The question asked in the title has been edited from what was asked today at Quora, the Q&A forum at which I participate as expert columnist. The original question was a bit more ambiguous: “Which is better? — a digital bitcoin wallet or a physical one?”
I have included the original question, because so that we can get better distinguish products and terms. Otherwise, we might be addressing the wrong question.
Why is the original question vague? Because bitcoin wallets are all digital — even one printed onto paper as characters or a QR code. Conversely, an exchange may use “physical” wallets to host client assets, individual application wallets, or they may simply keep records of client assets that are stored, collectively, in their own master wallet.
To complicate matters, Bitcoin is never really “stored” by you or an exchange service. It is stored on a public blockchain, where assets and transaction history can be traced through time by anyone. Therefore, all forms of user access are “digital”. What the reader really wants to know is this: “Which form of access control is better? — personal or custodial?”
Type 1: Personal Wallets are Private
—but with privacy comes risk!
Wallets are personal if the private keys are generated and stored by the user, either on paper, in their PC or smart phone, on a thumbdrive, in a hardware wallet, or even uploaded to cloud storage. As long as the asset owner holds the keys and securely encrypted any uploaded file that contains the keys, the assets are accessible only with his consent.
Type 2: Custodial Wallets are Managed by a Trusted Party
—just like a bank account
The reader uses the vague term “digital wallet” to mean a hosted wallet in which a trusted 3rd party holds the private keys, or aggregates the assets of many customers and tracks their individual ownership in their own accounting system, like a traditional bank or broker. In this case, the 3rd party is trusted to maintain security, privacy, and constant, robust user access.
It is possible that the reader may have used the term “digital wallet” to additionally refer to PC and smartphone applications, such as Bitcoin Core, Armory or Electrum. But, these are really personal and private wallets — because they are created and configured by the owner, and only the owner has the private keys. And so, we group these device wallet applications with hardware or paper wallets under heading #1: Personal.
You use the words “digital or physical wallet”. This is a vague distinction, because all Bitcoin wallets are digital, even one that is printed onto paper as a string of characters or a QR code. Likewise, a hosted service may use a “physical” wallet to host your assets, or they may simply keep records of client assets in their own common bucket.
But, you are really asking “Which of these is the better option for securing your cryptocurrency access credentials?”
- A wallet that is completely controlled by you, and with the private keys in your head or lock box
- A hosted wallet or account-ledger balance maintained by an exchange or trusted 3rd party. That is, the actual wallet and keys are not private and under your control
A crypto purist or Libertarian might insist on taking full control of the assets. That is, storing them locally and with only the owner having the private keys.
I am privacy zealot. And yet, to the dismay of some followers, I believe that—for most cryptocoin owners—a hosted, custodial wallet is better than taking possession of a hardware wallet, paper wallet or digital wallet (anything that the user personally stores in a PC, phone, on paper or in a personally encrypted cloud account).
To explain, I shall call out  a critical requirement, and  the deciding factor in determining this advice applies to you.
1. Critical Requirement
The host must have impeccable credentials, a solid and ongoing regimen of security reviews and unscheduled audits — and they must be sufficiently capitalized by large, respected organizations, such that widely recognized individuals and organizations are at substantial risk if anything were to go wrong.
Trust among strangers is easily scammed. So let me be clear. Regarding the investors, board, executives and security auditors of a custodial wallet service, both their reputations must be at risk as well as their worldwide assets across other business areas.
Coinbase in San Francisco is such an exchange and hosting service. Currently, there are only two others that meet this extreme level of vetting. If Fidelity Investments enters the market as a crypto-hosting service, they would likely meet this bar.
2. Deciding Factor
There are few individuals for whom direct and private ownership makes sense. In fact, until this month, it did not make sense for me. I am only now configuring my first hardware wallet. I still trust Coinbase to host and control most of my assets.
The reasons boil down to security, forgetfulness, errors, legacy ownership and instant access. The ONLY factor that is arguably better with personal custody & control is privacy.
Take me, as an example…
Due to a lack of education, standards, and definitive best practices, this option makes sense for fewer than 5% of Bitcoin owners. In fact, I have been involved with Bitcoin since the first years of its existence, and
I have been a Bitcoin educator since shortly after Satoshi’s original bombshell. Today, I am a keynote presenter at blockchain and cryptocurrency conferences. I teach blockchain seminars, design courseware for colleges, and am co-chair of the Cryptocurrency Standards Association and partner in Blockchain Research Council.
Yet, I am only now configuring my first hardware wallet. I still trust Coinbase to host and control most of my cryptocurrency.
How do I know if I am a candidate for full / private control?
Using an exchange hosted wallet service is best for most individuals. But, for some, it makes sense to maintain private, local control of blockchain assets. If all criteria in the bulleted list below applies to you, then local and private ownership might make sense. But if you fail even one criteria, then WAIT! Wait until multisig becomes uniform and ubiquitous — and wait until a larger fraction of society is comfortable with the concept and practice of managing private keys. These are gradually becoming new norms. But, it will take a few more years for the world to become comfortable with an unfamiliar concept: personal control of a decentralized asset.
If you plan to control and secure your own private keys, you should meet ALL of these conditions. The technical items below will not be requisite in the future. But they are necessary today, because the market currently lacks simple, standardized, widespread tools and uniform practices for safely securing, accessing and passing on these credentials to your heirs.
Do all of these criteria apply to you?
- You have a comprehensive understanding of cryptography, including the principals of RSA public-key crypto.
- You have practiced multisig decryption for at least a year. For now, you will need to roll-your-own multisig, to ensure that your heirs or executor can access your wealth in the event of death, forgetfulness or incapacitation.
- You have experience and a clear, documented and standardized plan for separately encrypting and distributing your private keys.
- You understand how to implement a hard fork and have the time to do it after any hard fork split.
- You have an exceptional need for privacy or anonymity, and you feel that a custodian is more likely to “sing” in the event of an audit or court order.
- You have a rehearsal plan for testing your multisig recovery and a willing group of trusted friends (most of them younger than you) who can combine their keys to access your wealth.
- After ensuring that encrypted wallet works, is completely secure and is accessible to your heirs, you have replicated it in a sufficient number of places, that you are certain that your heirs will find it after you die, even if it is 90 years in the future.
It must not only survive your lifetime, but the knowledge of where to look and *IF* to look, must be certain, even if your home burns down, your cloud accounts have been deleted and/or Google, Amazon, Microsoft & Apple are no longer in business.
If all conditions apply to you (and only if they apply), then you may be among the 5% of enthusiasts for whom a personal hardware wallet makes sense. At some time in the next few years, it will make sense for a far greater fraction of cryptocurrency holders, rather than just the most disciplined and knowledgeable Geek-enthusiasts.