Monday 29 January 2018

Bitcoin holder alert: financial libertarians beware

A few days ago, news emerged that Japanese cryptocurrency exchange Coincheck had been hacked, with more than US$500m worth of digital tokens reported to have been stolen. This is just the latest in a string of cryptocurrency exchange hacks. Back in 2014, for instance, Mt Gox - then the largest Bitcoin trading exchange in the world, handling an estimated 70% of all global Bitcoin trading - reported that 850k Bitcoin had been stolen (about 4% of the total amount of Bitcoin that will one day be on issue, and 'worth' some US$9.0bn at today's prices). If you were one of the unlucky customers that held Bitcoin or other affected crypto custodised by these exchanges, then tough luck. Your money is gone, and you have no recourse.

How can something like this happen? Isn't the whole idea of Bitcoin that it is a distributed ledger where transactions on the blockchain are verified by multiple nodes, rendering this sort of catastrophic failure impossible?

One of the key issues is this: actually transacting on the Bitcoin blockchain is incredibly slow and costly. Owing to Bitcoin's flawed architecture and its capacity limitations, in recent times it has cost as much as $100 per transaction, and taken 8hrs or more to process, and these capacity limitations will only get worse if the crypto's popularity were to rise (I doubt it will).

Consequently, what has been happening is that Bitcoin has instead been primarily transacted on exchanges. Here, the exchange buys Bitcoin on the blockchain and then custodises it (or at least claims to) on behalf of its clients. It then allows its customers to buy and sell the exchange's Bitcoin off one another. These transactions are not actually on the blockchain (which is why they are comparatively fast and cheap). What this means in practice is that you do not actually own any Bitcoin, and instead are little more than an unsecured creditor of whatever exchange you happen to be using. Furthermore, these exchanges are (for the timebeing) completely unregulated. They could defraud you and steal all your money; underinvest in proper security systems at get hacked; or otherwise fall into financial difficulty and fail, and if they do, you will lose all your money, and have no recourse whatsoever.

There is a reason the financial sector is subject to so much regulation (which is what makes it costly and cumbersome): there are a lot of unscrupulous folk out there that will happily fleece you, given the chance. Historical experience has shown the average punter to be too naive and easily fooled to allow the financial sector to operate in an unregulated manner - the smart and cunning too easily prey on the weak and inexperienced. The regulations are there to stop that from happening and protect you from the Wolf of Wall Street types out there (self-described as such; in fact, Jordan Belfort never worked on Wall Street, and was shut down by regulators within years and thrown in prison, and rightfully so). Those regulations are there to protect you from getting swindled. The financial libertarians out there championing Bitcoin should stop and think about that for a second. They are essentially inviting unsophisticated investors en mass to get ripped off by scamsters. 

The financial sector has come to be seen as popular villain number one by main street, and to be fair, bankers have not covered themselves in glory in the past, and so have partly brought this bad reputation on themselves. This antipathy has unleashed people's financial libertarian streaks, which has found expression in Bitcoin. However, what is often forgotten is how much actually goes right in the financial sector every day. Crises are actually very rare, and most of the time everything works seamlessly. It is much like the air transportation industry. Aeroplane crashes occasionally happen, and when they do they garner a lot of publicity and result in a lot of finger pointing. However, most of the time, everything works smoothly and with a remarkably high degree of reliability and safety. That happens because hundreds of thousands of smart people around the world work incredibly hard to make that so, but they are seldom shown any popular appreciation or recognition for it.

To some extent, the same is true of the financial industry. Although there are occasionally widely-publicised mishaps, every day, billions of transactions take place securely, reliably, promptly, accurately, and at low cost, and with almost no fraud or theft. It is remarkable. When was the last time you woke up and you bank accounts had been hacked, and not only had you lost all your money, but you also had zero recourse? Furthermore, on the rare occasion when something does go wrong (e.g. if someone steals or otherwise defrauds your credit card), you are suddenly happy that there is someone you can call who can help you out. You are happy that your accounts are on a non-distributed, centralised ledger held with a reliable and regulated institution, that can help investigate the problem, correct any errors, and ensure you recover any losses. All these security and reliability measures, and associated customer service, cost money, and that is why there are bank fees.

A completely unregulated and distributed cowboy 'currency' ('financial product' is probably a better description) like Bitcoin offers you no such protection. You have zero recourse if you are defrauded or hacked - none. And unlike the banks, nobody is out there regulating Bitcoin exchanges to ensure they have proper systems and cybersecurity in place to guard against massive customer losses (or requiring them to have a significant capital buffer of shareholders funds in place to absorb first losses, like banks and insurance companies do).

Furthermore, unregulated markets like crypto that are sucking in large amounts of inexperienced retail investor money are going to attract swarms of unscrupulous players like moths to a flame. Fraud will be very prevalent; retail losses enormous; and no one will have any recourse whatsoever.* The financial libertarians out there should be careful what they wish for.


*Steve Johnson of Forager Funds - an investor I highly respect - tweated a prediction a few months ago that the bulls currently reveling in Bitcoin's distributed, extra-governmental status, were likely to turn around and blame the government for their losses and failing to protect them after it all turns to pumpkins and mice. I suspect he will be proven right.

With the fullness of hindsight, when retail investors lose billions of dollars to fraudulent crypto scams, and the customer complaints role in and lawsuits start, serious questions are going to be asked about how this was allowed to happen in the first place. The whole crypto eco-system, including ICOs, will then come under serious regulation, defeating their whole raison d'etre. The entire crypto ecosystem is a giant financial accident waiting to happen.