reason #2
bitcoin IS TRUSTLESS
In his testimony before Congress in 1912, legendary banker JP Morgan stated "gold is money, everything else is credit". Money is debt. It is made from thin air and costs nothing. Ninety percent of all money is not physical - it is a string of numbers on a screen. Money is created when you take out a loan from a bank or when the central bank purchase government bonds. The financial system is built on trust and money is a trust system.
In the good old days, money was backed by precious metals like gold or silver. The Great British pound was the equivalent of 1 pound weight of sterling silver. That was a small fortune in the 8th century. By the tenth century, it was still a sizable chunk of change and could buy 15 cows. But it was downhill from there. The British Empire rose and fell, and two world wars later, you will need over 300 pounds sterling to buy one pound of silver. Over the centuries, the British pound has devalued 300 times. This is a global phenomenon and not limited to the United Kingdom. Countries all over the world debase their currencies. It goes back as far as the Romans when Nero started to add copper to silver coins. He started in 60 AD and in less than 200 years, his successors had reduced the silver content of coins from 100 percent to 5 percent. When a currency is debased it loses its value.
Sometimes the debasement is subtle. In the United States, for example, the money supply is increasing by 7 percent per year. This is a big increase, but not large enough for people to realize. Venezuela is debasing its currency at a far greater pace and the results are more obvious. When a currency is aggressively debased, people soon realize this and they start to demand higher prices for their goods and services. This is known as inflation.
So why do governments debase their currencies? Is it because they are evil or is it the unintended consequence of something else? Governments collect money in taxes and then spend that money in a variety of ways for the benefit of the country's hardworking citizens. Roads are paved, power plants are built to supply a steady stream of electricity, hospitals are erected, airports, old age homes, etc. What happens when there is insufficient cash from taxes and duties to complete all these noble projects? Governments can borrow money or they could print money. What sounds the easiest?
In the game of inflation, there are winners and losers. The winners are people and organizations that borrow money. They borrow strong money today and repay the loans with weaker debased money tomorrow. Who are the biggest borrowers in the world? Governments. Who are the people most hurt by inflation? Honest and hard-working citizens saving their money. Who are the biggest savers? Older people who are retired or on the point of retiring. Inflation hurts everyone, but it hurts the elderly the hardest.
If the United States continues to debase its currency at 7 percent per annum, the US dollar will lose half of its value in 6 years. To understand the impact of this debasement over time, $1 in 1913 (the year in which the United States Federal Reserve was created) had the same purchasing power as $26 today. In one century, the US dollar is 26 times weaker. Those are big numbers. The problem is that 95 percent of people in the world do not live in the United States. They live in countries with weaker economies and are therefore at the mercy of governments that are increasing the money supply at a faster rate, which means the half-life of their money is less than 6 years. It means that their money is losing half its value in 5, 4, 3, or 2 years, or maybe it is losing half its value in a couple of months. Let's now go back to the opening quote from JP Morgan. Gold is money and everything else is credit. Modern money is credit issued by the government. It is in their best interest to debase that money as much as possible without falling off a cliff like is happening in Venezuela.
Critics of currency debasement say it amounts to theft - that governments are gradually robbing people of their life savings. Most Venezuelans would concur because the robbery is in plain sight - Venezuelans can see their money devalue on a daily basis. The human brain, however, is not well suited to understanding dangers that are not visible in the short term. Hence our lack of urgency on climate change. Currency debasement takes place over months and years. Our time horizon tends to be days and weeks. This mismatch of time horizons means we are often oblivious to the profound damage being done.
Let's must now direct our attention to our trust in banks. Can you trust the banks holding your money? IN order to answer this question, you need to have a basic understanding of how banks work. When you deposit your money in a bank, it leaves the bank almost as quickly as it enters. Let's use some big numbers. You are Elon Musk and your cousin is starting a new bank. To help him out, you deposit $100 million for which an agreed interest rate of 2 percent is paid. Your cousin now has $100 million and he needs to put that money to work in order to pay the $2 million in interest in 12 months. He would like to use all this money, but banking regulations do not allow him. The regulators say he must keep 10 percent in reserve and can lend out only 90 percent. That reserve needs to be invested in a low-risk instrument like a US treasury bond that let's say earns 1 percent. Your cousin lends out the $90 million at 10 percent and makes a profit because the 10 percent charged is more than the 2 percent paid. This is known as fractional reserve banking and does give some comfort to depositors knowing that the bank has at least some cash on hand.
There are however two problems with this. Firstly banks can create money. Your cousin can lend out that $90 million, but he can also issue 1,000 credit cards and give customers access to credit in excess of the $90 million. Also, when times are tough and governments want banks to lend more money so as to keep the economy going, they can tweak the reserve requirements. In March 2020, at the start of the COVID pandemic, the Federal Reserve Board announced it had reduced its reserve requirements to zero. This meant that banks to lend as much money as they wanted. So what does this mean?
If every bank customer in the world demanded to withdraw their money from their banks, every single bank in the world would go bust, because banks have no money - they only have a list of assets and liabilities. As soon as the money comes in, it goes out. When you deposit money into your bank, you trust you will be able to withdraw it whenever you want. You will need to ask your bank's permission to withdraw your own money, and they may say no.
How often do banks fail? More often than you think. The fallout from the financial crisis in 2008 was severe in the United States. The Federal Deposit Insurance Corporation closed 465 failed banks between 2008 and 2012. Between 2013 and 2020 a total of 71 banks failed in the US. Most countries do protect depositors to a certain threshold. Prior to 2008, the limit was $100,000 in the US. In the throes of the 2008 financial crisis, the FDIC increased it to $250,000. If you held funds in excess of that limit, you found yourself at the hands of the bank liquidators.
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Another famous banking crisis took place in Cyprus in 2012. The largest commercial bank in Cyprus (aptly named the Bank of Cyprus) got into financial problems. In order to get out of its problems it seized the money of deposit holders with balances over 100,000 euros. The first 100,000 euros were protected by deposit insurance. Many countries offer this protection in order to promote financial stability and confidence and Cyprus is one of those countries. A total of 47.5 percent of all bank deposits above 100,000 euros were seized. The bottom line is that banks are not as safe as you think, and you need to think twice about putting too much trust in them.
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Finance is built on counterparty risk. Wherever you put your money, you need to have faith in your counterparty. When you invest in the stock market, you are buying shares in companies. You trust the directors will be good custodians of your investment. Companies, however, go bankrupt all the time. Sometimes on account of difficult financial conditions such as the 2008 financial crisis (Lehman Brothers and Washington Mutual in 2008), accounting scandals (WorldCom Inc in 2002), massive debt (General Motors and Chrysler in 2009), wildfires (Pacific Gas and Electric in 2009), fraud (Enron in 2001) or a contract dispute (Texaco in 1987). Sometimes companies fail due to external conditions and sometimes due to dishonesty, incompetence, or greed.
The same is true in the bond market. When you buy sovereign bonds, you trust the governments that issued the bonds will pay you the interest and the principal. Again, history is littered with sovereign debt defaults. In the last 20 years, there have been more than 20 sovereign defaults including Greece, Russia, Ecuador, Argentina, Venezuela, and Lebanon. The list of corporations that have defaulted on their bonds is too long to mention.
You also need to trust the intermediaries that buy these bonds and shares for you. Such is the structure of financial markets that there are gatekeepers. Shares and bonds are bought through stockbrokers and banks - again you need to trust they don't piss away your money before you get to buy your stocks and bonds.
That is a lot of trust at play. So how do you know whom you can trust and whom you need to avoid? We rely on companies known as rating agencies. They are independent research companies that calculate the credit risk of financial counterparties, and there are some big boys that play in this space. Standard and Poors, Fitch, and Moodys are the three biggest and they have the power to move markets. When they downgrade the credit risk on countries, politicians shake with fear and currencies devalue. When they upgrade the credit risk on corporations, CEOs rejoice and investors scramble to buy bonds. So how good are these companies at calculating risk? Can we trust them?
Their track record has been less than stellar. The collapse of Lehman Brothers in 2008 was the largest bankruptcy filing in United States history involving more than $600 billion in assets. The major rating agencies rated Lehman Brothers at single-A. The highest rating is AAA and the lowest rating is D for default. The scale is quite simple: AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Everything that is BBB and higher is known as investment grade. Single A is at the upper medium size of investment grade. At this rating, the obligor has a strong capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than the obligor in higher-rated categories. So Lehman Brothers, according to rating agencies, was quite solid a week before it went bust. In the wake of the financial crisis, it was revealed that rating agencies were not as independent as we thought. Banks were paying them large amounts of money to rate structured deals they were doing, and this could have clouded their judgment. It seems that money and trust do not mix well. If history has taught us anything it is that you need to be highly skeptical when handing custody of your money to anyone.
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In the crypto world, you can control your assets 100% and there is no need to trust anyone. This is how it is done. You store your crypto assets in a wallet. There are two kinds of wallets - custodial and non-custodial. The former is offered by exchanges such as Binance, Kraken, Coinbase, and unfortunately, FTX. When you store your crypto assets on an exchange, the exchange has access to your private keys and can do whatever they want with your assets. That is what Sam Bankman-Fried did to bring on the demise of FTX. After the FTX debacle, there was a mass exodus of assets out of exchange custodial wallets into non-custodial wallets notwithstanding the assurances from the exchanges that they would not steal your crypto.
With a custodial wallet like BitPay (also known as a self-custody wallet) you, and only you, have full access to and control over your 12-word secret recovery phrase and private keys. Who has custody over your funds is a very important issue in the world of crypto investing. It can all be distilled into one single word "permission". For example, if your crypto is in a custodial exchange, you need to ask permission from that exchange to withdraw your funds.
According to CNBC, the top 50 creditors of FTX are owed over $3 billion and the largest single creditor is owed $226 million. Traditional banks are also custodial institutions. When you deposit your money in the bank, your money gets mingled with all the other depositors. This is known as fractional reserve banking and exchanges operate in a similar fashion. Banks make money by taking your deposits, paying you a few percent per year, and then lending that money out at 10 percent. Regulators force banks to hold at least 10 percent of total assets in reserves. So, if they have lent out $10 million, they must hold at least $1 million in reserves.
The challenge is that FTX was not regulated so there were no reserve requirements. This means that all the assets that were held by customers on the exchange could be used by FTX. This is not stealing and only becomes an issue when the exchange is unable to pay back customers, and that is exactly what happened. Everyone is saying that SBF is a thief and should be thrown in jail. That may be true - but let me present to you an alternative opinion that may not get as many hits on the internet. Maybe SBF borrowed customer assets and then used them to trade Bitcoin. Again, banks do this all the time - it was one of the reasons Lehman Brothers failed in 2008. We all know that Bitcoin is in a bear market- its price has declined more than 70 percent over the past 13 months. Maybe SBF took a mega leveraged long bet on Bitcoin using customer money and was horribly wrong and lost customer money.
Ok, let's now work through the pros and cons of a custodial wallet. On the pro side, if you are the kind of person that is forgetful and absent-minded, the custodial wallet on an exchange may be best for you because you are more likely to lose or let your seed phrase fall into the hands of bad actors. Also, if you are a newbie to the crypto space and you want to learn, it may be a good idea to start with a small amount of cash using a custodial wallet. If you forget your password you are able to approach the exchange which will assist you in regaining access to your wallet.
On the negative side, we have already discussed how the exchange holds your private keys and may irresponsibly use your assets. The threat, however, is not only from within. Custodial wallets are also vulnerable to hackers. If you are a big-time hacker, are you going to spend your time trying to hack into the laptop of some schmuck working in Starbucks, or are you going to hack an exchange where the assets are? There is an old saying that if you want to steal lots of money, go to where the money is - ie the bank or an exchange. When you open an account at an exchange, you also have to go through the process of submitting documentation so that your account can be verified - that is another downside.
Custodial wallets are nearly always web-based and are usually provided by centralized exchanges like Coinbase and Binance. The interface is designed so users never have to directly interface with their wallets and do not need to worry themselves over seed phrases and private keys. It is easy to buy, sell and send crypto off the exchange because the user interface has been designed for ease of use. The custodian of the private key (namely the exchange) is tasked with "signing" transactions using the private key to ensure they are completed correctly.
Using a custodial wallet requires a great deal of trust in the institution which means you need to do your homework. In the wake of the FTX scandal, exchanges are doing their best to allay the fears of investors who have been pulling their crypto out. Major exchanges have been publishing proof of reserves (PoR). This is a verifiable auditing procedure that helps to enhance transparency to centralized cryptocurrency reserves. PoR uses cryptographic proofs, checks the ownership of public wallet addresses, and recurring third-party audits. It helps customers understand the platform's financial position and whether it has adequate funds to match customer deposits.
Non-custodial wallets are also known as self-custody wallets in that you have complete control of your keys and therefore your funds. There are two different kinds of non-custodial wallets - hot and cold. A hot wallet is a software wallet in that it typically comes in the form of an app you download onto your phone or laptop, while a cold wallet comes in the form of an external device that can keep your data offline and out of the gaze of bad actors. Both types of wallets protect your public and private keys. The right type of wallet for you depends on how much crypto your hold, your security preferences, and how easily accessible you need your crypto assets to be.
We are now going to do a blow-by-blow comparison of a hot versus cold wallet.
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1) Price
Almost all hot wallets are free. The most popular are Atomic, Coinbase Wallet, Electrum, Exodus, MetaMask, and Trust Wallet. A cold wallet, given that it comes in the form of a piece of hardware, can cost anything from $50 to $250. Three popular options are Ledger, SagePal, and Trezor. Whatever wallet you decide to use, it is important to check if it supports your crypto asset. Electrum, for example, only supports Bitcoin while MetaMask supports more than 500,000 because it integrates with many of the Web3 applications.
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2) Suitability
Hot wallets provide quick access to your assets which is perfect if you are a trader. If you are a long-term holder (or HODLer), you don't need access to your assets and the cold wallet is better for you.
3) Security
Anything that is connected to the Internet is riskier than something that is not. Recently, hackers stole around $5.2 million worth of Solana from 8,000 hot wallets, such as Phantom, Slope, and Trust. Solana claimed that the security vulnerability was in the code of the third-party wallets and not in their own, but this could have been nothing more than a finger-pointing game. Solana has suffered numerous security breaches and it could be that this hack was not the fault of the wallets. However, although security in hot wallets is average, you need to know that the security of cold wallets is excellent. They cannot be accessed online, but they do require security measures to keep them from getting damaged, lost, or stolen. But if you lose access to your hardware wallet, all is not lost. For example, if you are using a Trezor wallet, the recovery method is quite simple. You go into their website and choose the option "create a new wallet". That will generate a new seed phrase. You need to make a note of all the public addresses for the coins you are using. To find these, click on receive and it should pop up with your public address. You need to remember that each crypto has a different public address. Public addresses are often compared to your bank account number, which is a good comparison, but there is a small shortcoming. When you transfer Bitcoin into your wallet, the address will not be the same as when you transfer Ether. Transactions are recorded on different networks (normally BTC for Bitcoin and ERC20 for Ether). Luckily, the software used to send crypto knows this. If you put an Ether address in for a Bitcoin transfer, the software will pick up the error and inform you. Now that the new wallet had been created, you need to recover the wallet of the lost device. You will do this with your seed. Once the wallet has been recovered, you will send your assets to your new wallet.
4) Transfer to Exchanges
The interface between hot wallets and exchanges is easy because they are both online. Cold wallets on the other hand require an extra step to connect online through a USB, WiFi, or QR code. In summary, the biggest trade-off when it comes to wallets is between security and convenience. Whether you decide to go for a custodial or non-custodial wallet depends on whether you prioritize safety from potential online hacking or easy access to trading and staking. For a better balance of security and convenience, you can use a combination of both wallet types, storing easy-access funds online to trade and earn interest while keeping the keys to larger investments offline for longer-term storage.
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Seed Phrases: the most important layer of security for crypto users.
Seed phrases serve as the last line of defense preventing you from losing access to your wallet - be it a hardware or software wallet. Computers crash, phones get stolen or broken and wallets can be lost. If any of these things happen, your seed phrase will get you back into your wallet.
You need to keep your seed phrase safe and out of the reach of bad actors. No one should ask you for your seed phrase - not the exchange where you may operate, not the wallet vendor - nobody. If someone is asking for your seed phrase they are trying to scam you. If you are looking after your own crypto - also known as self-custody (when you store your crypto on an exchange, they are the custodians of your crypto), you need to know that the seed phrase cannot be recovered. If you are using a Guarda, Electrum, Binance, or Coinbase Wallet, and you lose access to the wallet for any reason, you are not going to able to contact these vendors in the hope they will restore your wallet.
So what is a seed phrase?
It is also known as a recovery phrase. It is a cluster of random words generated by your crypto wallet when setting it up, which can be used as an emergency backup if ever you need to restore access to your funds. Although somewhat similar, recovery keys should not be confused with private keys. Recovery keys are 12 or 24 words. Private keys are alphanumeric sequences that allow users to execute crypto transactions from their wallets. They both should be guarded with rigor.
How does a seed phrase work?
The term wallet can be confusing. People think that your crypto is physically stored inside the wallet. But crypto is 100% digital and therefore "lives" as data on the blockchain. This means that if access to your wallet is at some point interrupted (ie you cannot get into it for some reason), the data representing your funds are still securely recorded on the blockchain.
Seed phrases are generated whenever a new crypto wallet is created regardless of whether it is a hardware or software wallet. The phrases contain words drawn from a list of 2,048 words called the BIP39 Standard offering 128-bit encryption. Most seed phrases are either 12 or 24 words in length and are unique to the wallet that was created.
The words making up a seed actually correspond to strings of random digits called a seed. All the 2,048 words have a number assigned to them. When the seed numbers are configured correctly, that will generate the user's private master key, which in turn can be used to generate the rest of the user's private keys. This means that when you enter your seed phrase, the words need to be entered in the exact order in which they were provided in order for the recovery to work.
What does a seed phrase look like?
You are not allowed to choose them because humans are not good at generating random sequences so it is best you let your wallet do the hard work. An example of a seed phrase would be:
Tomorrow Snake Spell Frost Grant Acoustic Camera Correct Cotton Pony Remain Zebra
It needs to be reiterated that the seed words cannot be entered in any order - they must be entered in the EXACT order in which they were generated by the wallet.
How should I store my seed phrase?
It should never be stored digitally because then it is subject to being hacked. Of course, memorizing the phrase is technically the safest bet, but we all know that human memory is flawed. The best way is to go old school with a trusty pen and paper. You must write it down in proper order and guard that paper with your life to ensure it never falls into the wrong hands. This includes keeping the paper containing your seed phrase safe from fire, water, and anything else that may render it unreadable.
When it comes to storing your paper, you can keep with the old-school theme and acquire a safe that offers fire and water protection. However, if a full-blown safe seems impractical to you, there is the option of a steel wallet. These are the size of a credit card and they start at around $100.
Prepare for Emergencies
One more thing to consider is what happens to the seed phrase in an emergency. If you are the only person that knows the seed phrase, nobody else will be able to recover your funds without it. For these contingencies, it might make sense to have a trusted friend or family member be able to access your recovery phrase in the event you are physically unable to do so.
What happens if you lose your seed phrase?
If you have a self-custody wallet and lose access to your wallet and your recovery phrase, you will not be able to access your funds. If there was a workaround to a lost seed phrase it would render them pointless. If you are uncomfortable about storing your seed phrase, then you are better off taking the risk of using a custodial service.
What is the difference between a seed phrase and a private key?
They can be easily confused. Both are sequences generated by new crypto wallets which must be protected to keep intruders from accessing your funds. The two, however, serve different functions and it is important that your know the difference.
A private key is like the PIN to your ATM, a password that is necessary to withdraw funds from a checking account or to approve a purchase when using a debit or credit card. A seed phrase on the other hand is like a master key to your entire lifestyle savings, which gives whoever possesses it the ability to assume total and permanent control over it and everything in it.
Can seed phrases be hacked?
The only way that seed phrases can be hacked is through human error, including a lapse in security judgment like keeping it in a Google Doc or a text file on your desktop. Assuming your seed phrase is recorded physically, either in writing or in a steel wallet, nobody but you can gain access unless you reveal it or someone steals it. That said, there are a number of known malware or phishing methods designed to trick a user into revealing their seed phrase. This means you should be highly suspicious if anyone prompts you to reveal your seed phrase, no matter the reason.
