Are you keeping bitcoin on an online exchange? Let me tell you about what happens when people leave their bitcoin on exchanges. You might be surprised at what this means for your holdings. It may sound a lot like yours. Let’s call our character Bill. Bill has been watching bitcoin closely for years, reading a few articles and hearing about it occasionally. After accidentally saving a lot of money due to lockdowns he decided to finally dive into bitcoin. He was advised by a friend to visit Coinbase, Binance, or another trusted exchange to purchase his first bitcoin. Once he reached the “Buy Bitcoin!” screen, he uploaded his name, address, and ID. After spending a lot of time researching the exchange, Bill decided to buy a fraction of bitcoin. However, he realized that he didn’t need to know all the technical details about hardware wallets or self custody. He just wanted his bitcoin safe. Bill looked at the website of the exchange and decided that the security professionals at the exchange would be more effective at protecting his bitcoins with their state-of the-art encryption and wiz-bang cold store. Bill has since come to trust exchanges with his bitcoin — his coins are now safe from his mistakes! Bill is now comfortable with the idea that he can trust exchanges with his bitcoin. His coins are now safe from his mistakes! When Trust Disappears: The fall of FTX. Bill was stunned to see that FTX, a large crypto exchange, had paused withdrawals and lost $10 billion. This came after a CEO appeared on Bloomberg, CNBC, and before the U.S. Congress(!) SourceNow Bill was caught between a rock & a hard place. He was skeptical of his own exchange but set up his own hardware wallet seemed daunting and difficult. He would have to purchase a physical device, learn the proper security techniques and keep track his backup. Even if he knew the basics, there was always the possibility of his device being lost or misplaced. He could also lose access to his backup. It would be obvious that if you trust your bitcoin to an exchange, there is a risk that you will log in one morning and find that your bitcoin is not there. This is possible if you keep your bitcoin in your own hardware wallet. Economics teaches us that the market price of a good is determined by its buyer and seller, not the person who holds it. Self custody is important to price, and it has to do something I’ll call “paper BTC.” Let’s take a look at how an exchange works. We will use a hypothetical exchange called ExchangeCorp that is owned and operated by Bernie, a jolly entrepreneur. ExchangeCorp created an easy way to buy bitcoin and hired security experts to keep hackers away. ExchangeCorp gained trust over time through excellent marketing campaigns. This attracted many investors and traders to exchange their bitcoin. The CEO Bernie and his team retain control of the coins. Customers have a claim to their coins. They can log in to see their balance and request to withdraw their coins. Bernie can technically transfer the coins owed to customers to other Bitcoin addresses if he so chooses. Because ExchangeCorp is doing well more bitcoin are coming in than going out, so Bernie has a smart idea. He could lend some of the customer coins, earn some interest and get the coins back with no one noticing. He would be richer and the chance of ExchangeCorp customers asking to withdraw their vault’s huge balance to zero is minimal. Source. ExchangeCorp is worse than traditional banks. They can now lend 100% of your money starting in March 2020! ExchangeCorp customers have a claim for their bitcoin, but ExchangeCorp does not have the actual bitcoin. They only have a claim for the coin they lent. Customers now have a claim on Paper BTC, which ExchangeCorp holds. Borrowers hold the real bitcoin. All ExchangeCorp customers believe they have a claim on real bitcoin that is safe and soundly held by ExchangeCorp. ExchangeCorp’s customers still believe they have a direct claim on real bitcoin that it holds. However, ExchangeCorp is lending out large amounts of bitcoin its customers have deposited. There is a lot of bitcoin floating around the market because investors who believe they are holding real bitcoin are actually only holding paper BTC. This hypothetical story sounds a lot like the recent news about FTX. This hypothetical story sounds a lot like the recent news about FTX. The Paper BTC at the Center of the FTX FraudThe story behind ExchangeCorp and Bernie is exactly that of FTX and its founder Sam BankmanFried. They borrowed customer funds and used the trust they placed in FTX as a way to increase the supply of bitcoin. FTX produced tons of paper BTC. We don’t know the exact amount, but we can estimate that FTX had 80,000 worth of paper BTC. This is 24% of the approximately 330,000 new bitcoins that were created through predictable mining issuances over the past year. This is a lot of bitcoin that was not known to anyone except a few FTX insiders. For example, the story of gold’s failure against centralized capture can reveal where Bitcoin is heading if we continue trusting exchanges and third parties to hold our Bitcoin for us. It takes only a short visit to a museum to see the old gold coins that were once in circulation in local markets. The traditional view of gold’s demise as a transactional currency is that it became too heavy or too valuable to continue functioning as a means of buying groceries and beer. A visit to a museum of ancient history can reveal the collections of old gold coins that were once used in daily transactions. Banks began to take customer’s gold in exchange of bank notes, giving customers some security and a simpler way to transact. The bank could lend out your precious metal or make poor investments without the depositor’s permission if you entrust it to them. A bank that was caught between bad loans or high rates of depositor withdrawals had to declare bankruptcy and close down. This left many depositors without a livelihood and their paper claims on gold worthless. The problem of bankrupt banks leaving depositors without money was solved by central banks. Central banks held gold for both individuals and commercial banks and gave them banknotes from their central bank as receipts for the gold. In 1960, about half of all aboveground gold stocks was held by central banks. Their banknotes circulated freely. Individuals and commercial banks didn’t mind because each note could be converted to a specific weight of gold by any central bank that issued it. This $5 Federal Reserve note, also known as a $5 bill, is redeemable in gold. SourceThis would have been a good idea, except that the central banks, especially the Federal Reserve in the U.S., started creating more bills than they had gold backing them. The Fed creating more bills than it had gold to back was effectively creating paper gold. Each bill was a claim on the gold. The Fed manipulating the price for gold by doing this secretly was due to the fact that there was an extra supply of gold which the market didn’t know about. The threat of a run-on gold in the U.S. was created by the Federal Reserve’s gold depositors, which included the French government. This culminated in the Nixon shock in 1971. Nixon announced that the U.S. would temporarily suspend the trading of Federal Reserve notes by depositors in order to make way for the promised gold. This temporary halt to withdrawals was never lifted. The Nixon Shock saw the world go off the gold standard immediately because all currencies were linked to gold via the U.S. Dollar under the Bretton Woods Agreement. All currencies were now pieces of paper and not notes that gave the holder a claim to a certain amount of gold. SourceThis was possible because gold was gradually deposited into commercial banks, and then to central bank. The central banks could manipulate the gold price and take it out of daily commerce once they had most of it. People chose the convenience of using paper notes over the security and safety of gold, and they paid the price. It was no longer possible to create neutral money that was backed by a precious metal that is hard to find and impossible to synthesize. Instead, currencies were easy to print and highly politicized. To keep the dollar at the top, it no longer required good stewardship and restraint to ensure that its backing in gold was secure. It required strong policing and military expeditions to ensure that the dollar was used by global governments and citizens to transact. It would be impossible to return to gold at this stage. The world’s commercial networks are too far apart and transactions happen at too fast a pace. With digital banking systems and paper currency, we lost the stability and neutrality that we gained in speed and convenience. As a result, we lost our savings and social cohesion as well as our political institutions. Preventing Bitcoin’s Falls Taking your bitcoin off your exchange is not only good for your security but also protects the price of your bitcoin. Individuals have control over their wealth. This is what gives us our freedoms. We follow the same path as gold when we give our wealth to states or companies. Because bitcoin is digital and divisible, it can overcome the obstacles that prevented gold from supporting our modern, interconnected economy. Bitcoin can support a global market, but it won’t if everyone has their own bitcoin. Don’t allow bureaucrats and banks to manipulate the price of bitcoin. Take it off the exchange and put it on your hardware wallet. Captain Sidd contributed this guest post. These opinions are not necessarily those of BTC Inc.