Over the past year, some of the crypto world’s biggest companies have collapsed, from Celsius and Voyager to BlockFi and FTX. The one constant in all these failures has been the massive breach of trust for everyone involved – from retail investors to crypto institutions. I think it’s important to reflect on how and why this happened.
Let’s think back to the innovation that launched the entire crypto industry – the Bitcoin white paper. The very first sentence of that paper explains that the central problem of online commerce is trust. Internet payment infrastructure “still suffers from the inherent weaknesses of the trust-based model”, the pseudonymous author Satoshi Nakamoto wrote, “What is needed is an electronic payment system based on cryptographic proof instead of trust.”
But recent events provide a stark reminder that when dealing with crypto assets in practice, investors still need to think carefully about who and what they trust. I believe there are three important categories of trust in crypto – you can trust the code, you can trust the law, or you can trust the person. I’d like to explain each of these, and offer some advice on how to think about protecting your digital assets.
Trust the code?
The Bitcoin white paper invites us to trust the code, and because of this, Bitcoin and similar crypto assets are often referred to as a “trustless” system. In certain limited scenarios, it is possible to rely on this trustlessness. This has given rise to the maxim: “not your keys, not your coins”, suggesting that only those who self-custody their own crypto have true ownership of their assets.
It’s true that more centralized methods of holding assets involve some level of trusting an institution, just like you trust your local bank to keep your paycheck and retirement accounts safe. Of course, that doesn’t mean that self-custody – choosing to exclusively trust the code – is the right option for everyone. For one thing, not everyone has the technical savvy to do this successfully and safely. Even those who do will often still find themselves using centralized institutions to trade and access advanced products, so some level of dependence on trust is hard to get away from.
There are a host of DeFi protocols that offer a service that is more code-governed than a traditional centralized financial institution run by people. Trusting these protocols, however, requires that you personally verify that the code does what it says it does, or alternatively, trust the people who programmed it. We have seen throughout the course of 2022 that some of these decentralized protocols come with their own significant risks to investors.
We need to remember that a lot of the time, when we are told to trust the code, we’re really placing our trust in people. Just look at FTX. In public, FTX touted its automated liquidation engine as the ultimate risk management tool. In reality, FTX management appears to have secretly exempted Alameda Research, a huge trading firm personally owned by its founder, from that protocol. Alameda failed, and now the exchange itself is insolvent.
At the end of the day, if you are asked to ‘trust the code’ to protect your assets, you either need to be very certain that you understand the code yourself, or you need to think about whether you trust the people behind the code.
Trust the law?
In everyday life, we largely trust the law to protect our interests when we rely on banks and other financial institutions to make transactions and save our hard-earned wealth.
Fraud and financial crimes do happen, of course, but legal protections limit the impact on individual customers. In the United States, for example, even if a consumer bank were to become completely insolvent, the US government insures account holders to the tune of $250,000. In addition, there are well-developed laws and regulations as well as stiff civil and criminal penalties for financial misconduct in most parts of the world, which go a long way toward deterring bad actors.
Thanks to these legal protections, people generally have very good reason to trust retail bank deposits, at least in the developed world. In these places, “self-custodying” one’s fiat savings would entail a much bigger risk.
So another important question for crypto users to answer is: to what extent are they protected by law? In this regard, they need to think about not just their own home country, but also about which jurisdiction the institution they may be trading with is based in.
Users can more likely have some trust in the law when they are dealing with an institution that’s physically based in the country where they live, not offshore. It is also very important to consider whether that institution is licensed by local regulatory authorities who provide oversight.
In the case of Coins, we are regulated by the Philippines’ central bank, and hold a variety of licenses which are also held by local financial institutions. We’re audited regularly, and we comply with the rules. That’s what happens in places where there is real regulatory oversight – you follow the rules or you go to jail. It’s pretty simple.
Of course, there are still criminals in this world who choose to break the law, in finance and in every other area of life. As with “trust the code”, when you are relying on the law to protect your investment, there is always some degree of trust in institutions and people. It will be important to watch how legal authorities respond to the recent breaches of trust in the crypto space.
Trust the person?
I’ve established that in crypto, as in any other financial endeavor, there is almost always going to be some level of needing to trust your counterparty. We are not yet living in the totally trustless world envisioned by Satoshi Nakamoto.
What crypto users must not do is place their trust entirely in a group of people, or even worse, a single powerful individual. If a counterparty is a centralized institution that takes custody of your assets, and does so offshore, potentially beyond the reach of regulators and law enforcement, then they are essentially asking you to trust a person. If you wouldn’t agree to that with your fiat savings, you should think twice about doing it with your crypto assets.
If any good comes out of the recent negative events in the crypto markets, hopefully consumers think more carefully about the risks they are exposed to. And as crypto companies continue to build through the current bear market, let’s hope that both capital and customer interest flow to platforms and products that offer consumers some level of code-based or law-based protection beyond simply telling them: “trust me”.
By Elijah Tan, VP of Exchange, Coins.ph and ex-Binance Fiat Lead
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