Exchanges seem to be emerging as a weak point of Bitcoin. As recently as August 3, 2016 The Guardian reported that 120,000 Bitcoin worth US$ 78 million were stolen from Bitfinex, a Hong Kong based exchange.
Back in 2014 Mt. Gox, a Tokyo based Bitcoin exchange responsible for handling as much as 70 per cent of Bitcoin transactions went under. The reasons for Mt.Gox’s winding up - mismanagement, neglect and ‘raw inexperience’ according to wired.com.
That disappearance of a major exchange also made US$ 460 million vanish in a puff of air.
Bitcoin should have been empowering but...
The idea of Bitcoin is that anyone who has access to basic technology such as a mobile phone would also have access to a fully functional bank account by default. However, unlike a traditional bank account there are some differences.
With Bitcoin, you are ultimately responsible for your money. You need to keep it safe and secure and you need to make sure that there are no mistakes made in the transfer of money from Point A to Point B, because there is no going back.
This immutability, which is typically considered a strength is perhaps also the achilles heel of the Bitcoin system.
As an example, if you pay with a credit card and you are victim of a fraud, you might be able to initiate a chargeback and the ‘bad’ transaction will go away. This is much more complicated when you use a Bitcoin-like system.
Immutability can cut both ways
Prior to the Bitfinex fiasco, the most discussed hack was probably the DAO heist which cost DAO holders US$ 50 million. The Ethereum community decided to implement a hardfork to try to reverse that damage.
Unfortunately that ended up splitting the currency itself and now we have ended up with two flavours of Ethereum, the regular Ethereum and a new-old currency called Ethereum Classic.
Can these forks to reverse dodgy happenings be considered as a form of customer protection like deposit insurance?
We talked with Fran Strajnar, CEO at BNC, and he says:
“What happened to the DAO was the world's first citizen asset forfeiture. A user driven bail-out. It was not insurance by definition, nor should it be viewed this way.”
Indeed many people would agree that immutability is a characteristic of cryptocurrencies which is worth preserving.
As Aleksandar Matanovic, CEO of EC District, points out, “I would be very disappointed to see the DAO approach being replicated to Bitcoin.”
Lack of deposit insurance is affecting Bitcoin adoption
At the moment the fiat currency banking system certainly has an advantage in the form of deposit guarantee insurance. In the United States such an insurance is given by the Federal Deposit Insurance Corporation (FDIC). In the United Kingdom this type of insurance is available from the Financial Services Compensation Scheme (FSCS) and many other countries have similar provisions as well.
In the Bitcoin world though such an insurance is not available from any governmental body. Coinbase does provide a private insurance cover to its users. The insurance that Coinbase provides is only against theft and ‘electronic compromise’. They are very categorical in mentioning that “This insurance policy does not cover damages resulting from a specific user's loss, such as the losses resulting from a compromise of the customer login credentials.”
Would having such an insurance make a difference to how widely Bitcoin is adopted? Aleksandar Matanovic believes that it does make a difference.
He says to CoinTelegraph:
“I do think that a lot of people don’t feel comfortable being totally responsible for holding their assets. Add Bitcoin’s complexity and regulatory uncertainty in the mix and there are plenty of reasons for a majority of people to wait and watch rather than get involved.”
Another point which is worth considering is institutional investors. Presence of deposit guarantee insurance could attract more investments into Bitcoin as well.
Fran Strajnar makes a point about this issue:
“Lack of deposit guarantee on exchanges is a concern for the buy-side. Some guarantee would see more institutional investors come into this Asset-Class.”
Deposit Insurance or similar is possible in Bitcoin
The experience of hackings, thefts and mismanagement at Bitcoin exchanges can be seen as a learning curve, albeit an expensive one. Innovative answers to the lack of a deposit guarantee can be brought out from within the Bitcoin community as well. Deposit insurance like products, for example, could be offered by private companies.
Aleksandar Matanovic describes one possible solution:
“I think very soon we could have companies storing customers’ Bitcoins (or altcoins) with a deposit guarantee and charging small fee for that. Similar to paying for the safe deposit box in the bank.”
There are other solutions too which are possible due to the unique nature of cryptocurrencies themselves.
Fran Strajnar explains:
”Cryptocurrencies will eventually evolve to offer more guarantees in the form of collateralized and insured exchanges, particularly if we see a successful ETF. We will also see a range of new decentralized instruments come to market which put ownership of balances (private keys) on trading platforms back into users hands.”
Keep your money safe - It is common sense
Exchange vulnerability is now a widely discussed phenomenon and anyone who deals with cryptocurrencies should practice some level of commonsense. It is best not to leave unnecessary funds lying around in an exchange wallet. My colleague Joseph Young has written an excellent article on where to store your Bitcoin.
Remember until the time there is a deposit insurance on cryptocurrencies, you are responsible for the safekeeping of your money.