Hardware wallet or software wallet: where the key sits

Anyone buying bitcoin or other crypto-assets does not acquire a file that can be handed around. They acquire the ability to change an entry in a public database, and that ability sits in a private key, a random number of 256 bits. A wallet is the shell around that key. The difference between wallet types is therefore mainly this: who holds the key day to day.

A wallet stores no coins, it stores keys

The balances sit in the blockchain, a database that thousands of nodes keep in parallel. A transfer counts as valid if it is signed with the matching private key. The public address can be calculated from the private key, but not the other way round. Whoever knows the key controls the balance, regardless of who paid for it.

Two things follow that work differently in everyday banking. First, nobody pulls back a confirmed transfer: there is no chargeback and no complaints desk inside the network itself. Second, there is no password reset: if the key is lost, the balance stays visible in the chain and out of reach for good. Which type of wallet fits you therefore depends less on the interface than on the question of which mistake you would rather carry, your own or a company's. The wallet type finder asks a few questions on that and points in a direction at the end.

The 12 or 24 words are the key

Nearly all wallets today generate their keys from a word sequence under the BIP 39 standard. The word list that goes with it holds 2,048 entries, so each word stands for 11 bits. From 128 bits of randomness come 12 words, from 256 bits come 24 words. On top sits a checksum with a length of the entropy divided by 32, that is 4 extra bits for 12 words and 8 bits for 24 words. A word copied down wrongly therefore shows up immediately in most cases: arithmetically, the 4 or 8 checksum bits let only about 1 in 16, or 1 in 256, wrong word sequences through.

From the word sequence the wallet calculates a seed of 512 bits using PBKDF2 with the function HMAC-SHA512 over 2,048 rounds. Optionally a passphrase of your own choosing is added, which under the standard goes into the salt: a single extra character leads to a completely different wallet, with different addresses and a different balance. For everyday use that means two things. These words are the assets, not an aid to access. And they belong on paper, better on metal, not in a photo, not in cloud storage and never in a form on the internet.

Three routes of custody compared

In practice there are three patterns. With a software wallet the key sits encrypted on a phone or computer that is online every day. With a hardware wallet it sits in a device of its own that signs transactions internally and never releases the key; approval happens on the device, usually with a PIN. With custody by a provider the company holds the keys, you see a balance and have a claim to have it handed over.

The row on insolvency is the real difference. On the first two routes you carry the risk of your own handling; on the third you also carry the risk of somebody else's company.

What happens when a custodian goes insolvent

How that plays out was shown by the collapse of a large trading platform: on 11 November 2022 the company and more than 100 affiliated entities filed for insolvency under Chapter 11 of US law. The US derivatives regulator gives, in its statement of 8 August 2024, a loss of customer funds of more than 10 billion US dollars; the figure is expressly stated there as an estimate. On the same day it announced a court-approved settlement of 12.7 billion US dollars, of which 8.7 billion as restitution and 4 billion as disgorgement. Customer money had been mixed with company money.

Since 30 December 2024, Regulation (EU) 2023/1114 has applied to providers of crypto-asset services across the European Union. Article 75 requires crypto-assets held in custody to be separated from the provider's own assets, so that creditors cannot reach them in insolvency; the same article makes the provider liable for losses attributable to it, capped at the market value at the time of the loss. In Germany the transition period for existing providers under section 50(2) number 3 of the Kryptomärkteaufsichtsgesetz (the German Crypto Markets Supervision Act) ended at the close of 31 December 2025. Even so, there is no statutory deposit guarantee for crypto-assets as there is for a current account. That does not follow from Article 2(4)(b), which merely takes out of the regulation's scope those crypto-assets that are deposits themselves. It sits in the mandatory warnings: Article 6(5)(f) requires the white paper to state plainly that the crypto-asset is not covered by the deposit guarantee schemes under Directive 2014/49/EU; point (e) names alongside it the investor compensation schemes under Directive 97/9/EC.

What the German BSI requires, in short

The BSI, the German Federal Office for Information Security, keeps a module on Bitcoin of its own in its IT baseline protection catalogue, last amended on 25 October 2018. It separates requirements that must be met from those that should be met. Mandatory there are: up to date software with security updates applied promptly, a sufficiently complex password, a wallet with encryption that is actually switched on, and at least two-factor authentication for online wallets. As a standard requirement the module names a deputising arrangement for emergencies. Only where protection needs are higher do an offline wallet, a hardware wallet for larger amounts over longer periods and access protection through multi-signature in an M of N pattern come on top.

On second-factor logins the BSI advises using them everywhere a service offers them, and choosing the two factors from different categories: knowledge, possession or biometrics. It rates hardware-based methods as safer than a code sent by text message, above all where the same device is used for login and confirmation. The Bitcoin developer documentation adds practical points: only small amounts on the everyday device, encrypted backups in several places, a password of at least 16 characters, an offline backup for reserves, multiple signatures in a ratio such as 3 of 5, and a note for your heirs.

How to set up your custody and check it

Start with a split rather than with a device. A small amount for everyday use may sit in a software wallet; the rest belongs in cold storage. Write the 12 or 24 words down by hand, check each word against the device display and keep the copy separately from the wallet, ideally safe from fire and water.

Then comes the part most people skip: the restore test. Reset the wallet or use a second device, restore it from the words alone and send a small amount first. Only once that test has worked should more of the balance go into the wallet. Check three further points: whether the second factor is active on every account and not tied to the same device, whether the firmware is up to date, and whether somebody knows where the backup is if the worst happens. Anyone who also wants to know how fraudsters go after exactly these words will find the methods in our piece on the warning signs of crypto fraud; anyone still facing their first purchase will find the order of steps under buying bitcoin. Terms such as seed, cold storage or multi-signature are in the glossary, and anyone wanting to test their own knowledge can use the crypto knowledge quiz.

Frequently asked questions

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