Swimming Naked: Don’t Trust Custodians As The Bitcoin Price Falls

Swimming Naked: Don't Trust Custodians As The Bitcoin Price Falls thumbnail

This is Josef Tetek’s opinion editorial. He is the Trezor brand ambassador at SatoshiLabs.

Bear markets can be scary, with bitcoin dropping to unthinkable levels, leverage positions being liquidated and custodians failing on their promises. Fortunes can easily be lost when FOMO replaces FUD. To survive in this unpredictable environment, it is important to keep your head cool and your bitcoins in cold storage.

“Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”

Satoshi Nakamoto

The current situation that some of the bitcoin exchanges and custodians are facing reeks of solvency issues, colloquially known as “bank runs.”

Bank runs are nothing new. There are well-documented bank runs dating back over 200 years; the first American bank run happened just a few decades after the Declaration of Independence, in 1819 (for curious readers, I recommend Murray Rothbard’s “The Panic Of 1819“). Bank run are a result of greed and counter to the idea of “getting away” with it. The 200first American bank run occurred just a few decades after the Declaration of Independence. Bank runs in a fiat economy are prevented by a typical statist manner. The practice of fractional reserve banking, which leads to bank run, is sanctified and the inevitable losses are mitigated through more money printing. And while this practice has been mostly hidden from the public eye for the most part of the 20th century, it became quite obvious after 2008: Banks that were supposed to fail were simply bailed out with taxpayers’ money and via a zero-interest rate policy, which ultimately led to inflation levels not seen since the 1980s.

But still, bank runs are mostly a thing of the past in the fiat economy, though they are still very much a possibility in the “crypto” economy.

In Bitcoin, Shysters Face The Music

In many aspects, Bitcoin is the direct opposite of fiat. The fixed issuance of 21 million coins is widely cited, but the fact that there are no leaders and no bailouts is no less critical for Bitcoin’s long-term success. However, this does not stop some risk-prone individuals from creating fiat institutions. Celsius and other “crypto lending” shops are in principle fractional reserve banks. However, there is no central bank to bail out the founders or their clients if things go sour.

Let us be clear: a yield must always come from somewhere. The institution offering the yield must leverage the client’s deposits in different ways to generate a positive yield on a rare asset like bitcoin. Banks are subject to strict regulations regarding what they can do with customer deposits. This includes buying treasuries and facilitating mortgage loans. However, cryptocurrency lending companies do not have to comply with such strict regulations. Instead, they simply put customers’ funds into various types of casinos — DeFi yield farming and staking, as well as speculating on obscure altcoins.

As Twitter user Otterooo recently mapped out, Celsius thus lost hundreds of millions dollars in user deposits on various badly-placed bets:

As of the time of this writing, Celsius has stopped all user withdrawals and seems to be having a serious solvency issue. With no bailout incoming, all the hapless users can do is grab some popcorn and watch the Celsius team fight for its half-billion leveraged position, the liquidation of which could mean the evaporation of most of its users’ funds:

Celsius Is Not The Only One

“You never know who’s swimming naked until the tide goes out.”

Warren Buffett

It’s quite frustrating to witness people lose funds in essentially the same way as Mt. Gox users did in 2013. Custodians and exchanges are tempted to leverage user deposits to make more than they would from service fees. It is quite paradoxical that bitcoin and most altcoins offer an easy way to provide a proof of self audit via a cryptographic signature of addresses having sufficient balances. Yet, no exchange, except for a few exceptions performs such proofs.

It may be true that all exchanges are solvent, but we must trust them on that. The “Oracle of Omaha” once said that we won’t know who’s naked until it’s gone out. So, when Binance, one of the world’s largest exchanges, halts bitcoin withdrawals, we never know if it’s really only a temporary technical hiccup, or a much more sinister liquidity issue.

How Can We Protect Our Coins?

While we can collectively call for exchanges to offer proofs of reserves, the only real mitigation of the counterparty risk that exchanges pose is to take possession of our coins. To be sure that nothing is shady with our coins, you must have the private keys. Bitcoin is unique in the way it makes administering one’s own wealth easy, and ever since the first hardware wallet in the form of Trezor was introduced in 2014, there are no excuses not to hold your own keys. Buying bitcoin in a peer to peer fashion is preferred from a privacy standpoint. If you can find a trustworthy seller (usually through Bitcoin meetups), making regular purchases through that channel and stacking directly into a hardware wallet are the best options. ATMs also can allow for purchasing amounts of bitcoin up to $1,000 with good privacy. If you prefer to buy bitcoin through exchanges, there’s no reason to keep your coins in your wallet.

If you are keeping your coins on an exchange, it is a good idea for you to withdraw your coins into your own wallet. Even if you earn a yield on your coins, the long-term risks of losing 100% of your coins simply isn’t worth it.

Hardware Wallet Manufacturers Do Not And Cannot Gamble With Your Wealth

Surprisingly, a lot of people misunderstand the nature of hardware wallet devices and the business models behind them. Many people believe that hardware wallet makers are in possession of the coins of users and can retrieve the coins if the user loses their passphrase or recovery seed. This is false! The wallet users are the ones who have the sole and exclusive ownership of their coins. The manufacturer’s only business is to sell the devices, not to lend out or leverage the coins of their customers.

There is no counterparty risk when using a hardware wallet, contrary to other custodians and exchanges. Users would not be affected if Trezor or any other manufacturer went bankrupt tomorrow. They are the sole owners and holders of their coins. Compare this fact with the disclaimers of the major bitcoin exchanges, which can state that, in the case of bankruptcy, users’ coins are basically confiscated.

Nightmare For Some, Lifetime Opportunity For Others

The discovery of the fractional reserve practices being undertaken by some of the foremost custodians in the space might be an unpleasant surprise for many newcomers, who were seduced by the vision of earning yield on their otherwise “unproductive” assets. Further, the discovery that there are no bailouts could prove to be a nightmare. Bitcoin is a unique system that rewards the responsible and punishes those who are foolish. That mechanism helps Bitcoin build a more responsible world.

This is a guest post by Josef Tetek. Opinions expressed do not necessarily reflect the views of BTC Inc or Bitcoin Magazine HTML1.

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