What you can and can’t trust in crypto
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 is 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 this article explains that the central problem with online shopping is trust. Internet payment infrastructure “still suffers from the inherent weaknesses of the trust-based model”, wrote the pseudonymous author Satoshi Nakamoto, “What is needed is an electronic payment system based on cryptographic proof rather than 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 think 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.
Do you trust the code?
The Bitcoin White Paper invites us to trust the code, and because of this, Bitcoin and similar cryptoassets are often referred to as a “trustless” system. In certain limited scenarios it is possible to rely on this distrust. This has given rise to the maxim: “not your keys, not your coins”, implying that only those who self-custodialize their own crypto have true ownership of their assets.
It’s true that more centralized methods of holding assets involve a degree of trust in an institution, just as you trust your local bank to keep your paychecks and retirement accounts safe. Of course, that doesn’t mean that self-storage—choosing to rely solely on the code—is the right option for everyone. Firstly, not everyone has the technical knowledge to do this successfully and safely. Even those that do will often still find themselves using centralized institutions to trade and access advanced products, so a degree of reliance on trust is hard to escape.
There are a number of DeFi protocols that offer a service that is more code driven than a traditional centralized financial institution run by people. However, trusting these protocols requires you to personally verify that the code does what it says it does, or alternatively trust the people who programmed it. We have seen during 2022 that some of these decentralized protocols have their own significant risks for investors.
We have to remember that a lot of the time, when we’re asked to trust the code, we’re really putting our trust in people. Just look at FTX. Publicly, FTX touted its automated liquidation engine as the ultimate risk management tool. In reality, FTX management appears to have secretly exempted Alameda Research, a large trading firm personally owned by its founder, from that protocol. Alameda failed, and now the stock exchange itself is insolvent.
At the end of the day, if you’re told to “trust the code” to protect your assets, you either need to be very sure 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 rely on the law to protect our interests when we depend on banks and other financial institutions to make transactions and save our hard-earned wealth.
Fraud and financial crime do happen, of course, but legal protection limits the impact on individual customers. In the US, for example, even if a consumer bank were to become completely insolvent, the US government insures account holders to the value of $250,000. In addition, there are well-developed laws and regulations as well as severe civil and criminal penalties for financial misconduct in most parts of the world, which can go a long way in 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-storage” one’s fiat savings would involve a much greater risk.
So another important question for crypto users to answer is: to what extent are they protected by the law? In this connection, they must think not only of their own home country, but also of the jurisdiction in which the institution they may deal with is based.
Users may be more likely to have some confidence in the law when dealing with an institution that is 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 that provide oversight.
In terms of coins, we are regulated by the Central Bank of the Philippines, and hold a number of licenses that are also held by local financial institutions. We are 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 quite simple.
Of course, there are still criminals in this world who choose to break the law, in finance and in all other areas of life. As with “trust the code”, when you trust the law to protect your investment, there is always a degree of trust in institutions and people. It will be important to see how legal authorities respond to the recent breaches of trust in the crypto space.
Trust the person?
I have established that in crypto, as in any financial endeavor, there will almost always be some level of need to trust your counterparty. We do not yet live in the totally trustless world that Satoshi Nakamoto envisioned.
What crypto users must not do is trust entirely a group of people, or worse, a single powerful individual. If a counterparty is a centralized institution that looks after 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 don’t agree with that with your fiat savings, think twice about doing it with crypto assets.
If anything good comes out of the recent negative events in the crypto markets, hopefully consumers will 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
Disclaimer
In accordance with Trust Project guidelines, this opinion piece presents the author’s perspective and does not necessarily reflect the views of BeInCrypto. BeInCrypto remains committed to transparent reporting and maintains the highest standards of journalism. Readers are advised to independently verify information and consult with a professional before making decisions based on this content.
