Bitcoin financialization and custodial services, the real threat too few talk about

Financialization will bring new risks and will increase third party custody well above 50% of current stock. This may be a systemic risk for bitcoin.

Andrea Bianconi
7 min readFeb 24, 2021

Financialization of bitcoin is coming. This is the only reason why Wall Street is interested in bitcoin. The objective is to package bitcoin into some fancy financial product that they can sell for a profit. And sell a lot of it, for lots of profits.

Some say this is good because it increases adoption. Think about a bitcoin ETF. It is no doubt easier for traditional investors to buy an ETF and get an exposure to the bitcoin price rather than buying the real thing with the added complications of self-custody. The recently launched Canadian physically settled ETF BTCC undoubtedly has merit and it has been attracting investors at breakneck pace since its inception.

But there are certainly drawbacks as well. One is the potential impact that the financialization of bitcoin could have on the price of the real asset. Think if the ETF is not a physical one but a synthetic one. This will divert investors from “physically” holding bitcoin to holding an IOU which mimics bitcoin´s price fluctuations.

Indeed, Caitlin Long said, “what is the purpose of bitcoin if we go back to the same [paper] instruments which are the cause of the problem”.

If Wall Street creates a large enough supply of “paper” alternatives to bitcoin, the demand for the real asset can be easily capped. This is what effectively caps the physical demand and the price of precious metals.

But one thing is to steer investors away from the real asset into a paper product and another is an outright manipulation of the price. Crypto IQ´s Zachary Mashiach makes the case that CME´s bitcoin futures have been responsible for the long 2018–19 drop in bitcoin prices, drawing a similitude with the alleged manipulations of precious metals in the futures market.

But I am not convinced. The reason is that the price for bitcoin futures is set on the main spot exchanges such as Binance, Coinbase, Bitfinex, Kraken etc. and so far it has been spot driven. So much that one can argue that in the past the price of bitcoin could have been manipulated by unloading a large quantity of bitcoins on a major spot exchange to trigger a cascading effect with stop-losses in both spot and futures market. Then positions are switched to profit from both spot and futures long position rebounding. But the trigger was initiated in the spot market, not vice versa. How can a large sale on the futures market trigger the same cascading effect on spot markets if there is no connection between the two markets? Differently from precious metals markets bitcoin futures do not have a physical settlement, they are solely cash settled. It is like a betting market giving the odds on a horse race. It does not affect how the race goes. The only possibility would be a reflexive psychological loop if investors on the spot market were influenced by what happens in the futures market. But who cares about what bitcoin futures are doing? Do you first look at spot markets or futures markets?

But no doubt this is an issue which has complexities that I might be missing and which might be worth looking into more detail with people who know better how futures markets work.

Furthermore, if we look at how precious metals have been allegedly manipulated via paper products, another problem appears. Precious metals are difficult to audit. A reputable and trustworthy auditor is needed. Then vaults must be physically inspected and the bars must be visually identified and counted. In most cases this happens once a year. Barring extreme cases of outright fraud, issuing IOUs on unallocated accounts is therefore a piece of cake, so much so that no one really knows how many claims exist for every ounce of physical metal vaulted, some say 100 some say even more. Luckily though, bitcoin is clearly superior to precious metals on that aspect, in the sense that it is 100% auditable at any moment without need for a trustworthy auditor. Thus — for the Wall Street con artists — playing the three-card trick will be much harder if the investors remain vigilant and require the proof of reserve and the periodical disclosure of the bitcoin addresses.

But the real threat might be yet another one. And it might be a systemic one for bitcoin.

Bitcoin´s exploding custodial services are the culprit.

Jameson Lopp and Hasu have indicated the main causes for concern:

(i) “…if something goes wrong [with the custodian] and people want to exit to the safety of self-custody, the on-chain throughput limits mean that it’s infeasible for a mass exit to happen quickly. Another point was that custodians will be more capable of paying very high transaction fees to make settlement transactions between each other, thus pricing out the average user from making on-chain transactions”

(ii) a political attack could unfold, whereby authorities “… will demand more onerous disclosure requirements from exchanges, more draconian rules around AML/KYC, and so on. Eventually, pressure from regulators and nation states results in custodians censoring transactions and seizing funds” [like banks did to do to comply with Roosevelt Executive Order 6102].

(iii) an attack on the protocol could unfold, whereby “the custodians coordinate a fork (hard or soft) and change the rules. 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.”

On the more technical issues (i) and (iii) above and the chances of success of such actions, there are more qualified people who can give more reliable answers, though the highlighted risks seems entirely plausible. On the point (ii), the risk of a more geopolitically motivated attack, this is no doubt a highly probable scenario. But if on one side one can be confident about the battle tested censorship resistant capabilities of Bitcoin to deflect such an attack — most certainly if one keeps custody of its own keys — on the other side one has to be concerned of the likely repercussions that this attack might have on the whole network considering that it might impact between 40% to 60% of the total bitcoin supply. And the quantity of third party custodied bitcoins will increase proportionally in the future with its financialization. This threat will therefore grow exponentially bigger.

I wish there were more awareness and more discussion on the above topics within the bitcoin community. So far these are fairly new topics but they are far more complex to understand and potentially far more damaging than the usual FUD theories which have been dealt with in the last 10 years.

Above all the community must continue educating new bitcoiners and investors about the importance of both self-custody and the proof of reserve concept. The time to do it is now.

Elon Musk must prove Tesla owns the bitcoins he claims it does. Bitcoiners should not trust him, they should verify. The same goes for every big Wall Street or corporate investor who goes about boasting its holdings. And if you are a Tesla or a Microstrategy investor you should ask the company to show you their bitcoin addresses duly authenticated with a message signed with their private key. Form 8K is not enough as it simply shows a material acquisition or disposition of assets. You want to be able to monitor their bitcoin holdings, as this might materially affect the value of your investment.

Start questioning, not their keys, not their bitcoins.

© — 2021

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© — 2021

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