Lessons from FTX

by Jim Davidson
[email protected]

Special to L. Neil Smith’s The Libertarian Enterprise

The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.

“A generation ago, multi-user time-sharing computer systems had a similar problem. Before strong encryption, users had to rely on password protection to secure their files, placing trust in the system administrator to keep their information private. Privacy could always be overridden by the admin based on his judgment call weighing the principle of privacy against other concerns, or at the behest of his superiors. Then strong encryption became available to the masses, and trust was no longer required. Data could be secured in a way that was physically impossible for others to access, no matter for what reason, no matter how good the excuse, no matter what.

“It’s time we had the same thing for money. With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.”
~ Satoshi Nakamoto, 11th day of the 2nd month of Anno Domini 2009

Recent events in the crypto-currency industry should raise concerns about what you should do. Should you buy and hold long term? Should you trade incessantly? Should you use proof of work or proof of stake cryptos? How do you protect yourself from crashes like Luna and disasters like FTX?

Before answering these questions, let me explain a bit about who I am. Way back at the end of the last millennium, I spent quite a lot of time studying mathematics. In 1992 a friend of mine introduced me to email encryption using public key cryptography. In a few days, I began teaching it to others.

A few years later, I met Ralph Merkle at a gathering in Arizona of cryonics enthusiasts. In 1998 I began working in the digital currency business using e-gold. Subsequently I helped with the deployment of one of the first automated digital currency exchanges, bought and operated a digital gold stock exchange, and worked with a network of exchange operators to curb fraud and theft. More recently, I corresponded and spoke with Phil Zimmermann about him speaking at an event a group of us were planning. Some have used terms like “OG” or “original gangsta” to describe me. I myself do not. I’m just this guy, y’know? I know where my towel is.

What do I advise? I suggest you understand the elements of cryptography, especially how public key cryptography works. If you understand what your private key and key password are, and if you understand the basic mechanisms for securing your keys from bad actors, you can protect what is yours. Ultimately, what data security and communications privacy are about is keeping what you value in the digital world.

We use a lot of jargon in the crypto-currency space. You’ll find an endless assortment of acronyms. I don’t like acronyms much because I’ve worked in a bunch of different industries. APU, for example, means a variety of different things depending on what industry you’re in, with whom you are talking, and expectations they have about what you know. My own role in many situations has been to bring understanding from a group of technology sophisticates to a group of business sophisticates, speaking both languages as it were, to establish common understanding. When it works, it is much fun.

One phrase we like to repeat is, “Not your keys, not your coins.” What does that mean? It means that if you have an account with a trusted third party like an exchange, brokerage, or trade system, just like your account with a bank or credit union, the value stored in that account is only yours to the extent that the third parties involved can be trusted.

If you look at some of the reported features of the FTX scandal, you can see that there were major issues with trust. The people purporting to regulate the crypto industry were not trustworthy in that they performed essentially no diligence, let alone enough diligence to be all that was due and proper. The people purporting to operate the FTX exchange operations appear to have sent customer funds to their associates at Alameda. In turn, Alameda seems to have been front-running trades in the crypto space. Worse, the liabilities of the FTX group of companies appear to have been much greater than the available collateral, especially when the market for cryptos suddenly turned down after the collapse of Luna in the second quarter of 2022. It took less than a day for Binance to evaluate FTX and conclude it was beyond repair, so there was evidently a complete absence of regulatory diligence.

Why trust any of these third parties? Bitcoin was created because of the difficulties experienced by e-gold and to some extent by other gold and silver currencies such as Liberty Dollar, e-Bullion, Pecunix, and GoldMoney. You can read about the “e-gold problem” in the Bitcoin white paper from 2008.

What was the problem? The problem was that e-gold users trusted the United States government to use only its lawful authority in regulating digital gold activities and fiat to gold to fiat exchanges. While that was true when e-gold was small between 1995 and 2001, it became increasingly obvious that additional levels of regulation beyond the constitution’s limits were being imposed after the “war on terror by non-state actors” began in earnest in late 2001. The window of opportunity for moving e-gold’s servers offshore was thwarted in the 2000 to 2002 timeframe.

By 2006, the exposure was significant. Total transactions on the e-gold system involved over a million user accounts and moved something over $50 billion of economic activity annually. The volume of gold in storage and the amount of economic transactions were increasing exponentially and had been for years. All the principals of e-gold were United States citizens living in the United States. Their transaction servers were in Melbourne, Florida. Their gold was stored in London Bullion Marketing Association good delivery bars held in certified storage in London, Zurich, and Dubai. And in 2007, it all came under attack by a small group of federal agents who were tasked with destroying it.

What we saw was the elimination of e-gold and its primary exchange operation (also based in Melbourne, Florida) and the confiscation of the e-gold system servers. After several years of inoperability there was an opportunity for some users to get their funds out, closely scrutinised by federal agents. The government broke e-gold. A little later in 2007 the government destroyed Liberty Dollar.

You’ll get arguments from various parties as to what the exact nature of the e-gold problem was, and whether the government agents involved acted in good faith. There remains considerable prospect for recovering the e-gold technology and making digital gold a useful part of the future economy. But the criticism levelled by Satoshi in the 2008 bitcoin white paper remains: single points of failure must be addressed. Trusting a small number of servers, trusting third parties, trusting that an agency agreement with even the most scrupulous exchange, is problematic. The problem is: what you cannot hold in your hand is not really yours.

That is why people have hardware wallets. That is why people have cold wallets. Paper wallets. Offline wallets. These are technologies that have one simple rule: if you hold the keys, you control the coins.

Conversely, if someone else holds the keys, they control the coins. You might have a relationship of trust with them, a long and detailed contract, terms of service to a fare thee well, and none of that means anything if they choose to betray your trust.

Complying with a government edict is probably covered in your terms of service. They “have no choice” but to obey orders. We can get into the depths of moral considerations and the Nuremberg defence if you please, but that is a topic for another day. In this day, the simple fact is that your bank or credit union will “levy” your account and give its contents to the government if it is so ordered. If they would not, they would lose their ability to function as a bank or credit union. So, whether the order is fair, whether there is justice, whether there is constitutional authority for the government’s action, none of that matters. What matters is: you have to trust them with the value you leave in their hands.

In the case of a great many companies, individuals, and institutions, that trust is reasonable. There are insurance agreements which can help you recover value in the event trust is breached. There are ways of mitigating the risk of betrayal through diversification, putting only some of your eggs into each basket.

But, evidently, the people, roughly a million individuals and enterprises based on recent reports, who trusted FTX and its related enterprises, should not have done so. Some recovery is possible, of course. But bankruptcy liquidation and receivership are costly procedures, and the people with the expertise to undertake those activities are paid handsomely for doing so.

If you want to benefit from the experiences of those who have gone before you, take heed. What you have in a “safety deposit box” in a bank may not be safe. It is not, after all, your safety that is on deposit. A recent court opinion indicates that the government is free to seize assets without limitation and without proving compelling cause. People who held gold coins in 1933 were about 80% likely to keep those coins — the vast majority of Americans did not turn in their gold, and most of it was not confiscated. But a lot of safety deposit boxes were emptied, and a lot of “coin melt bars” showed up in federal inventories after 1933.

Your money in bank accounts is liquid to the extent that the banks are trustworthy. Depositors in Cyprus learned that their money on deposit can be “bailed in” to bail out the troubled banks. Bank failures happen. Diversification and insurance will only ameliorate these problems.

The innovation of bitcoin is to remove third parties by decentralising on a massive scale. Millions of servers worldwide run the bitcoin core protocol and operate as miners, wallets, and transaction processing nodes. Similar currencies like Litecoin operate on the same basic approach. Proof of work systems do not typically require you to trust the parties who are the major stakeholders.

Now, should you never trust anyone? Larry Niven, in his novel Destiny’s Road, points out that if you never trust anyone, you cannot accomplish very much. But, by the same token, you should not trust everyone.

Keep your keys. Be vigilant. Watch out for scam operators. If a Nigerian prince, or a Bankman of some sort, makes you an offer that seems too good to be true, it probably isn’t true. The Spanish prisoner fraud is centuries old.

The cryptocurrency revolution is the revolution of decentralised finance. It is the opportunity to develop systems and services where individuals have the ability to have financial autonomy. Secure wallets and secure keys and login security are possible. We have built these technologies and deployed them in systems all over the world.

Our challenge today is in some ways much greater: we who want you to be free have to explain to you and billions of people like you how it all works. Which is why the SpacePrivé News substack exists, and why I’ve been asked to build a network of businesses, teachers, students, and entrepreneurs.

Free markets are essential to freedom. Free people need effective tools to stay free. And wealth is a critically useful tool. The long march away from tyranny and toward freedom is fraught with perils. It is also brimming with opportunities. Let’s go see!


Reprinted from SpacePrivé News for Nov 23 2022

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