How crypto can prevent financial crises in the future...
On self-custody, why banks are poor custodians of your money, and how crypto can prevent financial crises in the future.
There are a lot of unanswered questions from the Silicon Valley Bank crisis last week.
Most importantly, perhaps, is “what can be done to prevent such a crisis in the future”?
“Bitcoin fixes this” is an overused meme on crypto twitter, but funny enough – Crypto actually has a solution to prevent such crises from happening again. And it might be the only catch-all solution for financial crises like this one.
But first…
Why Banks are not good custodians of your funds.
When you deposit money into your bank, you are trusting them to keep your money safe.
Now, banks have to abide by regulations, and there are government agencies watching the banks closely.
But the key risk you can’t overcome is that your interests and your bank’s interests are not perfectly aligned.
Your bank is in the business of using your money to make money for itself.
Regulations can help keep greed at bay, so this doesn’t bubble into a crisis regularly.
But misaligned incentives encourage misaligned actions. And it only takes a few misaligned actions to lead to an economic crisis.
The 2008 financial crisis is a good example. The custodians (banks) got greedy. Rating agencies got greedy. The gov missed the plot too.
Eventually, lots of people lost money, companies went bankrupt, and the government bailed out the banks with printed money.
Bitcoin was born out of this crisis.
Enter Self-Custody
Until blockchain, we didn’t have a good way of handling this risk, save from storing cash under your mattress. But now we do - self custody.
Just to clarify the terminology:
Non-custodial account / self-custody account = you own your assets
Custodial account = you trust someone else (a custodian) to hold your assets.
Self-custody solves the problem where you are required to trust someone else to keep your money safe.
No one can take your money away if it is held in a self-custody wallet.
No one. Not your wallet provider, not the government, not even Satoshi.
This distinction is hard for lay people to understand. To an uninformed person, there doesn’t seem to be a difference between money in a Bank account (custodial) vs money in a Metamask wallet (non-custodial).
Most of the time, you can deposit, withdraw and transfer funds from either account, and it has the same effect.
But every once in a while…
Your bank can tell you to buzz off because “the system isn’t working”.
Or they can make mistakes like SVB and lose everyone’s money.
Or they can get greedy and lose your money like FTX (yes, these were custodial accounts too - not very different from a bank account).
Or they can seize your funds like some governments have been known to do.
Or they can freeze your money like the Canadian government did to protestors last year. (Keep in mind, this is a pretty liberal democratic government - these problems can be much worse in other regimes).
It’s worth nothing that even in the crypto space, custodial solutions (like FTX) have had the same problems. (though even worse since crypto is less mature and therefore poorly regulated).
Self-custodied funds, on the other hand, are completely in your possession.
There is effectively no difference between funds in your MetaMask wallet and cash in your pocket. You have complete control and autonomy over the funds. You keep it safe, you move it around, you decide where it lives, breathes, and how it earns interest.
You, and ONLY you.
The fundamental mantra behind self-custody is this:
Do not trust someone else to keep your most valuable assets safe.
(Especially not when that “someone” is in the business of using your money to make themselves money)
The way forward…
Consider the recent downfall of Silicon Valley Bank...
(For those who weren’t able to keep up with the chaos, here’s a brief explanation of what went wrong)
Most of the solutions being proposed to ensure this doesn’t happen again involve additional regulations and government oversight. And most likely, this is all that will come of this crisis.
But this is a flawed approach.
Of course, we can make new regulations so this specific issue doesn’t happen again.
But slapping a bandaid on the problem isn’t the answer. It will just come back in a different form.
We need a goddamn transplant.
We need self-custody. We need blockchain.
Counterpoints
Though the above views are idealistic, I recognize the challenges with what I’ve discussed above, so I want to give some recognition to the practical difficulties as well.
Systems aren’t changed overnight - it will be a slow and gradual process, even if the world unanimously decided that self-custody is the way forward.
Most likely, self-custody is not a catch-all solution. There will surely be situations where we still need custodians to safeguard our assets. But self-custody is a viable solution to prevent against MANY of the risks mentioned above.
And we can certainly get a lot from the other benefits that blockchains and smart contracts bring: transparency, decentralization, trustlessness, fraud and censorship-resistance, programmability, etc
For example, a financial system built on smart contracts would allow code to regulate the risk profile that a financial institution is allowed to take.
Regulation via code is pre-emptively enforceable to restrict bad actions altogether.
This is better than regulation via court, which is retroactively punitive, but cannot actually restrict the action.
In other words - "Crypto fixes this" 😏
Finally, I want to address a problem that people often mention regarding self-custody:
“Everyone can't handle self-custody - there’s a steep learning curve. It’s too complicated.”
Indeed, self-custody is a big burden - many good coin have been lost forever to misplaced seed phrases.
I believe that the problem ISN'T that everyone isn’t ready for self-custody. Rather, self-custody isn’t ready for everyone.
We need better paradigms and user experiences that allow for self-custody with better recovery options.
All of this (and more) is coming.
It will take some time – but in the end, crypto fixes this.