When you purchase Bitcoin from a centralized exchange, you never know whether your account is credited with actual Bitcoin or paper Bitcoin. Paper Bitcoin is a “I owe you” Bitcoin, implying that the exchange owes you a certain amount of Bitcoin. The only way to ensure that the Bitcoin you purchased is genuine is to withdraw it to a self-storage wallet or sell it for another asset or product.
To save on transaction fees, most exchanges will not create a separate wallet for your account and transfer your Bitcoin to that address. The Bitcoin balance displayed on your centralized exchange account is a number next to your name on a spreadsheet. This explains why, despite Bitcoin’s 10-minute block time, exchanges can instantly transfer Bitcoin to your account. That is, the time it takes to transfer Bitcoin from one address to another.
Exchanges keep their Bitcoin in a wallet or set of wallets where they possess the private keys and store safely. If they transferred small amounts to your exchange wallets every time you buy and sell within the ecosystem, they would lose a lot of money from the transaction fees.
The vast majority of major exchanges do not provide proof of customer deposits. However, some small exchanges, such as Luno, are audited on a quarterly basis, and clients are forced to rely on this audit report to ensure that the exchange has a one-to-one backing of the Bitcoin reserves they hold against customer deposits. As a result, for all of the “I owe you” Bitcoin held at exchanges, there is no transparency regarding how much real Bitcoin is held in reserves to back up customer balances.
If you decide to withdraw your Bitcoin from a centralized exchange for self-storage to a non-custodial wallet or a hardware wallet, the exchange is forced to deliver the Bitcoin to your wallet. This ensures that you receive real Bitcoin in your wallet and eliminates the possibility that the Bitcoin you purchased is paper Bitcoin. This action reduces the amount of Bitcoin in circulation provided you are not purchasing to resell soon.
The most important factor encouraging Bitcoin adoption is its limited supply of 21 million coins. But we must examine this claim and determine what it means. Bitcoin supply is increasing every ten minutes until the last Bitcoin is mined in the year 2140. We currently have slightly more than 19 million Bitcoins in circulation, and the remaining Bitcoins will be mined between now and 2140. This means that official supply-side inflation will be 0.09 percent per year until 2140 without considering the growth in value per Bitcoin.
When it comes to exchanges that provide a market for buying, selling, and staking Bitcoin, it is possible that they (exchanges) are selling more Bitcoin than they hold. This means that if all Bitcoin owners who hold their Bitcoin on exchanges decided to withdraw all of their Bitcoin at the same time, there is a chance that the paper Bitcoin they have collectively issued is greater than the Bitcoin they hold. This leads to the belief that they are printing paper Bitcoin and selling it to unsuspecting customers.
Under what conditions would exchanges print paper Bitcoin? So, if all Bitcoin held at exchanges amounts to a certain pool of Bitcoin and traders only transact a small percentage (top layer) of the total pool, the exchanges can lend the dormant (reserve) Bitcoin to unsuspecting buyers. This means that two or more people could hold different amounts of bitcoin backed by a smaller amount of Bitcoin held at the exchange.
What makes this possible? The recent saga involving Terra’s Luna
If exchanges sell more Bitcoin (real and paper) than they own, they will be net short. That is, if the price of Bitcoin significantly increased, they would have larger claims on their customers’ accounts. This encourages exchanges to advocate for a lower Bitcoin price. To reduce the price of Bitcoin, you must suppress demand while increasing supply. This entails taking a larger short position by flooding the market with paper Bitcoin.
To make the supply go up, the exchanges need to make sure that the amount of Bitcoin that new market entrants buy doesn’t reduce the overall market supply. This means that they either offer derivative contracts on Bitcoin or they get paper Bitcoin.
Most institutional investors seeking exposure to Bitcoin buy Bitcoin Futures ETFs (Exchange-traded Funds) rather than actual Bitcoin. They can trade Bitcoin using these ETFs without actually owning it. This means that there are billion-dollar positions in paper Bitcoin that are not reducing the market supply of Bitcoin. These ETFs are suppressing Bitcoin demand and contributing to the price of Bitcoin falling.
Furthermore, the exchanges may offer incentives to Bitcoin holders to keep their Bitcoin on the exchanges. As a result of fewer withdrawals, exchanges have more Bitcoin liquidity and are not forced to cover withdrawals. Lower transaction costs for clients who hold more Bitcoin at exchanges, staking rewards, and high withdrawal fees may help achieve this. Many exchanges are already doing this right now.
Rehypothecation is another term for how exchanges allegedly use their clients’ Bitcoin. In this case, an exchange uses the deposits of clients as collateral to back a loan that they use to make a profit. Coinbase
Of course not everybody will agree with me but there is a strong case that centralized Bitcoin exchanges are practicing fractional reserve banking where only a fraction of the “I owe you” Bitcoin displayed in customer balances is available in their reserves to cover withdrawals.
Customer deposits are used by fractional reserve banking to generate more fractions. So, by keeping your Bitcoin at the exchange, you provide the exchange with more liquidity, allowing it to create more fractions. Simply put, the exchange prints more Bitcoin backed by your deposit, which increases supply and lowers the price of Bitcoin. As a result, there is a compelling case to be made that keeping your Bitcoin at the exchange contributes to lower Bitcoin prices.
Bitcoin is a custodial asset. The only way to really own it is by owning your private keys. If you want to take advantage of all of Bitcoin’s features, such as permissionless transactions, pseudo-anonymity, and censor-proof money, among others, you must own your private keys. As seen in the recent Luna events, an exchange can limit your Bitcoin withdrawals, trade your Bitcoin, and take ownership of your Bitcoin in the event of bankruptcy.
Disclosure: I own bitcoin and other cryptocurrencies.