Cryptocurrency has been in the news a lot in the last month. Most importantly FTX’s fraudulent fall, which led to Bitcoin’s (most recent) crash. However, what many techies see in the historic loss is a lesson that can be learned: crypto isn’t simple, it was never meant to be, and trying to simplify it doesn’t lead to anything good. The creation of centralized “simple crypto” has made cryptocurrency less simple and is the root problem in cryptocurrency fiascos.
It’s not a secret that a large number of cryptocurrency investors really don’t know what they’re stepping into. The average person has likely heard the ubiquitous “invest in crypto” cries from coworkers, friends, or even family. PayPal, Venmo, and Robinhood all allow users to exchange USD for currencies like Bitcoin. Furthermore, many may assume that crypto is as secure of an investment as legacy mediums like stocks and bonds.
Unfortunately, this fundamental misunderstanding can be traced to users’ loss of billions in FTX.
To understand cryptocurrency, one must first understand the blockchain. Put simply, the blockchain is a decentralized, distributed database that records transactions on a network. One could say it is a digital version of a ledger.
Transactions are stored in units called “blocks,” and once a block is verified and added to the chain, the transactions stored within are guaranteed to be legitimate, and the entire group cannot be changed. This guarantee is secured via cryptographic techniques which correspond together between each block. This creates a chain of blocks that cannot be altered, and guarantees the authenticity of the stored information.
As stated earlier, the blockchain is fundamentally decentralized, which means it is controlled by no singular entity. Instead, it is stored and maintained by a network of computers, each individual computer a “node” in the system. The cooperation of these nodes ensures that transactions are validated and recorded onto the blockchain. This is one of the most important concepts to understand about the technology, and a driving principle in Satoshi Nakamoto’s creation of the first blockchain.
Crypto & Fiat
Cryptocurrency is a digital asset that uses this blockchain technology as a means of storing and proving value. There are a lot of things that separate cryptocurrency from standard fiat currency like the U.S. dollar, but the most important ones to understand are where value is derived from and what governs them.
Cryptocurrencies (with some exceptions) derive their value from two things, the resources required to produce them, such as electricity and time, and investor confidence. If one of these variables decreases, the value of the cryptocurrency will also decrease.
By contrast, fiat currencies like the U.S. dollar derive their value from one variable, government confidence. Since the U.S. dollar is no longer attached to the gold standard, and the resources required to make them are negligible, nothing backs the currency except trust in the U.S. government.
As for governance, there is nearly no law in the U.S. that pertains to cryptocurrency. All that exists is a barebones framework by the SEC that can be boiled down to “it exists as a ‘security.’” Fiat currencies such as the dollar are far more regulated. While this does come with all the classic problems of regulation, it also comes with a lot of protections, such as fraud prevention, oversight on market manipulation (something that cryptocurrency has a serious problem with) and relatively higher stability.
“The Wallet” Error
These are complex concepts to grasp, which is why companies providing exchanges and managed wallets became popular for the crypto-curious and enthusiasts. Unfortunately, the service that these companies provide actually breaks the entire concept of decentralization, the cornerstone of the blockchain. FTX was one of those companies.
FTX, in a nutshell, was a cryptocurrency market combined with a cryptocurrency wallet. A cryptocurrency wallet is a software program that stores a user’s cryptocurrency and proves that the user owns it, and you can imagine it just like a wallet you may carry in your pocket.
Users would transfer cryptocurrency from their personal, private wallets into their FTX wallets, and from there, use the FTX wallet funds to trade. However, by transferring cryptocurrency into a wallet that a company or entity can access, an individual immediately loses the protection of decentralization: the user no longer has sole access to his or her funds, nor can they change their wallet in any way.
After accruing a large amount of credibility in the crypto enthusiast community, and becoming the second most popular cryptocurrency exchange in the world, FTX exercised its full authority over the funds stored in their affiliated wallets. Why throw away all the goodwill the company had formed? Pure necessity.
Binance, the only exchange larger than FTX announced they were going to sell off all their FTT, a cryptocurrency that made up a large amount of FTX’s value. This caused the value of FTT to fall, which in turn caused FTX’s value to fall, which created a liquidity crisis. FTX simply couldn’t continue to pay for its existence, so they froze all transactions, stopping users from retrieving their cryptocurrency.
From here, the story diverges depending on who one listens to. FTX claims that the company was hacked and that they lost the majority of what they had left. The unofficial story was that the CEO of FTX, Sam Bankman-Fried, was allegedly the individual, or was linked to the individual, who drained FTX wallets of their remaining assets.
This is, of course, massively oversimplified, but regardless of which story one decides to believe, there are two things in common. First, the money is gone, at least for now. Users have lost more than a billion dollars worth in cryptocurrency. Second, if FTX didn’t have custodial authority over the associated wallets of their users, individuals would have been completely safe.
Bottom line, if user wallets remained decentralized and only accessible by their respective owners, all users would have access to all of their finances while FTX crashed and burned in the background.
Dozens of other crypto exchanges also have users deposit their funds with them in order to trade on their platforms. Each and every one of these exchanges and programs that force the user to give up their autonomy has the exact same ability to devastate users as FTX did.
Now, the knee-jerk reaction to understanding this from politicians, online influencers, and even some “intellectual” cryptocurrency enthusiasts has been to call for regulation of cryptocurrency in order to keep similar problems from happening again. Ironically, they want to fix a problem rooted in centralization with federal government intervention—which would create more centralization, and worse still, not with a company, but with one of the most centralized and top-heavy entity types in the world.
In reality, regulation will never help solve the underlying problem that caused the loss of billions in FTX. Every custodial wallet provider has one thing in common, and it’s the fact that they try to make cryptocurrency as easy as possible to get into. Ease of access requires users to give up some amount of autonomy to the providing company. This is the true problem.
Cryptocurrency was made to be complicated and decentralized on purpose. The overengineering is necessary to protect users and their anonymity as much as possible so nobody can be responsible for the loss of his money but the user himself. The second that overengineering is peeled back, the whole intricate process is damaged, much like with any complex piece of machinery. The solution could never be regulation. No, the solution was already there from the beginning. The solution is simply using the technology the way it was meant to be used. Individually, autonomously, and anonymously.