What you actually get when you buy Bitcoin
Bitcoin symbol in a 3d illustration
When you buy bitcoin, ether, or other assets on an exchange, you often don’t get crypto.
Instead, you receive a promissory note or IOU. In essence, you become a creditor to the stock exchange or broker. It’s a similar setup to opening a savings account at a bank.
The only way to know for sure that the crypto exists is to withdraw it from the exchange and place it in a private wallet that you control. Unfortunately, some investors have learned this lesson the hard way after high-profile collapses and bankruptcies this year of companies such as FTX, BlockFi, Celsius
You may have heard the phrase “Not your keys, not your coins”, which means that if you don’t personally have your own private keys, you can’t be sure that you have full control over your cryptocurrency. This is an important phrase to remember so you understand the beauty of buying crypto from a centralized entity.
Does it matter?
It may. Most investors are more concerned with gaining exposure to bitcoin and other digital assets than actually holding it themselves. This makes perfect sense, as it is a true bearer property with little recourse if lost. Additionally, the technological hurdles to holding your own crypto, let alone getting involved in other activities like lending and staking, can be daunting. Everyone who bought shares of Grayscale invested in SkyBridge’s Bitcoin
That being said, many people either knowingly or unknowingly have adopted a similar mindset when buying crypto from popular exchanges and services such as Coinbase, Gemini, Kraken, Square, PayPal, eToro and a host of other services. They want convenience, value the websites and applications that look and feel like mobile banking or merchant services, and trust that their regulated nature will ensure that the platforms operate honestly. They have faith that when they go to withdraw their coins, the funds will be there.
What are the risks of not checking your keys?
The risk manifested itself this year with all the bankruptcies mentioned above. The millions of unfortunate creditors of these firms may be forced to wait years for repayment and are likely to recover only a proportionate share of their assets. For a point of reference, creditors of Mt. Gox, the original crypto exchange that had 850,000 bitcoins stolen from them in 2014 before declaring bankruptcy, is still waiting for its own payouts.
Additionally, exchanges do not carry FDIC or SPIC insurance, and each has its own refund policy. Some have a rainy day fund set up with their own assets, while others have acquired private insurance to cover funds in cold storage. Please note that most of this will not protect you if the loss of funds comes from user error. Some firms offer services to trace stolen funds, but one recently Forbes research has shown that the results often do not match the promises.
What should you do?
There is no universal answer as every investor has a different level of risk tolerance, technical sophistication and frankly portfolio size. Like most things in life, it’s an individual decision.
Ideology is also important. Crypto supporters believe in decentralization, and they feel that some of the industry’s authenticity (and long-term potential) may be compromised due to the heavy reliance many people have on centralized service providers. Most accept this deal because they recognize that these firms offer important advancements to the industry, but hope that over time people will take higher levels of control over their crypto.
If you have a few thousand dollars in your portfolio, it’s still probably okay to keep it all on a reputable exchange. However, as your holdings continue to grow, you may want to consider moving some funds to an unhosted wallet, where you are the only person in control of the private keys that can initiate transactions. Some of the more popular manufacturers include Casa, Trezor, Ledger, ColdCard, KeepKey.
