personal wealth at stake, this is not a decision to take lightly, so do your own research and find a crypto consultant to help you understand your options.

How does one use a deep freeze wallet? Like a treasury used to lock away huge amounts of wealth securely. Once your deep freeze wallet is set up, leave your crypto there and don’t touch it. This type of wallet is not suitable for DeFi, just for holding.

Final thoughts

You are only limited by your imagination, so don’t feel like you have to copy the tiered wallet system above exactly, but its useful as a framework.

So where should you begin?

Hopefully you already have a hardware wallet setup as your cold wallet. If not; set this up first. Next, choose one of these hot wallets as your everyday, convenient wallet and you should be ready to roll. At this point, you can decide yourself if you need to set up another cold wallet to diversify risk, but consider a deep freeze wallet for larger holdings.

Your tiered crypto wallet is ready to use, and your assets will be much safer as they grow. See you on the moon. In a Lambo.