Bitcoin you’re hodling may be a derivative

Demons in Digital Gold, Part 1

If you have not already done so, please read the introduction to this series.

A derivative is security with a price that is dependent upon or derived from an underlying asset. The derivative itself is a contract between two parties based upon the asset. Its value is determined by fluctuations in the underlying asset.

The most notorious derivatives were the primary cause of the 2008 great financial crisis.

— Financial Times

The Times 03/Jan/2009 Chancellor on brink of second bailout for banks

— Message embedded in the Bitcoin Genesis Block by Satoshi Nakamoto

This detail, “second bailout for banks,” suggests that rescuing banks [from reckless investments in financial derivatives] was a problem for Satoshi. It is seen as one of his motivations for developing Bitcoin.

— Bloomberg

Summarizing the quote-a-thon: financial derivatives can be dangerous and lead to ruin on an individual or MUCH larger scale. A derivative is a contract between parties that must TRUST each other to fulfill their obligations. When a party cannot meet their contractual obligations, bad things can happen. Combining “much larger scale” with widespread failure to “fulfill their obligations” and TREMENDOUSLY “bad things can happen.”

Fair to say that Satoshi loathed financial derivatives, and Bitcoin was developed as an anti-derivative. TRUSTLESS. DECENTRALIZED. SECURE.

Stone tablets

Those three properties certainly make it onto the stone tablet of Bitcoin’s customer-perceived value proposition. (Quotes in the bullets below are taken directly from the original whitepaper.)

Trustless: the system is entirely self-enforcing, so parties do not have to trust each other — or even know each other — to transact. “What is needed is a system based on cryptographic proof instead of trust.”
Decentralized: the system is peer-to-peer, and eliminates the need for “financial institutions serving as trusted third parties.”
Secure: the system absolutely assures transactions between parties. Confirmed transactions are “completely non-reversible.”

Before continuing, let’s address perspective as discussed in the introduction to this series (that you’ve already read).

This series focuses on the present perspective, because we live here.

So far, I’ve spilled quite some ink on the past perspective. That’s copacetic: these were not only foundational elements serving as key motivations and objectives in 2009, these remain core elements that define Bitcoin (et al) in the eyes of today’s cryptocurrency users. In other words, we are firmly in the present perspective.

Bitcoin you’re HODLing

“What does all this have to do with my Bitcoin?” you may be thinking, and justifiably so. I am working from the assumption that you hold Bitcoin for one or more reasons, and hopefully not STRICTLY because the price goes up. Your reasons have to do what makes Bitcoin different, and most all of those differences are rooted in the three “stone tablet” properties.

Speaking for myself, I consider them THE BIG THREE: these are the properties that initially attracted my attention, then piqued my curiosity, then drove me to learn about blockchain technology down to “the bare metal,” and built my enormous respect for what Bitcoin (et al) has accomplished and represents. Hell, I was inspired enough to write a book.

TRUSTLESS. DECENTRALIZED. SECURE. I’m betting we agree that these are key properties that help define Bitcoin’s value. I’m betting we agree that these are key reasons that we own Bitcoin.

May be a derivative

“Major dissonance!” you contend. “You used the term ANTI-derivative. How the hell could my Bitcoin be a derivative?” I feel you, the dots do not seem to connect. At long last, a thousand words into this post, I am gonna’ get down to dot connecting.

I’m here to lay out facts that you may have overlooked. You’re here to reach your own conclusions.

Y’all being a sophisticated readership, many of you hold Bitcoin (et al) on your own private wallet. Some of you hold your Bitcoin on an exchange, and I’ve got news for you: you don’t own Bitcoin, you own a bitcoin derivative. [Those of you with your own private wallets need to keep reading, as this also impacts you in a BIG WAY, albeit indirectly.]

This is NOT a matter of definitions/nomenclature. This cuts straight to the matter of what makes a Bitcoin a Bitcoin. Your Bitcoin (et al) on an exchange does not pass the test. While the explanation that follows is not technical, curious readers may want to consult Where is a Bitcoin?

What’s in YOUR wallet?

Bitcoin held in your own private wallet — Mac/Windows/Linux/mobile app, full node, Trezor, etcetera — includes the PRIVATE key of each bitcoin address you own. That private key enables your wallet to construct and submit transactions to the bitcoin network, transactions that SPEND your Bitcoin. Let’s quickly evaluate The Big Three …

Trustless: check. You transact with other entities across the bitcoin network with complete certainty, with absolutely no implicit trust.
Decentralized: check, as long as you pass Our Bitcoin wallet checklist. You interact directly with the bitcoin network, peer-to-peer, not relying on ANY intermediary.
Secure: check, ditto passing the checklist. Your wallet performs its own cryptography, generating its own digital signatures when sending Bitcoin and verifying applicable data when receiving Bitcoin. Another facet here is cyber-security — keeping your private keys, well, private — and that element (for example, proper anti-malware and backup) is up to you.

Holistically, this is the promise to “be your own bank” fully realized.

What’s on your exchange?

“Aren’t you nitpicking?” you ask. “Holding Bitcoin (et al) on an exchange just means that the exchange manages my wallet, right?” WRONG. On an exchange, you DO NOT HAVE a bitcoin wallet, full stop. “But right there on the home page it says ‘My Wallet’ and lists my balances by coin!” What you see is simply your account balances tracked by an internal database maintained by the exchange.

**Let’s unspool this**You open and fund an account on an exchange. You purchase Bitcoin on the exchange. The exchange records that purchase in their own internal database. You cannot see the private key corresponding to your Bitcoin purchase. You cannot even see the public key corresponding to your Bitcoin purchase. In fact, THERE IS NO private-public key pair corresponding to your Bitcoin purchase, and furthermore, your purchase IS NOT RECORDED on the bitcoin blockchain.

“Say WHAT?!” Re-read the above paragraph and refer to Where is a Bitcoin? as needed. Before evaluating The Big Three, let’s see what IS on an exchange.

Your exchange DOES own Bitcoin (et al). Your exchange holds its Bitcoin in a real wallet with a private-public key pair for each address the exchange owns. In theory, every exchange keeps a full reserve of each cryptocurrency they own. In other words, your exchange holds an amount of Bitcoin in its wallet equal to the grand total of all bitcoin holdings of all users as recorded in their own internal database.

An exchange expands its reserve by purchasing Bitcoin from another exchange, or when a user transfers (“deposits”) externally held Bitcoin onto the exchange. An exchange reduces its reserve by selling Bitcoin to another exchange, or when a user transfers (“withdraws”) Bitcoin off the exchange.

The “in theory” qualifier two paragraphs above may or may not make you uncomfortable. If you routinely review your exchange’s published audits, you’re probably quite comfortable that your exchange is fully backed. If you are confident that your exchange is routinely audited by a reputable third-party, you’re probably pretty comfortable. Do a little homework and you’ll sleep easier.

So you’ve done your homework and are secure in the knowledge that your exchange holds a full reserve of Bitcoin. Your account is a balance recorded in their own internal database. Recognize that you DO NOT own any Bitcoin at any specific address.

You literally own a bitcoin derivative: an entry in their internal database, representing a tiny fraction of the underlying asset that is the exchange’s reserve of Bitcoin held in its wallet.

**Let’s continue to unspool this by selling some of your Bitcoin**Your sell order is matched against buy orders in the exchange’s dark pool. The match — your sell order and one or more buy orders — is settled entirely within the exchange. Your bitcoin balance is reduced reflecting your sell, and some other user(s) bitcoin balance is increased reflecting their buy. Fiat currency balances are adjusted accordingly for you and the other user(s).

Now let’s look at what DOES NOT happen in this trade. The exchange’s reserve of Bitcoin does not change. The private-public key pairs in the exchange’s wallet do not change. NO TRANSACTION is recorded on the bitcoin blockchain. The only time your activity is recorded to the blockchain is a transfer off the exchange, for example, to your own private wallet.

By now you have an inkling of what evaluating The Big Three will yield …

Trustless: NO. You depend on your exchange and trust them implicitly.
Decentralized: NO. All of your activities — and the activities of your fellow users — strictly run through the exchange.
Secure: check, with caveats. A top-notch, reputable exchange is secure on a transaction basis. Such an exchange should also be secure on a cyber-security basis, with low risk that your Bitcoin will be lost. You in an awkward position, nevertheless, as significant hacks with significant losses regularly make headlines. This shouldn’t be a surprise, because successfully hacking an exchange is extremely profitable and VERY difficult to catch. Every one of the major exchanges has a ginormous target painted on their back.

“So I hold a bitcoin derivative,” you acknowledge. “Why should I care?” That is such a great question, I will tackle it in two sections.

Bitcoin derivatives: your own holdings

Recognizing that on an exchange you hold bitcoin derivatives — as opposed to “Bitcoin proper” — is the first step. If you bought Bitcoin (et al) because you feel strongly about The Big Three, your next step is adjusting your thinking, planning, and actions.

I wrote about the pros and cons of Keeping your cryptocurrencies on an exchange, complete with actionable mitigations. Check out that post.

**Know thy exchange**One key takeaway from the section above: you are placing A LOT of trust in your exchange. If something happens to your exchange — through hacking, malfeasance, or plain bad luck — you will be in a world of pain. No FDIC insurance. No zero-liability credit card protection. No “contact us” (it’s hard enough to get a reply out of an exchange in the best of times). And most pertinent to our dialog, none of the “be your own bank” dynamic that many of us hold so dear. In short, you could be SOL.

So do your homework. Read the terms and conditions. Read reviews from reputable (that would exclude Reddit) sources. You might decide that a different exchange is more trustworthy and/or secure than your own.

If you are wedded to keeping your Bitcoin (et al) on an exchange …

there is a concrete measure you can take to mitigate risks of your exchange being hacked: spread your cryptocurrency holding across multiple exchanges.

… technically speaking, that spreads but does not reduce your risk.

**Consider using your own private wallet**There are many options here: an app on your Mac/PC, an app on your mobile, running a full node, and a hardware wallet. Read my earlier series Where can I keep my Bitcoin? for an overview of these options. Yes, you can “be your own bank!”

With that said, a note of caution from The Bitcoin Tutorial is in order …

If misused, however, every bitcoin wallet has the potential to LOSE all of your bitcoin. Throughout The Bitcoin Tutorial, we’ve discussed the contemporary cryptography that protects Bitcoin. It is unbreakable. Should you end up on the wrong side of all that cryptography, there isn’t a person on the planet who can help you.

Please RTFM. If you are not comfortable with a wallet you’re considering, find another wallet.

**One last reality check**Transferring Bitcoin (specifically BTC) has become more challenging and expensive in the past months. This is not much of an issue if you are HODLing Bitcoin, as you will not make frequent transfers to and fro. If you want to trade your Bitcoin (specifically) at the drop of a pin, however, you need to be aware of the transaction traffic jam that is the bitcoin mempool. [Lest you wonder, yes, an upcoming post in this series will dissect said traffic jam in detail.]

Bitcoin derivatives: the macro picture

Hey! You with your own private wallet! This is the where I describe how …

this also impacts you in a BIG WAY, albeit indirectly.

... thanks for rejoining the class. There are many reasons why ALL cryptocurrency owners should be concerned about bitcoin derivatives.

**The adoption bullshit**First, recognize that the VAST majority of bitcoin (et al) owners keep their holdings on an exchange. When you read about soaring “adoption” rates, those new users are opening an account on an exchange. As spooled out above, such “adoption” has NOTHING to do with the bitcoin ecosystem.

Headlines proclaiming “Mass Adoption of Bitcoin!” are bullshit. Are more and more real people transacting commerce in Bitcoin? That would be fabulous news, but you would be quite wrong to reach such a conclusion. Quite the opposite, as the aforementioned Bitcoin traffic jam REDUCED the number of businesses and people transacting in Bitcoin in 2017.

**The price discovery distortion**Next, consider a properly functioning price discovery mechanism that reflects the customer-perceived value of a cryptocurrency. Yes, I know, this exercise requires temporary suspension of disbelief … we can at least PRETEND to be value investors driven by fundamentals.

Sense of scale: the number of trades of Bitcoin (specifically BTC) on exchanges EACH DAY is greater than the number of transactions recorded on the bitcoin blockchain IN A MONTH. [Ratio extrapolated using data for the last quarter of 2017.]

In other words, “bitcoin activity” is dominated by trading that has NOTHING to do with the bitcoin ecosystem. If you’re a speculative trader, you’re totally cool with that. If you’re fundamentals-driven investor, you must recognize that the price discovery mechanism has little if anything to do with any underlying value. Let me drive that point home with …

**A creative thought experiment**Finally, imagine that the entire bitcoin ecosystem suddenly goes “poof” and we find ourselves with no miners, no peer-to-peer network, no blockchain. Ask yourself: is the disappearance reflected in the hulking bulk of trading activity? Nope. We’re in the world of make-believe here, so work with me. Everyone trading on the exchanges goes on merrily trading on the exchanges (other than a tiny number of souls unable to transfer Bitcoin to/from their private wallets).

I am not working a philosophical “if a tree falls in a forest” exercise with you. I am playfully illustrating that the VAST amount of cryptocurrency activity has precious little to do with the underlying blockchain, much less customer-perceived value of the cryptocurrencies.

Sotto voce: at least a dozen circa 2013 cryptocurrencies — each built atop the bitcoin code base with their own blockchain ecosystems— continue to trade today on exchanges, despite the fact that their respective blockchains have long since gone completely dark.

Long-time Bitcoin bull and top-flight FinTwit contributor Brent Johnson (@SantiagoAuFund) recently opined thusly:

Bitcoin as described in Satoshi’s whitepaper is a marvelous & revolutionary invention. But from what I can see, it is being used very little as Satoshi intended.

Once again, I remind you that the raison d’etre of this series is for you to assimilate facts and reach your own conclusion. Neither Brent nor I are throwing the bitcoin baby out with the blockchain bathwater. We believe Bitcoin holds value, and we strongly believe everyone needs to evaluate its value with the latest facts in mind.

Future perfect tense?

“But what about SegWit and Bitcoin Cash?” you ask. “Won’t they ‘fix’ the derivatives conundrum and make this issue moot?” In a word, NO.

Yes, SegWit increases Bitcoin’s (specifically BTC) transaction throughput by as much as 5x. Yes, Bitcoin Cash increases its transaction throughput by as much as 8x compared to pre-SegWit BTC. Those are both laudable and useful improvements, though hardly of the scale needed to close the gap with trading activity. And neither improvement changes the 1+ hour latency needed to fully confirm a transaction on their respective blockchains.

Furthermore, exchanges are struggling — to say the least — to support trading activity within their independent closed systems. They have ZERO interest in adding complexity, as would be required for a fully blockchain interwoven system. Even granting a miracle would not “fix” the derivatives conundrum.

A suitable deus ex machina could reveal your PUBLIC keys, but the exchange can never hand you the corresponding PRIVATE keys; that would open the Pandora's Box of an entity yanking the bitcoin carpet out from underneath the exchange, with no way to determine if the entity was you or any random ne’er-do-well.

Can’t we get a simple Thomas Cook?

Way back when I first heard the term “cryptocurrency exchange,” I had a mental image of a simple Thomas Cook exchange. Ya’ know, the airport booth where you exchange “your” fiat currency for local fiat currency. This is entirely workable …

Your private wallet app generates a new private-public key pair
Your wallet calculates a Bitcoin address from the public key
You include that address with the fiat currency transfer to the exchange
The exchange sends Bitcoin (et al) to the address you provided
Your private wallet acknowledges receipt of the expected Bitcoin

… indeed, the above is EXACTLY how some bitcoin ATMs operate!

So why don’t cryptocurrency exchanges work that way? Simple: there isn’t much money in it. There is way, WAY more money to be made off spreads and fees in crazy-high-volume crypto-currency trading. Hell, we haven’t even mentioned MARGIN extended by most of the major exchanges. These highly profitable aspects of running an exchange are NOT compatible with the vision of a fully blockchain interwoven system. They are maximized by a closed system trading within the exchange’s dark pool.

I leave this post with a word-association exercise …

derivatives
dubious price discovery
exchange dark pools (a.k.a. “ponds” of liquidity)
margin (a.k.a. leverage)

… see if that rings any bells.

Next in the series …

Do exchanges pose a systemic risk?

Follow me @Pressed250 on Twitter