Can Bitcoin Exchange Risk Lead to Bitcoin Regulation?
Editor’s note: this is the first of a two-part series.
First things first, I am no IT security expert or Bitcoin core developer-level coder. The technical bits of Bitcoin are not my strength, nor my concern. Bitcoin’s currency, not its Block Chain, are in no real need of security optimization. You can make a wallet as secure as you want it to be, from multi-sig to cold storage, to paper wallets. If you hand your bitcoins to a third party, that’s your choice. And the Block Chain has had no actual security issues in its entire existence. The basics with Bitcoin are established, well-designed, and are not in need of repair. To follow up upon my previous article about Bitcoin’s reputation, the problem with Bitcoin is not the technology or design, it’s those who deal with it the most. Bitcoin’s security isn’t flawed. The people who use it most are. The biggest fish in the pool are perhaps the weakest links.
Novices think you can divorce the Bitcoin currency from the Bitcoin Block Chain, but that is like removing the tracks from a tank. Any problems with the currency deeply affect the entire network’s ability to function as intended. The currency’s price is nothing more than a reflection of its strength versus the fiat currency of choice. Considering the short-term strength the U.S. Dollar is now showing globally, there is no need for a better financial mouse trap, at this time. That can be a card Bitcoin can play at a later time. With that in mind, Bitcoin’s teething problems right now are real and need to be addressed with the long-term health of Bitcoin in mind. This time should be spent perfecting Bitcoin’s ability to acquire new users and serve the newest members to the community to the best of its ability. These problems we’ll call “Exchange Risk,” meaning problems safely exchanging new fiat currency or existing Bitcoin, at Bitcoin exchanges due to potential theft or closure. This is the biggest problem facing Bitcoin right now. Trust in Bitcoin exchanges has really dropped within the last year, and this reflects badly on the entire Bitcoin community.
Let’s think of it as designing Bitcoin 2.0. What should the next few years bring to Bitcoin in regards to a better, safer purchasing experience. Can you minimize Exchange Risk, without over-regulating Bitcoin, and throwing the baby out with the bathwater?
Bitcoin Regulation is not needed. Oversight is.
The problem is that the casual investor is now seeing the exchanges, where Bitcoin meets the world most directly, as the weakest link in Bitcoin’s security. This means many will never experience digital currency at all. There may be a day in the future when there are no more fiat currencies, and the mainstream monetary systems are digital like Bitcoin; easily integrated into Bitcoin’s ecosystem. Until then, we, as a community, need to find ways to make exchanges more secure, more accountable, and less prone to destroying overall trust in the Bitcoin currency. Leaving this to national governments, Ben Lawsky-type regulators, or the exchanges themselves is a poor man’s game, and will only lead to larger issues for Bitcoin. We have to be better than that, and hold the management of these companies to a higher standard or suffer the consequences of their ultimate failure.
Bitcoin will only become more and more valuable as we go forward. Need any proof of that? Just ask NASDAQ, as they announced on Monday that they were going to build digital currency exchanges with Bitcoin startup Noble Markets in New York. A brand and company with the size and clout of NASDAQ isn’t jumping into Bitcoin unless the demand and upside are HUGE! This means they know of hundreds, maybe thousands of institutional investors, corporations, and hedge funds that want in on Bitcoin, and want to deal with their branded service to do it right. NASDAQ may be after only the biggest of fish, but the ante in Bitcoin exchanges has just been upped. Can the current crop of Bitcoin exchanges handle these growing market pressures, and the responsibilities that come along with that?
Do you think the temptation to make an exchange and run away with the BTC under the cover of darkness will go down as its value increases? When exchanges are holding thousands of BTC, worth hundreds of million of dollars, will the ownership that in effect controls these Bitcoin allow themselves to be held accountable, at that point? Why would they do that? This exchange issue needs to be nipped in the bud, and an exchange protocol needs to be established now, or else the whole Bitcoin concept will collapse upon itself, it’s just a matter of time. As generally corrupt as the central banking system is, having a $250k Federal Deposit Insurance Corporation (FDIC) guarantee of your deposit account is valuable and necessary. People trust the system because of this safeguard. Bitcoin has no such thing right now, and going from an established safety net to none with a person’s personal wealth is not very realistic, nor logical.
Like using a regular bank, you don’t have to to have money or do business with them at all, just like you don’t have to use an exchange to get Bitcoin. It does make the currency easier to acquire and much more convenient overall, and we humans like greater conveniences, not fewer as we evolve. Exchanges will be seen as nothing but neighborhood gangsters if they don’t up their game in the name of consumer protection to compensate for their lack of FDIC protection.
For the first five years, until Mt. Gox, there probably wasn’t one exchange failure, not that there were that many exchanges to begin with. Now, with more exchanges, there is more exchange risk. With more value in the global Bitcoin market, there are more exchanges created, by who knows who. New exchanges are popping up all the time, only to be closed just as fast, with the walls far from barren. It doesn’t take a genius to figure out some people are smart enough to build an exchange and win some accounts from those who want to invest, but are only after a short-term theft. I’m tired of reporting on one theft or failure after another. It won’t get any better as each Bitcoin becomes more valuable over time, and it doesn’t have to be this way.
Is there any record of who controls these exchanges? Are they accountable to anyone? Letting a private bank run an economy is exactly how the U.S. Dollar is run with the Federal Reserve, and how is that going, by the way? The U.S. Dollar is going to lose its Global Reserve Currency status within this decade, destroying the dollar’s value for all times and the U.S. economy with it. Dollars used to hold checks for Gold on deposit. Now they are only valuable if you believe in their value. They have no inherent value at all.
Government has let The Federal Reserve, which is about as “Federal” as Federal Express, run amuck, and has been complicit in the economic destruction it has produced. Have we not learned from the mistakes happening right now in the economy? Don’t Bitcoin owners deserve better for their faith in Satoshi Nakamoto‘s vision? What are we doing to protect Bitcoin from “bad actors?” Not much, from where I sit. The last few months should be an aberration, not accepted as the cost of doing business. The Bitcoin Community has to make some choices as it grows, and the sooner, the better. If not, we risk destroying what could be the greatest thing we’ve ever had through our neglect. An economy of our own, designed to be more valuable as we grow older and use it more, and far more valuable than any fiat currency ever could be.
“It Takes a Village to Raise a Child”
Have you ever heard that saying before? It definitely applies to bringing new Bitcoin owners/users to the community. And it applies to the Bitcoin technology itself. If an exchange has unknown leadership, with no widely recognized standards for fiduciary responsibility, and no assurances it’s going to be there tomorrow morning, why should someone outside, or inside, of the Bitcoin community trust them? What’s the difference in sending a child into a building that could be a bank, a haunted house, or an abandoned building? A new user doesn’t know what’s going on inside of an exchange, and is taking quite a leap of faith. One exchange could be just like a bank. One can be gone tomorrow with the funds. It’s a roll of the dice. No wonder the community has not grown as expected.
When it comes to Bitcoin itself being the child that must be raised by the village, if you see a problem, you should say something, just like with so-called “terrorism threats.” The government uses terrorism as a catch phrase to take your freedoms away, but we can use these exchange closures as a way to bolster consumer confidence without destroying Bitcoin’s natural freedom of use. With half as much thought as Satoshi Nakamoto put into Bitcoin itself, we can come up with a way to protect it from “bad actors” in the exchange industry. I clearly see exchanges as a weak link, and am going to propose what I can see as potential solutions. The exchanges themselves should be one step ahead of me and this article. They should be working together to bolster consumer confidence, raising security standards, and not waiting for oversight from a nation-state’s politicians. A good idea can come from anywhere. Hopefully, I have one! If you have one, share it below.
The point is, the stronger exchanges become in protecting, the greater good, the more money they’ll make in the long-run. Also, the faster Bitcoin and the community can grow and prosper, So this is pretty important. Now, let’s get to the solution phase of this article.
What are your options?
I’m just going to throw out an incomplete list to get the ball rolling, to get you thinking. Please add any suggestions in the comments below. The goal is to make people new to the Bitcoin community feel safe adding money to the ecosystem without creating a regulatory environment like fiat currencies have, and need. I’m really simple-minded. I think the Bitcoin community should have a Bitcoin version of everything successful and useful that exists in the establishment’s modern economy. Bookstores, bakeries, auctions, and private financial insurance companies, like the FDIC.
The FDIC has proven to be incredibly effective in growing the banking industry over the last seventy-plus years, and doesn’t really have a downside risk worth mentioning. With smaller U.S. banks closing by the hundreds annually in the U.S., banks themselves aren’t inherently safe. They close at a rate not dissimilar to the Bitcoin exchanges over the past year. And just because you are a bank does not mean your money or information, are safe. Just see the security breach at JP Morgan Chase last year. JP Morgan isn’t going under anytime soon, but they can be compromised just like Target or Home Depot when it comes to protecting the information from 21st-century hackers. Bank safety is one of many illusions in the greater fiat economy.
What banks have, that Bitcoin obviously does not, is the FDIC as a safety net. There is a reason the FDIC shield is prominently displayed at your bank teller. The local bank teller is really no different than an online exchange website account, except the Bitcoin exchange website account has no such protections to advertize at this point. Look at it this way. If a bank didn’t have FDIC protection, it would be very similar to a Bitcoin exchange today, except be primarily offline. When the FDIC was created in 1933, it raised the perception of the entire industry greatly, making them much more trust-worthy. The adage about hiding money in your mattress came from the early 20th century for a reason. This is why the FDIC insurance model has lasted over seventy years. Because it works. So the Bitcoin ecosystem should definitely look at it as a model of success that may need to be integrated as Bitcoin exchanges and the economy as a whole grows.
In a banking system that is built around making as much money as possible, legally and otherwise, a consumer can always know that they will get their money back if the bank folds. It may take several months, but with proof of account, you’ll at least get $250k back, to protect the most financially vulnerable. Anyone with an ounce of economic sense isn’t leaving more than $250k in a bank at the current rates anyway, plus factoring in a real-world inflation of 5-8%. The $250k is per account, not per person, so you can have a trust for your child, a joint account, an account for yourself, and an account under your spouse’s name and get $1 million protected, if you so desire.
Can Bitcoin offer FDIC-type insurance? Well, an exchange can offer that itself as some extension of its sales pitch, but that would be just as senseless as if a bank insured itself. That wouldn’t stop the bank from folding with your funds and your so-called insurance. The FDIC is a third-party insurance corporation for a reason.
Any private corporation has shareholders and needs to make a profit. Just ask The Federal Reserve. The FDIC being an insurance company can only cause so much damage without creating national monetary policy. Suffice to say a very well-funded private group would have to handle the creation of such an insurance corporation for the Bitcoin community. The corporation would most likely get paid on a monthly basis by the exchanges it agrees to insure. Just like a car dealership pays insurance on its vehicles held in escrow before they are sold to the consumer, or how banks currently pay insurance fees to the FDIC. Seems like a good idea, as it has worked well elsewhere. Bitcoin doesn’t need insurance, but users need separate insurance from exchange risk, especially as the Bitcoin value grows over time.
The consumer can get insurance privately for the Bitcoin, but it doesn’t look like this has been invented yet either within the Bitcoin community. Plenty of cottage industries are available in the Bitcoin community for the entrepreneur. That is a prudent, but unlikely scenario, at least initially. Most of us have auto and health insurance, but not Bitcoin insurance. Hey, who knows? It could be the biggest thing of 2017.
Finally, I think there needs to be a way to prevent exchanges from closing clandestinely without a third party. This needs to be seriously considered given the fact that exchanges are handling money that is not their own. The reputation of the Bitcoin community indeed rests on how they handle the fiduciary responsibilities of being a de facto bank. If an exchange has your hand over your private keys, they need to be far more secure than an exchange that does not need both keys. Until a third-party protection system for consumers is established, every exchange should have an external third-party who can stop the closure or the transaction of closure from being completed without an audit or funds protection.
This would be perfect for an organization like The Bitcoin Foundation to lend oversight. They cansend out press releases regarding the exchange, account for the exchange leadership, and audit their accounts at the first sign of trouble. No exchange should hold more than 50 BTC without being vetted by a third party. The management should be identified and accounted. Any quarterly audits should be stored with the third party (see The Bitcoin Foundation). Approved exchanges should be listed on the Foundation’s website, with audit history, current security features for consumers, and whether they can maintain a 100% reserve ratio.
This sounds like regulation, and this may be how regulation starts, but oversight does not give the third party power over the entity. The Bitcoin Foundation would not become judge, jury, and executioner. It would be understood, in the Bitcoin community, and by your users, that you are not a trusted exchange until you have a minimum of X number of bitcoins. Also, you transact in fiat currencies, and you submit to auditing by the third party, The Bitcoin Foundation in this hypothetical example. The third party is a legal arbiter, not a regulator. They lend credibility, not rule of law. The Bitcoin community will in effect be the law. We will decide what third party is trusted to provide exchange oversight, and what exchange is maintaining a responsible standard with our investment.
I make the distinction between functional oversight and Bitcoin regulation because the mainstream has not mastered the art of financial regulation. I will go over Bitcoin Regulation Risk in the upcoming Volume 2 of this article tomorrow.
The point is oversight, not regulation, can help Bitcoin, and cause minimal damage to its original mission of personal freedom and peer-to-peer transactions. The Bitcoin community needs to start policing itself when it comes to exchanges and third-party handling of Bitcoin. If the Bitcoin exchange market doesn’t correct this matter internally, with Wall Street getting ready to do cannonballs in Bitcoin’s pool, Wall Street will correct it. And Wall Street cares about Wall Street, not Bitcoin. Bitcoin is just another investment vehicle to manipulate for them. For us, this may be our last shot at economic sovereignty. Let’s act like it.
So an FDIC-type corporation to bolster trust in the Bitcoin exchange community, and protect consumers from “bad actors”. Private Bitcoin insurance for individual investors, when they buy from Bitcoin exchanges, especially if they require private keys, which is a red flag in itself. And Bitcoin Exchange auditing and oversight. If you have other ideas, please comment below and share this article above.
Images from Shutterstock
