Cryptocurrency: The Dangers Of Paper Bitcoin

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The Dangers Of Paper Bitcoin

The potential of losing your funds isn’t the only reason to secure your
own bitcoin. It also ensures the price cannot be manipulated.

Bitcoin Magazine
Captain Sidd

Are you keeping bitcoin on an exchange?

Let me tell you a story about what happens when you, and others, leave
your bitcoin on exchanges. You might be surprised to hear what that means
for your holdings. It might sound a lot like your own.

Let`s call our character Bill. Bill has been cautiously watching bitcoin
for years, hearing about it in passing and reading a few articles. After
inadvertently saving a lot of cash due to lockdowns, he decided to dive
into bitcoin at last. A friend told him to check out Coinbase, Binance or
another popular and "trusted" exchange in order to buy his first chunk of
bitcoin.

So, Bill created an account and uploaded his face, ID, social security
number, address and every other relevant detail about his life until he
finally reached the "Buy Bitcoin" screen. He picked up a fraction of a
bitcoin, but after all that trouble, he thought to himself:

"I don`t need to learn all these complicated technical details about
hardware wallets and self custody -- I just want my bitcoin safe."

Bill reviewed the exchange`s website and decided that the security experts
at the exchange, with their wiz-bang cold storage and state-of-the-art
encryption, would be better at securing his bitcoin than he himself would
be.

Bill was very pleased with himself after making that decision -- not only
did this exchange make investing in bitcoin simple, it gave him peace of
mind knowing that someone else was responsible for keeping his assets safe
from any kind of theft or malicious activity. After all, why should he
have to worry about such things when there were professionals available
who could handle them instead?

Bill has since become quite comfortable with the idea of trusting
exchanges with his bitcoin -- his coins are now safe from his own
mistakes!

When Trust Disappears: The Fall Of FTX

When Bill turned on the news one morning and found out that the massive
crypto exchange FTX had just paused withdrawals and seemed to
"accidentally" lose $10 billion, roughly a third of its market cap, he was
shocked.

How could a firm with its logo on the side of a major sports stadium and a
CEO who appeared on CNBC, Bloomberg and in front of the U.S. Congress(!)
to talk about digital assets and regulation have lost -- or likely stolen
-- so much from right under everyone`s nose?

The potential of losing your funds isn’t the only reason to secure your
own bitcoin. It also ensures the price cannot be manipulated.

Source

Now Bill was stuck between a rock and a hard place. He was suspicious of
his own exchange, but setting up his own hardware wallet seemed so
difficult and scary. It would require him to invest in a physical device,
acquire the necessary knowledge to secure it properly and keep track of
his seed phrase backup. Even if he figured out the basics, there was still
the risk of misplacing his device or improperly storing his backup and
losing access to his bitcoin.

FTX was shocking, but surely Bill`s exchange would never conduct itself
the same way. People would see it before it was coming, and he`d have time
to get out, right?

Reasons To Take Your Bitcoin Off Exchanges

It`s clear that trusting your bitcoin to an exchange brings with it the
risk that you`ll log in one morning to find that your bitcoin just isn`t
there. If you hold your bitcoin yourself using a hardware wallet, this
can`t happen.

However, there`s another big reason it`s important to take your bitcoin
off exchanges: the bitcoin price.

How could self custody affect bitcoin`s price? Everything in economics
says that buying and selling affect the market price for a good, not who
holds it. However, self custody is very important to price -- and it has
to do with something I`ll call "paper BTC."

Introducing The Next Big Thing: Paper BTC

Let`s look at how an exchange works by considering a hypothetical exchange
called ExchangeCorp, owned and operated by a jolly entrepreneur named
Bernie. ExchangeCorp built an uncomplicated way to buy bitcoin, and hired
a team of security experts to make sure hackers are kept at bay. Over time
and through great marketing campaigns, ExchangeCorp built trust with
traders and investors, drawing many in to store their bitcoin on the
exchange.

When users keep their bitcoin with ExchangeCorp, the CEO Bernie and his
team maintain control over those coins. Customers simply have a claim on
their coins: they can log in and see their balance as well as request to
withdraw their coins. However, if Bernie wants to transfer those coins
owed to his customers to other Bitcoin addresses, he`s technically able to
do so without any customer`s permission.

When Bernie kicks up his feet and looks at the balances in ExchangeCorp`s
vault, he`s pleased to see tens of thousands of bitcoin that his customers
have deposited sitting pretty. Since ExchangeCorp is doing well, more
bitcoin are always coming in than going out.

So Bernie gets a wise idea. He could lend out some of those customer
coins, earn some interest, and get the coins back without anyone noticing.
He would get richer, and the risk of enough ExchangeCorp customers asking
for withdrawals at one time to draw its vault`s massive balance down to
zero is miniscule. So Bernie loans out thousands of coins here and there
to hedge funds and businesses.

The potential of losing your funds isn’t the only reason to secure your
own bitcoin. It also ensures the price cannot be manipulated.

Source. Traditional banks are even worse than ExchangeCorp. And from March
2020, they can now lend out 100% of your money!

Now there`s another set of claims to consider. Customers have a claim on
their bitcoin at ExchangeCorp, but ExchangeCorp no longer has the actual
bitcoin -- they only have a claim on the coin they lent out. What
customers now have is a claim on Paper BTC held by ExchangeCorp, with the
real bitcoin in the hands of borrowers.

This is where things get weird. All of ExchangeCorp`s customers still
think they have a direct claim on real bitcoin held safely by
ExchangeCorp. However, that real bitcoin is in fact in the hands of those
who borrowed from ExchangeCorp, and those entities are selling it out in
the market.

What happens when ExchangeCorp lends out a large quantity of the bitcoin
its customers deposited? A lot of extra bitcoin starts to float around in
the market, because investors who think they`re holding actual bitcoin are
only holding paper BTC. All of that extra supply of bitcoin in the market
absorbs buy pressure, which suppresses the price of bitcoin.

Let`s look at simple supply and demand here:

The potential of losing your funds isn’t the only reason to secure your
own bitcoin. It also ensures the price cannot be manipulated.

When paper BTC comes into the market, because market participants are
unaware that this new supply is not real bitcoin, it has the same effect
as increasing the supply of real bitcoin -- until the fraud is uncovered.

Does this hypothetical story sound anything like the recent news around
FTX?

The Paper BTC At The Center Of The FTX Fraud

The story of ExchangeCorp and Bernie is exactly the story of FTX and its
founder Sam Bankman-Fried, with some save-the-world complexes, study drugs
and polyamorous orgies redacted.

By lending out customer funds, FTX essentially inflated the supply of
bitcoin by taking advantage of the trust users placed in FTX to safeguard
their funds. FTX created tons of paper BTC.

Just how much paper BTC might FTX have created? We cannot be sure of the
exact amounts given its absolutely horrid bookkeeping, but the estimate
below suggests FTX had 80,000 paper BTC on its books -- bitcoin owed to
customers that is not backed by real bitcoin.

That would represent a staggering 24% of the roughly 330,000 new bitcoin
that were created over the past year through the predictable mining
issuance process. That is a ton of extra bitcoin entering the market that
nobody -- aside from a small group of insiders at FTX -- knew about!

It`s impossible to tell where the price would have gone without that extra
bitcoin supply entering the market, but we can be almost certain that the
price would have climbed higher than it did in 2021.

While the FTX collapse is recent and still unfolding, history has a few
cautionary tales to tell about the dangers of paper assets and price
manipulation. The story of gold`s failure to resist centralized capture,
for instance, can tell us where Bitcoin is headed if we continue to trust
exchanges and third parties to hold our bitcoin for us.

The Fall Of Gold

Gold was once used in daily transactions -- it takes no more than a visit
to a museum of ancient history to see the collections of old gold coins
once circulating in local markets. The traditional view of the demise of
gold as a transactional currency was that it became too cumbersome or too
valuable to continue to function well as a means to buy groceries and
beer.

However, this story omits a few key components that only reveal themselves
when we trace the evolution that societies took from gold coins to paper
bills and digital bank accounts.

Centuries ago, banks started taking customer's gold in exchange for bank
notes -- giving customers a measure of security for their gold and a more
convenient means of transacting. However, entrusting a bank with your
precious metal meant the bank was able to lend it out or make bad
investments without the depositor's consent. When a bank was caught
between bad loans and a high rate of depositor withdrawals, they had to
declare bankruptcy and shut down -- leaving many depositors penniless,
holding paper claims on gold now worth nothing at all.

Then central banks came along to "fix" the problem of bankrupt banks
leaving depositors penniless. Central banks held gold for people and
commercial banks, giving them banknotes from the central bank as receipts
for their gold. By 1960, central bank official holdings accounted for
about 50% of all aboveground gold stocks, with their banknotes circulating
freely. Commercial banks and individuals didn't mind, since each note was
convertible to a set weight of gold by the central bank that issued it.

The potential of losing your funds isn’t the only reason to secure your
own bitcoin. It also ensures the price cannot be manipulated.

Notice the note in the upper left? This $5 Federal Reserve note -- also
known as a $5 bill -- is redeemable in gold. Source

This would have worked well, except that central banks -- especially the
Federal Reserve in the U.S. -- started creating more bills than they had
gold to back. Creating more bills than the Fed had gold to back was
essentially creating paper gold, since each bill was a claim on gold.
Doing this in secret meant the Fed was manipulating the price of gold,
given the extra circulating supply which the market was not aware of. When
many depositors of gold at the Federal Reserve -- like the French
government -- started questioning the Fed's gold holdings and creating the
threat of a run on gold in the U.S., the U.S. government had to intervene.

In 1971, this came to a head with the Nixon shock. One night, President
Nixon announced the U.S. would temporarily stop allowing depositors to
trade in their Federal Reserve notes for the gold they promised.

This temporary halt in withdrawals was never lifted. Since all currencies
were connected to gold through the U.S. dollar under the Bretton Woods
agreement, the Nixon Shock meant that the entire world went off the gold
standard at once. All currencies were now just pieces of paper, instead of
notes giving the holder a claim on a quantity of gold.

The potential of losing your funds isn’t the only reason to secure your
own bitcoin. It also ensures the price cannot be manipulated.

Source

This was only achievable because gold, over time, was deposited into
commercial banks and then to central banks. Once central banks held most
of the gold, they could manipulate the price of gold and remove it
entirely from daily commerce. Everyday people chose the convenience of
paper notes over the security of holding gold, and paid the price.

Instead of a neutral money backed by a precious metal that is difficult to
dig up and impossible to synthesize, currencies became easy to print and
thus highly politicized. Keeping the dollar at the top of the food chain
no longer required restraint and good stewardship to ensure its backing in
gold. Instead, it required military expeditions and strong policing to
ensure global governments and citizens continued to use the dollar to
transact.

A return to gold at this point would be impractical -- the world's
commercial networks span too great a distance with transactions happening
at too high a speed. With paper currency and eventually digital banking
systems, what we gained in speed and convenience we lost in soundness and
neutrality. We lost our savings, our social cohesion and our political
institutions as a result.

Preventing Bitcoin`s Fall

Taking your bitcoin off of your exchange is not just good practice for
your own security, it`s protecting the price of your bitcoin as well. Our
freedoms depend on individuals having control over their own wealth. When
we entrust our wealth to companies or states, we go down the path we
witnessed with gold.

Thanks to bitcoin's divisibility and digital nature, it overcomes the
hurdles that held gold back from supporting our modern, interconnected
economy. Bitcoin can support a global marketplace, but it will only get
there if we each hold our own bitcoin.

Don't let the banksters and bureaucrats manipulate the price of your
bitcoin: take it off the exchange and get it on your own hardware wallet.