13.August 2022

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

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Bitcoin Custodians Facing Liquidity Crisis As Price Falls

This is an opinion editorial by Josef Tětek, the Trezor brand ambassador for SatoshiLabs.

Bear markets can be scary, with bitcoin 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.”

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 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 doesn’t stop certain risk-prone characters from recreating fiat institutions. The “crypto lending” shops such as Celsius are fractional reserve banks in principle; however 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.

Let’s make one thing clear: a 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 the clients’ deposits in various ways. And whereas 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 basically go and put their customers’ deposits into casinos of various kinds — DeFi yield farming, staking, speculating on obscure altcoins.

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:

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

Buying bitcoin in a peer-to-peer fashion is preferable from the privacy standpoint, so if you can find a reliable seller — usually through Bitcoin meetups — making regular purchases through the same channel and stacking straight into a hardware wallet is the way to go. ATMs also can allow for purchasing amounts of bitcoin up to $1,000 with good privacy. But, if for any reason you prefer buying through exchanges, there is no reason to leave your coins off of your own wallet.

And if you’re keeping your coins on an exchange right now, it’s a good idea to consider withdrawing 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.

Surprisingly, a lot of people misunderstand the nature of hardware wallet devices and the business models behind them. Some people believe that hardware wallet manufacturers are actually in possession of users’ coins and can recover the coins in case the user loses their recovery seed or passphrase — this couldn’t be further from the truth! It’s the wallet users that are always in the sole and exclusive possession of their coins. The manufacturer’s business is to sell devices; not to lend out or otherwise leverage the coins of their users!

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. The further discovery of there being no bailouts might turn into a nightmare. Yet 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 guest post by Josef Tětek. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.


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