The Hidden Dangers of “Paper Bitcoin” and Why Self-Custody Matters

(Not Your Keys, Not Your Coins)

Financial security and freedom are paramount in the ever-evolving world of cryptocurrencies.

Without self-custody, Bitcoin is just another digit on a screen! (Image from Paxful)

However, recent events have underscored the perils of entrusting our Bitcoin to third-party custodians. The FTX debacle, and the precedents set by Celsius and BlockFi, have thrown into stark relief the lurking dangers of entrusting your Bitcoin to others.

One such danger is a phenomenon known as “Paper Bitcoin,” and I’m not referring to Satoshi’s whitepaper.

Read on and get an education on why you need to self-custody your Bitcoin ASAP, lest it is lent to someone else, somewhere else, without your permission.

“Paper Bitcoin”: The Shadowy Threat to Bitcoin

“Paper Bitcoin” refers to a byproduct of leaving your Bitcoin on exchanges.

When a custodian lends your Bitcoin, that means that you no longer have access to it. (Image from Bulliscoming)

When these exchanges lend out customer deposits, they inadvertently create a scenario where customers possess claims on “Paper BTC” instead of actual Bitcoin reserves.

In essence, “Paper Bitcoin” refers to the pseudo-Bitcoin that exists only on paper or in digital ledgers of third-party custodians, without any direct correspondence to actual Bitcoin reserves.

This not only means that you lose access to your precious Bitcoin, but it also inflates the supply of Bitcoin in the market, suppressing its price and paving the way for market manipulation.

The Historical Fallout of “Paper Bitcoin”

The dangers of “Paper Bitcoin” are not merely theoretical.

The past has shown us stark examples of how this phenomenon can lead to disastrous outcomes.

The Mt. Gox Catastrophe

The infamous Mt. Gox collapse in 2014 is a grim reminder of what could go wrong when Bitcoin isn’t adequately accounted for.

Many people were affected by the collapse and mismanagement of Mt. Gox. (Photo from The Verge)

The collapse was a direct outcome of the exchange’s mismanagement of customer funds, leading to the loss of 850,000 Bitcoins, a significant amount of which belonged to their customers.

The fallout was catastrophic, plunging the market into a prolonged bear phase that took years to recover.

The Bitfinex Breach

In 2016, Bitfinex experienced a security breach that resulted in the loss of nearly 120,000 BTC, shaking investors’ confidence and causing widespread panic.

While the logo may look cool, being hacked for more than 100K BTC isn’t. (Image from CoinDesk)

This event negatively impacted the price of Bitcoin for months, demonstrating the tangible effects of exchange mismanagement and the inherent risks of “Paper Bitcoin.”

The FTX Liquidation

The most recent and potent example of the dangers of “Paper Bitcoin” is the liquidation of the Bahamas-based cryptocurrency exchange, FTX.

FTX was dealing in quite a lot of “Paper Bitcoin.” (Image from CNBC)

FTX was once the third-largest cryptocurrency exchange by volume, serving over one million users. Its collapse in November 2022 resulted from a liquidity crisis triggered by the crash of its trading token, FTT.

Even more concerning is the allegation that FTX had lent $10 billion from customers’ accounts to fund Alameda Research, a trading firm affiliated with FTX and owned by FTX’s chief executive Sam Bankman-Fried. Inevitably, this means that customer assets (including lots of Bitcoin) were not in their accounts or held by FTX.

This move, forbidden by FTX’s terms of service, is a prime example of “Paper Bitcoin” creation, resulting in potential customer losses and manipulation of Bitcoin’s market dynamics.

The Self-Custody Solution: Empowering Bitcoin Holders

So, how can we safeguard our investment and uphold the integrity of Bitcoin?

There are many hardware wallets to choose from, but they all do the same thing. (Photo from Bitcoin Wiki)

The answer lies in self-custody.

By withdrawing your Bitcoin from exchanges and securing it in a hardware wallet, you protect your funds from potential losses due to exchange mishaps or security breaches.

Moreover, self-custody helps maintain the authenticity of Bitcoin’s market dynamics by preventing the creation of “Paper Bitcoin.”

Why it Matters

Self-custody is not merely about protecting personal wealth; it’s about preserving the inherent value proposition of cryptocurrencies.

It couldn’t be any simpler. (Image from CoinPedia)

It’s about upholding the principles of financial freedom and sovereignty that cryptocurrencies like Bitcoin promise — ensuring that you hold the keys to your wealth, metaphorically and literally.

Not Your Keys, Not Your Coins

As the adage goes:

“Not your keys, not your coins.”

This saying underscores the importance of self-custody in the world of cryptocurrencies.

When you entrust your Bitcoin to third-party custodians, you give up control over your assets.

If the custodian fails, as in the case of FTX, Mt. Gox, or others, your assets are at risk.

The Road Ahead: Embracing Self-Custody and Due Diligence

The collapse of FTX, which has been likened to significant financial frauds such as the Enron and Madoff scandals, has had a broad and significant impact on cryptocurrency markets.

Using a hardware wallet and taking self custody of one’s digital assets is a fundamental step to preventing “Paper Bitcoin” from entering the market. (Photo from Ledger Insights)

It is a stark reminder of the dangers of “Paper Bitcoin” and the importance of self-custody.

To ensure a bright future for Bitcoin, we must embrace self-custody and exercise due diligence when dealing with cryptocurrencies. Understand the risks associated with third-party custodians and exchanges, and learn about the benefits and procedures of self-custody.

As we continue navigating this fascinating world of digital currencies, let’s strive for knowledge, empowerment, and security.

It’s what Satoshi would have wanted.