Should Bitcoin Exchanges Have 100% Reserves?

This piece was commissioned for the 8BTC special topic: http://www.8btc.com/caution-money

After many quiet days, the recent plunge in Bitcoin has finally made the various communities lively again. Quite a few people have popped up to cry, curse, or else gloat for a bit; of course, there are also some calmer players who have come out to reflect on the issues, such as once again reexamining the question of whether exchanges should maintain 100% reserves.

Markets rise and fall; that is perfectly normal. There is no need to make a fuss every time prices crash. Short-term coin speculators ought to welcome violent market fluctuations, while long-term hoarders need not care about these swings. As for those who borrowed money to speculate on futures and unfortunately got liquidated, that was simply because their risk control was not done properly, and they have even less reason to come out blaming heaven and earth.

But as Dong from Hezhuang said, when the market is falling, it is also good to bring out some old chestnuts and talk about them again, because during a bull market coin people generally cannot hear these warnings at all, nor do they bother to nitpick the various rules and practices of exchanges—after all, as long as they make me money. Once everyone has been stunned senseless by the drop, perhaps they will pay a bit more attention to these old problems.

When MtGox collapsed, I already said that one should interpret exchanges with the utmost malice: if something can be made public but is not made public, then there must be something shady going on. Looking at it now, Chinese players basically did not learn the lesson of MtGox. They only occasionally think of margin when prices crash, while in most cases exchanges still receive the greatest indulgence.

So is the recent downturn in Bitcoin prices really caused by evil exchanges? One can say yes, and one can say no.

To say no is to say that the fundamental reason for the sluggish market is still that the time has not come. Once a new round of a great bull market truly arrives, any little trick by any exchange will be like using a mantis to block a cart. Back when MtGox controlled 90% of Bitcoin trading volume in the world, it still ultimately failed to make the winds and rain obey its command; it could not stop the upward trend and in the end played with fire and burned itself. But on the other hand, we must also admit that if all exchanges guaranteed 100% reserves, the coin price would certainly not be at today’s level.

100% reserves are beneficial to boosting the coin price

The reason the coin price is undervalued is that, in the absence of reserve requirements, many coin people who think they have coins actually have none at all. The coins I store on an exchange are in fact not mine at all; what I possess at best is merely a “promise”—that supposedly, under certain circumstances, I can apply to withdraw these coins. Tomorrow’s salary is not today’s capital; supposedly being able to withdraw coins does not mean actually owning coins right now. Moreover, whether you can withdraw them in time still depends on the exchange’s mood—anyway, as far as I can see, not a single exchange has stipulated in its terms of service what should happen if coin withdrawals cannot be processed in time.

And, although it is still only a “promise,” there are different forms of promise; custodial agreements and lending agreements are vastly different. In principle, when we deposit coins into an exchange, we merely hope to establish a custodial relationship, hoping that the exchange will temporarily hold these coins for us so that we can trade conveniently on the platform. But in fact, these exchanges that do not publicly disclose reserves have never guaranteed to us that they are merely holding coins in custody for us. And if they can make use of the coins we deposit, then at most this is a lending relationship.

So the exchange’s proof of 100% reserves is nothing more than proof of the “custodial” relationship between the user and the exchange. But custody is still only a promise; these coins are still not under my own control, and the exchange still has the possibility of breaking the promise. But in any case, 100% reserves can at least guarantee that 1 coin is always 1 coin. Even if I still may not be able to get it back, it is after all still 1 coin.

And what would happen if there were no guarantee of 100% reserves? That would be the creation of coins out of nothing. The exchange can freely add a new entry for coins in its accounts without any real deposit of coins.

In fact, the trick of creating something out of nothing does not necessarily require deliberate forgery. If we acknowledge that the exchange has the right to use deposited coins, then it can completely use honest, compliant methods to make the number of coins appear to expand. For example, Exchange A deposits its own 1 coin into Exchange B, then Exchange B deposits 1 coin into Exchange A, then Exchange A deposits 1 coin into Exchange B… by going back and forth like this, the number of coins on the books of the two exchanges can increase without limit, but in substance the two of them together will still only ever have that 1 coin. Thus users could very well buy 10 coins on an exchange that actually has only 1 coin. If all users do not withdraw coins together, everyone would probably think they owned those 10 coins.

If people who think they have 10 coins actually have only 1, that means the scarcity of coins has in fact been underestimated by a factor of 10. Once this illusion is shattered, the coin price will have room to rise tenfold.

Of course, similarly, since there is no reserve requirement, exchanges could also fabricate RMB—so why am I only saying that Bitcoin is undervalued? Because the scope of application for Bitcoin and RMB extends far beyond exchanges. What fundamentally determines the value of Bitcoin is not the exchanges, but market adoption: the degree to which it circulates as a currency. And looking at the entire market, even if these exchanges fabricated Bitcoin and RMB in equal proportion, the fabricated RMB would be utterly negligible compared to the overall environment of RMB usage; it obviously would not make people underestimate the scarcity of RMB. But the weight of these fabricated Bitcoins in the Bitcoin ecosystem is not something that can be ignored; it is enough to significantly discount Bitcoin’s scarcity.

Forcing 100% reserves is not beneficial to the Bitcoin ecosystem

So, for exchanges to adopt 100% reserves should indeed be beneficial for boosting the Bitcoin market. But what needs to be distinguished here is, first of all, that being beneficial to price increases does not mean being beneficial to the ecosystem’s development itself. As the saying goes, forced sweetness is not sweet. If an exchange’s 100% reserves are not a model that naturally wins out after free market competition, but instead are established according to some ideal through the use of authority or violence, then it may not be a good thing.

The reason forcing the growth of seedlings is so bad is not merely a matter of lacking procedural justice. More crucially, the cultural habits and ideological beliefs of market participants must undergo a painful process before they can be slowly cultivated. “Freedom” is difficult to achieve overnight.

Although we know what 100% reserves mean, the general public does not. The painful lesson of MtGox is something only the older generation of players may have experienced, while the new batch of Chinese players who entered the market after CCTV publicity have no firsthand experience. Only when a similar event happens around them—when they see with their own eyes how their own or their friends’ and relatives’ assets go to zero overnight—can they truly feel why fund security is more important than a 0.1% fee. Without going through this, even if you put a platform with 100% reserves right in front of them, they will still remain unmoved. Under these circumstances, forcibly promoting 100% reserves is not very meaningful. We can only wait for the next MtGox, or slowly look forward to the formation of a new culture.

I have noticed that many coin friends have a similar misconception: on the one hand, they seem to yearn for Bitcoin’s decentralized, free spirit, but on the other hand, when they see the current market’s chaos and imperfections, they cannot hold themselves back and hope to invoke the government or some forceful power to rein it in. They always want to do something in the face of disorder, and they must find a “constructive solution” to eliminate the mess. Yet the best solution is precisely not to construct, to let things run their course. Especially during transitional periods when the ecosystem as a whole is changing, the environment is bound to be chaotic and unstable.

Adopting 100% reserves too early is not beneficial to exchanges

Second, even if we say that exchanges adopting 100% reserves is the general trend, for any individual exchange, the best strategy at the present stage is probably not to rush into achieving 100% reserves.

Because under the current environment, in which the general public is largely indifferent to fund security, achieving 100% reserves will not bring any particularly significant competitive advantage. On the contrary, in the current environment, exchanges that reject 100% reserves do in fact enjoy a greater advantage.

Whether it is coin speculation or futures, what Bitcoin exchanges provide is essentially a zero-sum game: the reason you can sell high and buy low is that someone else has sold low and bought high. But in this zero-sum game, if the exchange itself participates in the game, it will always enjoy some degree of advantage. First, it can increase its chips out of thin air through fabricated coins; second, it can anticipate market trends through its prior grasp of capital flows. Let me add here that some shameless exchanges even say that not publicly disclosing 100% reserves is a responsible act toward the market, because once 100% reserves are disclosed, the market’s overall capital flows are exposed to the public. But I already said in MtGox miscellany that this is bullshit. Since it is simultaneously exposed to anyone, there is nothing unfair about it. On the contrary, if capital flows are indeed important information affecting the game, then if only the exchange knows them exclusively, the exchange itself gains the upper hand.

In short, in a zero-sum game, exchanges that possess unlimited chips and also get the upper hand certainly have an advantage, so their best strategy is to participate in the game. Markets speak of interests, not moral integrity; not pursuing what is advantageous is what is unreasonable.

But why, then, do I still say that 100% reserves are the general trend? Because even if exchanges hold the advantage, they will always have moments of failure. For example, if among 3 exchanges, 2 make a fortune and the remaining 1 botches it and becomes the next MtGox, then that unlucky one will contribute to changing public opinion. After the public sees a second and third MtGox, they will increasingly come to realize the importance of fund security. At that point, exchanges with 100% reserves will become more attractive. And by the time that day comes, those exchanges that have already made enough money and have not botched things can still switch to 100% reserves; it will not be too late.

From the exchange’s point of view, in a zero-sum game there is a 2/3 chance of winning, so of course one should take a gamble and engage in falsification. But for customers, if they wake up to the fact that there is a 1/3 chance their entire fortune will go up in smoke, that is enough for them to reject exchanges that falsify things.

So my conclusion is paradoxical: 100% reserves are the general trend, but for exchanges, falsification is the best choice in the current environment. Bitcoin’s future is honest and bright, but its early participants and promoters are often cunning and sinister. This probably leaves many “righteous partners” feeling helpless, but that is the cruelty of the free market.

Translated from the Chinese original with AI assistance. The original text is authoritative.