The custodian menace | Casa

The custodian menace

by Jameson Lopp 6 years ago 9 min read

Being your own bank

Bitcoin has long offered the promise of being your own bank, though this comes with great responsibility and a high learning curve in order to do it well.

There are numerous threats to one’s bitcoin; protecting against them all can be time-consuming and is out of reach for the average person (if they don’t know about Casa, of course.) As such, many who buy bitcoin will simply leave it on the exchange where they acquired it, assuming that this exchange offers the same protections as their bank or brokerage account.

Many people use bitcoin custodians for convenience. Some reasons may be:

"My bitcoin is safe with custodian ___ because it's insured."

Insurance is just another trusted third party & potential point of failure. Your payout is not guaranteed; what is guaranteed is that the insurer will try their hardest to reject your claim. https://fosters.com/news/20200323/denied-restaurant-owners-find-insurance-wonrsquot-cover-coronavirus-losses…

At the same time, government regulations require that many companies and funds do not self-custody their bitcoin, but use “qualified custodians” instead. While I find these regulations to be outdated with respect to digital bearer assets, the reality is that they exist and institutions must follow them.

Big bitcoin banks

The end result is that a sizable portion of the total bitcoin money supply is held by custody services. How much? We can’t know exactly, but we can determine some reasonable estimates on lower and upper bounds.

We already know that at least 4% of all bitcoin is held in corporate treasuries. More is undoubtedly held by:

Other than exchanges, I’d expect the vast majority of the above entities are using third party custodians due to regulatory requirements or their own policies.

How many of these custodians can we track down? It is possible to use various heuristics to associate bitcoin transactions and addresses together in order to identify the single entity that is controlling them. These heuristics are probabilistic and can’t guarantee 100% accuracy.

Coinmetrics tracks 9 large exchanges and shows their aggregate bitcoin balances to be around 1.2M BTC at the time of writing.

Glassnode tracks 14 exchanges and shows their aggregate balance to be about 2.5M BTC at the time of writing.

According to Chainalysis, as of October 2019 roughly 60% of bitcoin that was not lost was held by a licensed custodial service. That would put 8.5M BTC in the hands of custodians. This is a lot higher than the 2.5M BTC in exchanges tracked by Glassnode.

The only other type of custody that is somewhat easy to track is tokenized bitcoin on ethereum, since you can query the ethereum blockchain to determine the supply. At the time of writing that comes to around 120,000 BTC.

As for all of the other possible entities / investment funds that may be holding bitcoin with a custodian, it’s quite hard for us to know about them unless they publicly announce what they are doing.

While it’s hard to pinpoint, anywhere from 20% - 60% of all circulating bitcoin are held with third-party custodians. Thus it appears quite reasonable that 40% of all bitcoin may be held by a small number of custodians. The higher this number becomes, the more concerning it is with regard to economic fork attacks, though in terms of seizure and theft risk, any double-digit percentage is concerning. For reference, MTGOX was thought to hold 850,000 BTC out of ~8M in circulation - when it ceased operating the shock to the ecosystem was massive.

Why does it matter?

The reason that bitcoin works is that power is highly distributed throughout the system. When power starts becoming too concentrated, the likelihood of coordination occurring in order to benefit those wielding power increases. One particular concern I have with custodial businesses is that their revenue is often directly tied to the amount of bitcoin they have under custody. As such, they are incentivized to control as much bitcoin as possible. It is to be expected that custodians will then seek to incentivize as many bitcoin owners as possible to store their funds with them. This is a tragedy of the commons situation that is creating perverse incentives.

For example, I expect the price of custody will continue to drop and even go negative as more custodians start offering interest on deposits. If too many coins are held in too few hands, the systemic risk of a coordinated attack rises. Such an attack could result from a variety of stressors, such as:

Political attack: expect that initial attacks will demand more onerous disclosure requirements from exchanges, more draconian rules around AML/KYC, and so on.

Economic attack: the custodians coordinate a fork (hard or soft) and change the rules for bitcoin they accept. Any contentious fork results in a chain split, at which point each side vies for economic superiority by selling off the branch of the fork they don’t support. This could be made more devious by custodians selling off the fork branch they want to see die off.

"When we can secure... a financial network by computer science rather than by accountants, regulators, investigators, police, and lawyers, we go from a system that is manual, local, and of inconsistent security to one that is automated, global, and much more secure." -@NickSzabo4

Every bitcoin that is held by an institution is a bitcoin that has had its security weakened by being subjected to bureaucratic and political decision-making. “Not your keys, not your bitcoin” rings true because when you have to ask someone for permission to transact, you are no longer in a position to resist censorship. Bitcoin owners must not trust third parties to act in their best interest!

Is systemic risk actually worth worrying about? It’s more of a risk than most people think. Sovereign debt crises and currency failures often go hand in hand with times of high inflation, as billionaire hedge fund manager Ray Dalio pointed out in his latest post, “ The Changing Value of Money.” In recent sovereign debt crises, such as in Lebanon today or in Cyprus in 2013, assets have been both frozen and seized, not to mention lost outright in bank failures.

Education as a solution

We must continue to educate users of the risks inherent to trusted third parties for the simple fact that these risks are invisible to many investors.

Storing your bitcoin with a custodian does not actually eliminate any of the risks inherent to key management, it just moves those risks into a black box that is out of your control. If this feels safer to you, it's because ignorance is bliss.

When users learned that BitMEX was being targeted by US regulators, they withdrew half of the bitcoins from the platform. This is because many users finally realized the counterparty risk to which their funds were exposed.

We need people to understand that every custodian faces the same risk of being targeted by nation states. Sure, being compliant with regulators decreases the risk of being targeted sooner rather than later. But there is no escape from their scrutiny, nor is there any guarantee that nation states won’t change the rules for custodians in the future. The only rules that are resistant to being changed are those of the bitcoin protocol, and their robustness is reliant upon as many users as possible individually resisting controversial rule changes.

When bitcoin custodians encounter problems, the failure tends to be immediate and catastrophic rather than slow degradation. Take the most recent example - one week prior to publishing this article, OKEx stopped allowing withdrawals. They remain disabled.

Technical solutions

We must continue building second layer solutions that enable custodians to settle with each other off the base layer and thus free up more space for people to exit to self-custody.

We have reason to believe that around half of all on-chain transactions occur between large custodians. Much of this volume is highly redundant, with the same custodians sending funds back and forth and not even knowing it - because they are just sending to random addresses. Layer 2 solutions such as Lightning Network and sidechains will allow for much of this volume to be removed from the bitcoin blockchain. This will help alleviate the “high settlement fee” scenario that has been raised.

We must also continue to scale bitcoin’s ability to provide users with trustless transactions. This may require innovation and creative cryptographic constructions that enable us to continue down the same path of doing more with less on-chain data.

Perhaps most importantly, we need to make self-custody safe and simple. This is our focus at Casa.

Be your own bank!

Being your own bank doesn’t need to be difficult or scary. It’s also the only way to benefit from the strongest security model bitcoin has to offer. By holding your own keys you not only empower yourself, you strengthen the entire ecosystem against systemic risks. If you need help taking the step into self custody, or improving your current setup, we’re here to help.

Jameson Lopp

Jameson Lopp is co-founder and Chief Security Officer of Casa. He is passionate about creating tools to empower individuals; he has been building bitcoin wallets since 2015.