The Dangers of Paper Bitcoin – BitcoinMagazine 12/19/22


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

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?

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.

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:…

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