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As the bitcoin price falls and custodians face solvency issues, bitcoin offers sovereignty to those who want it. By Josef Tětek.
Bear markets can be scary, with prices dropping to unthinkable levels, leverage positions being liquidated and custodians failing on their promises. When FUD replaces FOMO, fortunes are easily lost. Keeping your head cool and your bitcoin in cold storage is imperative to survive in this unpredictable environment.
“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
Some cryptocurrency exchanges and custodians are facing solvency issues as their customers panic and rush to withdraw their money, known as a “bank run.” In a fiat economy, bank runs are prevented through state intervention: the practice of fractional reserve banking that leads to bank runs is sanctified, and the inevitable losses are mitigated by printing more money.
While this practice was hidden from the public eye for most of the 20th century, it became 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. Bank runs are mostly a thing of the past in the fiat economy, but they are still very much a possibility in the “crypto” economy built around custodians.
Bitcoin does not forgive
In many ways, 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. But that doesn’t stop certain risk-prone characters from imitating the fiat institutions.
“Crypto lending” shops such as Celsius are fractional reserve banks in principle but this time there is no “lender of last resort” in the form of a central bank to bail out the founders and their clients when things turn sour. Buyouts may happen, but customer deposits are rarely guaranteed.
As Twitter user Otteroooo mapped out at the beginning of the crisis, Celsius thus lost hundreds of millions dollars in user deposits on various badly-placed bets:
otteroooo on Twitter: "Celsius Network will be insolvent by end of 2022 and users still with deposits locked will be forced into a bail in (confidence interval 75%)Here's 12 reasons whyAlpha at end of megathread👇🏼 🧵 / Twitter"
Celsius Network will be insolvent by end of 2022 and users still with deposits locked will be forced into a bail in (confidence interval 75%)Here's 12 reasons whyAlpha at end of megathread👇🏼 🧵
Yield always has to come from somewhere. To generate a positive yield on a scarce asset such as bitcoin, the institution offering said yield has to leverage its clients’ deposits in various ways.
Where banks face strong regulatory requirements as to what they can do with the customer deposits (such as buy treasuries, facilitate mortgage loans, etc.), cryptocurrency lending companies face no such regulatory requirements, so they are free to put their customers’ deposits into various high-risk bets like DeFi yield farming, staking, or speculating on obscure altcoins.
As of the time of publishing, Celsius has filed for bankruptcy, which could mean the evaporation of most funds which users have been prevented from withdrawing for several weeks.
Celsius on Twitter: "Moments ago, @CelsiusNetwork filed voluntary petitions for Chapter 11 protection and announced that the company initiated a financial restructuring. https://t.co/vf5wsT6TMp / Twitter"
Moments ago, @CelsiusNetwork filed voluntary petitions for Chapter 11 protection and announced that the company initiated a financial restructuring. https://t.co/vf5wsT6TMp
Celsius is not the only one
It’s frustrating to see people lose funds in much the same way as Mt. Gox users did in 2013. Exchanges and custodians fell for the same temptation that bankers did for centuries: leveraging user deposits to squeeze out more than they would earn from service fees alone.
“You never know who’s swimming naked until the tide goes out.” — Warren Buffett
It’s almost paradoxical that bitcoin (and most altcoins) offer a straightforward way to give proof of self-audit via cryptographic signatures of addresses with sufficient balances, yet only a few exceptions provide such proof of reserves. It may well be that all are perfectly solvent, but the issue is we have to trust them on that.
As the “Oracle of Omaha” famously quipped, we’ll never know who’s naked until the tide goes 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.
Binance on Twitter: "Binance has temporarily paused #Bitcoin withdrawals on the $BTC network. Meanwhile, you can still withdraw BTC on other networks.This is due to a stuck on-chain transaction. Our team is currently working on a solution and will provide further updates soon. / Twitter"
Binance has temporarily paused #Bitcoin withdrawals on the $BTC network. Meanwhile, you can still withdraw BTC on other networks.This is due to a stuck on-chain transaction. Our team is currently working on a solution and will provide further updates soon.
How can we protect our bitcoin?
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 custody into your own hands. We can only be certain that nothing shady is happening if we hold the private keys ourselves.
Bitcoin makes administering one’s own wealth easy, and ever since Trezor introduced the first hardware wallet in 2014, there are no excuses not to hold your own keys.
Buying bitcoin peer-to-peer (P2P) is preferable from a privacy standpoint, so if you can find a reliable seller — usually through Bitcoin meetups — making regular purchases through the same channel straight into a hardware wallet is the way to go. Some Bitcoin ATMs also allow purchases of up to $1,000 worth with good privacy. But, if for any reason you prefer buying through exchanges, there is no reason to leave your coins there when you can keep them in your own wallet.
If you’re keeping your coins on an exchange right now, it’s a good idea to consider withdrawing them. Even if you earn a yield on your coins, the long-term risks of losing those coins simply isn’t worth it.
Hardware wallet manufacturers can’t gamble with your wealth
Surprisingly, a lot of people misunderstand the nature of hardware wallets and the business models behind them. Some people think that hardware wallet manufacturers are in possession of users’ coins and can recover the coins if the user loses their recovery seed or passphrase — this couldn’t be further from the truth!
Hardware wallet users are always in sole and exclusive possession of their coins. Contrary to exchanges and other custodians, there is no counterparty risk with using a hardware wallet. If Trezor or any of the other manufacturers went bankrupt tomorrow, users would be unaffected, because they are the sole owners of their coins. Compare this with the disclaimers of major bitcoin exchanges, which state that customers deposits may be confiscated in case of bankruptcy.
Nightmare, or opportunity of a lifetime?
The discovery of the fractional reserve practices being undertaken by some of the foremost custodians in the space will be an unpleasant surprise for newcomers seduced by the idea of earning yield on otherwise “unproductive” assets. The truth that no bailouts are coming will be nightmare fuel to those hoping for withdrawals to reopen.
Jameson Lopp on Twitter: "No bailouts for gamblers in Bitcoin.On the bright side, prudent folks get to scoop up their assets at firesale prices. / Twitter"
No bailouts for gamblers in Bitcoin.On the bright side, prudent folks get to scoop up their assets at firesale prices.
That is the nature of Bitcoin: in a stark contrast to the fiat system, Bitcoin rewards the prudent and punishes the frivolous. And through that mechanism, Bitcoin helps build a more responsible world.
This is a repost of an article first published on BitcoinMagazine.com.
The views and opinions expressed in this article are solely those of the authors and do not reflect the views of Bitcoin Insider. Every investment and trading move involves risk - this is especially true for cryptocurrencies given their volatility. We strongly advise our readers to conduct their own research when making a decision.