Bitcoin has finally risen, but where is the most secure place to put it?

According to Golden Finance Blockchain on November 6, the price of Bitcoin has finally risen. At the time of writing this article, according to Coingecko data, it is $15,686.52, with a 24-hour increase of 10.2% and a market value of $290.75 billion. People who hold Bitcoin now must be very happy, but at the same time, these Bitcoin holders are also beginning to worry about the BTC in their hands. They began to think about a question: Is it really safe to custody Bitcoin?

In fact, Bitcoin holders are usually faced with many threats. It often takes a lot of time and cost to fully prevent these threats, and it is difficult for ordinary people to deal with all the risks. Therefore, for the sake of convenience, Bitcoin users have to store Bitcoin in cryptocurrency exchanges and trust that these exchanges can provide the same security protection services as banks, custodians, and brokerage service providers.

Bitcoin users choose custodians to "hold" their funds for the following reasons: first, they feel that if any problems arise, they can blame the outsourced professionals; second, they can easily obtain liquidity and the ability to exchange assets, and can easily access the traditional banking system and conduct fiat currency transfer transactions; third, they can easily obtain the ability to protect their assets, and most importantly, they can earn interest.

This custody practice is considered safe by many people because many custodians are insured. But they overlook the fact that insurance is only a trusted third party and they cannot guarantee compensation. The only thing they can guarantee is to do their best to "reject" customer claims. At the same time, some regulators also require institutional investors and funds not to custody Bitcoin themselves, but to choose to use "qualified custodians."

At present, the number of Bitcoins controlled by Bitcoin custodian service providers has accounted for a considerable part of the total supply of Bitcoin, with at least 4% of Bitcoin in the hands of institutions. The types of organizations holding Bitcoin are roughly exchanges, trading service providers/platforms, hedge funds, venture funds, retirement funds, university endowments, sovereign wealth funds, lending service providers, and Bitcoin anchor currency WBTC custodians. Among them, the number of Bitcoins held by exchanges is relatively easy to identify, especially the top 20 cryptocurrency exchanges, because most Bitcoin exchange activities are carried out in these exchanges. For example, if we analyze the well-known cold wallets in mainstream cryptocurrency exchanges, we will find that these wallets hold about 2 million Bitcoins. However, it may be difficult to analyze Bitcoin holdings for non-exchange virtual asset service providers, including custodian wallets and custodians. Unless you are their customer, these virtual asset service providers will not disclose the addresses of their own Bitcoin cold wallets.

If we think about it carefully, there is actually a problem here, that is, transferring Bitcoin from a deposit address to a cold wallet storage looks like a withdrawal transaction, which will confuse most data analysis service providers, because when they perform data analysis, they will find that the inflow and outflow of funds in the exchange are almost equal, while the balance of the exchange's Bitcoin account is constantly decreasing. Of course, although the number of Bitcoins held in cryptocurrency exchanges is indeed decreasing, the decline is not as large as people imagine.

In addition to exchanges, in order to track Bitcoin custodians, the method of linking Bitcoin transactions and addresses can be used to identify the relevant entities that control Bitcoin, although this method cannot guarantee 100% accuracy. Through the tracking of the number of Bitcoins controlled by cryptocurrency exchanges by several well-known on-chain analysis companies, we found that as of October 2019, about 60% of the unlost Bitcoins were held by licensed custodian service providers, which means that the number of Bitcoins held by Bitcoin custodians is about 8.5 million, which is much higher than the 2.5 million Bitcoins held by cryptocurrency exchanges tracked by Glassnode.

Of course, there is another way to track Bitcoin custody, which is to analyze the "tokenized Bitcoin" on Ethereum, which is often called Bitcoin-pegged coins because you can query the Ethereum blockchain to determine the supply. As for other entities and investment funds that hold Bitcoin with custodians, it is difficult to know the specific numbers unless they disclose their holdings themselves.

In addition, the analysis company Chainalysis believes that the 8.5 million bitcoins held by custodians is only an upper limit estimate, and the lower limit estimate is about 2.2 million. Of the upper limit estimate of 8.5 million bitcoins, 5.1 million bitcoins are held by custodian service providers, and non-exchange virtual asset service providers including custodian wallets and custodians hold the remaining bitcoins. If a rough estimate is made, 20-60% of the bitcoins in circulation are currently held by third-party custodians. Based on this judgment, it should be reasonable for a small number of custodians to hold 40% of the circulating bitcoins. The higher this number, the more attention people will pay to the fork attack on the Bitcoin economy.

In fact, no matter how much of the Bitcoin is held by the custodian, people should always pay attention to the risk of theft and hacking, which can cause a huge impact on the entire cryptocurrency ecosystem. Currently, there are three major risks known to Bitcoin custodians, namely regulatory risk, inherent risk, and on-chain throughput risk.

First, let's look at regulatory risks. You should know that every custodian has the potential to become a "target" of the regulator. Of course, as long as the custodian can be most compliant with the requirements of the regulator, the risk of them becoming a "target" will be greatly reduced. However, custodians cannot escape scrutiny, nor can they guarantee that regulators will not change the regulatory rules for custodians in the future - the only rules that cannot be changed are the Bitcoin protocol rules. When a Bitcoin custodian encounters a crisis, the speed of catastrophic consequences may be much faster than expected, because risks do not gradually degrade. For example, the cryptocurrency exchange OKEx recently encountered such a problem. Because a private key holder of the exchange needed to cooperate with the law enforcement investigation, it was unable to process the relevant authorized transactions, and as a result, the entire trading platform had to suspend withdrawal services.

Secondly, there are inherent risks. Users must understand that there are inherent risks in trusted third-party custodians, some of which may be invisible to investors. When you store your Bitcoin with a custodian, you do not eliminate the inherent risks of key management in essence, but only transfer the risks to a black box that you cannot control. If you think you are safer not managing your keys, then you are ignorant. As in a recent case, when users learned that BitMEX had become a target of US regulators, they immediately withdrew a large number of Bitcoins from the platform. This is because everyone finally realized that their Bitcoins had begun to encounter counterparty risks.

Finally, let’s talk about the on-chain throughput risk. Although on-chain throughput is also a bottleneck that Bitcoin holders have to face when performing self-custody, compared with the two Bitcoin custodian risks mentioned above, on-chain throughput is probably not a big problem. But for the sake of safety, this risk still needs to be paid attention to.

In addition to the risks mentioned above, there are actually many problems with Bitcoin custody. Since the income from custody business is usually directly related to the number of Bitcoins held in custody, this means that if the custody service provider wants to make money, it must control as many Bitcoins as possible. In this case, Bitcoin custodians often design many incentives to attract Bitcoin holders, which can easily lead to various "perverse incentives" in the market. The reason why Bitcoin has risen is that its power is decentralized through the system network. If power begins to become too concentrated, then only a few people can conspire to make a profit and bring huge risks to network security. If more and more Bitcoin custodians provide "deposit interest" in the future, and the custody service fee will continue to decline (may even become negative), then there will be a problem, that is, Bitcoin private keys will be more concentrated in the hands of a small number of people.

The above-mentioned custodians, which are similar to bank services, actually bring systemic risks to the entire Bitcoin industry. Once there is a problem with the custodian, and people want to withdraw their Bitcoin from the custodian, they may encounter the problem of on-chain throughput limit, which means that large-scale users withdrawing from the custodian is impossible. Secondly, compared with retail investors, custodians are more capable of paying high transaction fees, which means that the settlement transactions of the custodian will be easier to complete, which will cause ordinary users to be unable to process on-chain transactions normally. Therefore, if most Bitcoins are really controlled by a few people in the end, the systemic risk of coordinated attacks will increase, triggering political attacks and economic attacks.

The so-called political attacks mainly come from regulators, who will require cryptocurrency exchanges to disclose a lot of information and set strict rules around anti-money laundering, counter-terrorist financing and "know your customer". Ultimately, pressure from regulators will cause custodians to review user transactions and sometimes freeze user funds. Economic attacks are when custodians initiate hard or soft forks and change the rules they accept custody. Any controversial fork will cause the blockchain to split, and each party will sell off the cryptocurrency that the community does not support to compete for economic advantages. If the custodian also starts selling at this time, it will undoubtedly cause the fork to become more distorted.

So in the final analysis, if Bitcoin holders want to obtain the greatest benefits, not be affected by bureaucratic and political decisions, and ensure security, then they should not completely trust third parties. Only when you hold the keys yourself, Bitcoin is truly yours.

So is there a viable technical solution for Bitcoin holders to self-custody? The answer is - a second-layer solution! Building a second-layer solution will help individual custodians settle on the base layer, freeing up more space for Bitcoin holders to self-custody. Currently, about half of the on-chain transactions occur between large custodians, but the vast majority of these transactions may be highly redundant because the same custodian may transfer funds back and forth on their own, and they may not even know that the transaction was just sent to a random address for processing. If second-layer solutions like the Lightning Network and sidechains can be widely used, the amount of redundant transactions in the Bitcoin blockchain will be effectively eliminated. Not only that, we must also expand the ability to provide trustless transactions to Bitcoin holders. Although this requires building more innovative cryptographic structures, in the long run, more can be done with less on-chain data in the future.

So I am the most qualified Bitcoin custodian. Bitcoin has always hoped to allow each holder to become "his own bank". One of the most powerful security modes provided by Bitcoin is to let the holder control the key himself, which is also the only way for Bitcoin holders to fully benefit. By owning the key, you can not only enhance the ability to control the key yourself, but also help the entire Bitcoin ecosystem successfully resist systemic risks. Of course, to achieve this goal, you need to take on greater responsibilities and go through a long learning cycle. However, for Bitcoin holders, there is no need to worry, let alone be intimidated by difficulties and potential risks. The future Bitcoin self-custody method will definitely become safer and simpler.