Anthony* (a friend) called a few weeks ago, deeply concerned.
As a high school deputy principal in Queensland, he has spent hundreds of thousands of dollars buying cryptocurrencies over the past year, borrowing money using his home as equity.
But now all of his assets, worth A$600,000, were tied up in an account he couldn’t access.
He had bought through FTX, the world’s third-largest cryptocurrency exchange, endorsed by celebrities such as Seinfeld co-creator Larry David, basketball champions Steph Curry and Shaquille O’Neal, and tennis star Naomi Osaka.
With the spectacular collapse of FTX, he now awaits the outcome of the liquidation process that left him, 30,000 other Australians and more than 1.2 million customers worldwide lose everything.
“I thought these exchanges were safe,” Anthony said.
He was wrong.
Not like stock exchanges
Cryptocurrency exchanges are sometimes described as stock exchanges. But they are very different from those of the London or New York stock exchanges, institutions that have weathered multiple financial crises.
Stock exchanges are both highly regulated and help regulate stock trading. Cryptocurrency exchanges, on the other hand, are virtually unregulated and have no regulatory function.
They are simply private companies that make money by helping “mom and dad” investors with crypto trading, profiting from the commission charged on every transaction.
Indeed, the crypto exchanges that have grown to dominate the market – such as Binance, Coinbase and FTX – arguably undermine the entire vision that drove the creation of Bitcoin and blockchains – as they centralize control in a system intended to facilitate finance. decentralize and free them from the power of governments, banks and other intermediaries.
These centralized exchanges are not necessary to trade cryptocurrency and are pretty much the least secure way to buy and hold crypto assets.
Trading before exchanges
In the early days of Bitcoin (all the way back in 2008), the only way to acquire it was to “mine” it – earning new coins by performing the complex calculations required to verify and record transactions on a digital ledger (called a blockchain). .
The coins would be stored in a digital “wallet”, an application similar to a private bank account, accessible only with a password or “private key”.
A wallet can be virtual or physical, on a small portable device similar to a USB stick or small phone. Physical wallets are the most secure as they can be disconnected from the internet when not in use, minimizing the risk of hacking.
Before exchanges came into being, owners engaged in commerce selling directly to buyers through online forums, transferring coins from one wallet to another, as with any wire transfer.
Decentralized vs Centralized
However, all this required some technical knowledge.
Cryptocurrency exchanges reduced the need for such knowledge. They made it easy for less tech-savvy investors to get into the market, just as web browsers have made it easy to navigate the web.
Two types of exchanges emerged: decentralized (DEX) and centralized (CEX).
Decentralized exchanges are essentially online platforms to connect the orders of buyers and sellers of cryptocurrencies. They are only there to facilitate trade. You still need to hold cryptocurrencies in your own wallet (known as “self-custodial”).
Centralized exchanges go much further and eliminate wallets by offering a one-stop-shop service. They are not just a middleman between buyers and sellers. Instead of self-custody, they act as custodians and hold cryptocurrency on behalf of clients.
Exchange, broker, bank
Centralized exchanges have proven to be the most popular. Seven of the world’s ten largest crypto exchanges by trading volume are centralized.
But what customers gain in simplicity, they lose in control.
For example, you don’t give your money to a stock exchange. You trade through a broker, who uses your trading account when you buy and returns money to your account when you sell.
A CEX, on the other hand, acts as an exchange, a brokerage (taking customers’ fiat money and converting it to crypto or vice versa), and a bank (holding the customer’s crypto assets as a custodian).
This is why FTX held cash and crypto assets 10-50 billion dollars. It also acted like a bank by borrowing and lending cryptocurrencies – but without customers’ knowledge or consent, and without any legal liability imposed on banks.
With both wallets and keys, founder-owner Sam Bankman-Fried “borrowed” his clients’ money to support his other businesses. Customers realized too late that they had little control. When it ran into trouble, FTX simply stopped letting customers withdraw their assets.
The power of marketing
Like stock brokers, crypto exchanges make their money by charging a commission for each transaction. They are therefore motivated to increase trading volumes.
FTX did this most through celebrity and sports marketing. Since its inception in 2019, it has spent an estimated $375 million on advertisements and endorsements, including buying the naming rights to the stadium used by the Miami Heat basketball team.
Such marketing helped create the illusion that FTX and other exchanges were just as safe as mainstream institutions. Without such marketing, it is questionable whether the value of the cryptocurrency market would have increased from $10 billion in 2014 to $876 billion by 2022.
Not your key, not your coins
There is an adage among crypto investors: “Not your key, not your coins, simple as that.”
This means your crypto is not safe unless you have self-custody and store your own coins in your own wallet of which you only control the private key.
The bottom line is: crypto exchanges are not like stock exchanges and CEXs are not safe. If the worst happens, whether it’s a stock market crash or a cyber-attack, you risk losing everything.
All investments involve risk, and the unregulated crypto market carries more risk than most. So follow three golden rules.
Do some homework first. Understand the process of trading crypto. Learn how to use a self-custody wallet. Until governments regulate crypto markets, especially exchanges, you are largely on your own.
Second, if you are going to use an exchange, a DEX is more secure. There is no evidence to date that a DEX has been hacked.
Finally, in this world of volatility, only risk what you can afford to lose.
*Name has been changed.
This article has been republished from The conversation under a Creative Commons license. Read the original article.