This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.
Not what Bitcoin is meant to be
The crypto-inspired speculative asset trading on insecure exchanges is not what Bitcoin blockchain is meant to be and actually is (see, Bitcoin is not crypto).
The entire crypto world has become an irrational Ponzi-laden frenzy. The crypto industry has gone in the wrong direction long ago and gone too far by turning the original Bitcoin, one of the greatest inventions ever, into a multitrillion dollar gambling of speculations over other people’s speculations.
The wrong direction was not a necessary result of the technology itself, but caused by two concomitant factors: (1) the then temporary inefficiency of the Bitcoin blockchain itself; and (2) dubious human motivations that didn’t focus on real technology and business development, but on pure speculations and get rich quick schemes instead.
As a result of the misguided developments, many now mistakenly equate blockchain with ICOs and ITOs, or at least think that without ICO and ITO, there would be very little technological development.
With the crash of FTX, one of the largest digital currency exchanges, people even worry that if if these exchanges fail, the whole advancement of blockchain, DLT, crypto and DeFi will die.
But the opposite is true. The speculative nature of the crypto world is the biggest distraction and suffocation of the real technological development.
The entire crypto space, including Bitcoin, blockchain and DLT, has gone astray and wasted a decade of time and many billions of dollars to build on the wrong blockchains and ineffective infrastructure, business models and the subsequent ecosystems. The field lacks no talents and great ideas of use cases, but has generally missed what was envisioned by the inventor of the Bitcoin blockchain, and hasn’t come to understand that those great use cases will not happen in large scale without a unified base layer blockchain that has unbounded scalability, sub 1/100 cent transaction fees, true PoW without recentralization, and eventual integration with the IPv6 Internet.
As a result, very little resources have been directed to fundamentally sound infrastructures and applications, because who wants to do it the hard way when you can freely print your own money by issuing coins and tokens.
For more in-depth analyses, see:
- The New Internet & Blockchain;
- The necessary scalability of Layer-1 on blockchain ;
- One blockchain as the base layer of IoV.
The law and regulations are ineffective
As far as digital currency exchanges are concerned, they have started and continued in the environment that is nearly free of regulations. Although it is true that major countries like the U.S., China, India and many European countries all took an unwelcoming gesture toward digital currencies, the largest digital currency exchanges have taken advantage of digital currency-friendly jurisdictions and used the power of the Internet to operate globally.
The U.S., with its Securities and Exchange Commission (SEC), is among the most cautious nations watching the growth of the digital currency industry. But lack of understanding of the real capabilities of the original Bitcoin blockchain made the SEC uncharacteristically hesitant and unsure about what to do.
On the one hand, the SEC clearly sees that most digital currency coins and tokens are securities and need to be regulated. See an earlier article on the topic of the SEC and securities laws: Most cryptos are securities according to the Howey test.
On the other hand, seeing digital currency being hailed as the new industrial revolution, the SEC understandably took a much humbler and low-key position toward the industry, fearing being proven wrong and labeled as the backward obstructionist. While it is trying to enforce the existing law with certain earnestness, the agency also second-guesses what it is doing: perhaps we are unduly harming an otherwise revolutionary technology?
But what is really ‘revolutionary’ about digital gold and digital currencies? The SEC itself doesn’t show signs of understanding the real potential of the original Bitcoin blockchain, just like most others.
If the SEC, and also the public, can see there is a far more revolutionary and better direction for the industry to move (see the New Internet & blockchain), the law and regulations can be more helpful.
What has caused the toxic digital currency exchanges?
There are two major concomitant causes: (1) the then temporary inefficiency of the Bitcoin blockchain itself; and (2) dubious human motivations that didn’t focus on real technology and business development, but on pure speculations and get-rich-quick schemes instead.
While the above second factor is quite obvious, the first one is often overlooked and the relevant information not well understood. In fact, the truth is been hidden and even actively suppressed, because the then inefficiency of the Bitcoin blockchain was temporary, and could be, and in fact has been, subsequently solved, thus making the existence of the digital currency exchanges in their present form no longer justifiable.
When Bitcoin first came out, there was much debate of what direction the technology should go, despite the fact that Satoshi himself made it unequivocally clear that he wanted a scalable Peer-to-Peer system that is capable of micropayments first and eventually much more.
As the price of the bitcoin went up and the mining business became the dominating profit makers, the focus quickly moved away from Satoshi’s original vision, and focused on speculations.
At the same time, the rising cost of transactions on the Bitcoin Blockchain and subsequently all the other blockchains such as Ethereum, effectively killed the movement of blockchain utility along with any arguments supporting such a movement.
ICOs and ITOs started to explode, and digital currency exchanges, after the miners, became the leading profit centers. That part of history seemed like an unavoidable movement, but people don’t realize that it is the High Cost of Transaction (CoT) of the blockchains at the time that was a significant cause for the type of digital currency exchanges we have today.
So how did high CoT cause speculative asset trading on insecure exchanges?
Short answer: without a scalable base blockchain, centralization was the only way to lower the cost of transactions (Cost) and solve the problem of the high CoT of the participating blockchains. Hence the justification for centralized digital currency exchanges.
It led to the irony of an industry that worshiped ‘decentralization’ to accept extremely centralized platforms without making any inquiries beyond the skin.
How readily and the swiftly people can turn blind to obvious contradictions in what they believe and do, when quick money can be made!
It all started with BTC when it decided to limit the block size to 1M bytes in order to promote its “digital gold” and “every PC is a full node” narratives. The decision directly resulted in high CoT. Satoshi’s original vision of a Peer-to-Peer electronic cash system was intentionally mutilated and disabled, moving the digital currency world toward speculative trading of useless things, namely coins and tokens collectively called ‘crypto.’
When CoT is high, the real utility (if there is any in these new things called crypto in the first place) is ignored or destroyed, and speculative trading becomes the only thing that attracts people into the digital currency world.
Then came the digital currency exchanges.
Because the whole market consisted of purely speculative trading rather than utility transactions (trading tickets v. buying a ticket to see a movie), they needed digital currency exchanges, in large scales.
Leaving the legality of such exchanges aside, the digital currency exchanges that perform off-chain transactions are all completely centralized, not only the regular ones such as Binance and Coinbase, but also the so-called decentralized exchanges (DEX, these being actually centralized is a different topic to cover). The high CoT of the participating blockchains is the direct cause of such centralization.
See more on the structural impact of CoT.
The real Bitcoin blockchain does not need centralized exchanges
The assets—bitcoin and tokens created on the Bitcoin blockchain—are commodities of real utilities, not speculative assets or imaginary assets. Whatever transactions these assets may need, necessary services can always be directly built on the Bitcoin blockchain, with security, scale, efficiency and reliability far superior to that of centralized exchanges.
With a blockchain that has extremely low CoT and high scalability, there is no need for developing thousands of other blockchains, nor tens of thousands of coins or tokens without actual utility in the first place.
But more importantly, all transactions of every token created on such a blockchain can be processed and verified on-chain, enabling a truly decentralized exchange if needed, and making centralized exchanges unnecessary.
Tokens representing assets of real utility can be, and will be, created on such a blockchain, but they can all be carried on the same blockchain, and traded within the same ecosystem.
For example, with STAS tokens on BSV, all kinds of custom tokens can be created, but they are native on-chain tokens and can be transferred and traded just like bitcoin (BSV) itself, like Peer-to-Peer electronic cash. Even with L2 tokens such as Tokenized, every single transaction can be recorded and verified on-chain, and only the business logic of the tokens needs to be administrated off-chain.
But a world with the tens of thousands speculative coins and tokens needed centralized exchanges. Because most of these speculative coins and tokens are based on blockchains that have high CoT, the exchanges have no choice but to use high-level centralization to make the transactions less costly.
This is analogous to layer-2 (L2) solutions that have to use centralization to lower the CoT of the underlying blockchain (see “L2 solutions“). When you start from a wrong premise, you end up with a wrong conclusion, even if the rest of your logic is flawless. It is dictated by hard reality, be it economics or physics.
More specifically, with these underlying blockchains having such high CoT, these exchanges cannot possibly run all transactions on-chain, because if they did the high cost would have driven the customers away.
The illusion of low-cost digital currency exchanges
Ever wondered why trading BTC or ETH on a digital currency exchange would cost as little as a few cents, when the CoT of these blockchains are above $1 and can be as high as $50?
For example, if the total transaction value is $10, your cost would be about 2 cents based on a transaction fee of 0.2% on Binance, or 10 cents based on a transaction fee of 1% on Coinbase. But all this is masked by the fact that most people probably make transactions of at least $100, perhaps even $1000 or above. At $1000, the transaction fee would be $2 on Binance or $10 on Coinbase, and people probably think that is a result of the CoT of the blockchains.
But those are not the CoT of the blockchains. They are just fees charged by the exchange itself.
So how did exchanges magically make the CoT of blockchains disappear?
They have a clever solution, but they’re not going to truthfully explain to the public what they do.
They create virtual accounts for their customers but hold the bitcoin of customers in a collective (pooled) system account. Other than entering and exiting, customers who do trading on an exchange do not transact on-chain at all. Instead, they just allow the exchange to reallocate numbers from one virtual customer account to another while continue to keep the bitcoins in the collective system account. Only when the customer transfers bitcoin out of the exchange to an external address will the transaction be settled on-chain.
The result is a completely centralized system that creates and manages virtual accounts (which are completely off-chain) for users. These virtual accounts do not provide even a common legal/contractual ownership of the assets contained therein for the users (see below), let alone secure ownership safeguarded by a blockchain.
Due to the way these virtual user accounts are setup, users are creditors who have lent the assets to the exchange, rather than absolute owners of the assets.
That was the reason why in a recent disclosure made by Coinbase it stated that if Coinbase is in bankruptcy, digital currency holders may not retain their digital currency assets, because they will be treated as creditors rather than absolute owners of the assets in a liquidation and will have to fight for their priority order without any certainty attached.
Coinbase was not wanting to be mean. They were just telling the unfortunate truth. Given their priority when they designed their exchange, the choice they made was inevitable, and also intentional.
Simply put, because the coins and tokens they wanted people to trade were products of high-CoT blockchains, the digital currency exchanges have no choice but to create the current business and asset structure using virtual accounts.
You thought these exchanges have magically and graciously solved your high CoT problem, but you probably didn’t know that they did it all out of your expense. You sold your property rights because of your ignorance or perhaps even greed. But on the other hand, what you have may not be genuine “property” in the first place because most of them are speculative junk created by Ponzi schemes. Therefore, your justifiable level of rage against these exchanges may not be that high after all.
But it is even worse than that – exchanges being unregulated banks
Digital currency exchanges did not stop at just making virtual accounts. They started to behave like banks (but without being subject to any banking regulations), conducting highly leveraged lending of digital currency assets.
Without any regulatory supervision, the shadiness and reckless ‘creativity’ of digital currency exchanges became far greater than that of regular banks. The practice further fueled the crypto speculation frenzy, and increased the risks of the customers to madly high levels.
Then in November 2022, FTX, one of the largest digital currency exchanges in the world, collapsed.
How did a digital currency exchange collapse? Liquidity crunch, like a bank run when customers rushed to withdraw their assets. But how did a digital currency exchange have a liquidity crunch? Because it did leveraged financing and trading. But how did it do that without public’s knowledge? Because they are not regulated like banks are.
In wake of such disasters, major digital currency exchanges such as Binance are boasting their ‘cold wallets’ safely storing the deposited digital currency assets of the customers. But that is misleading or even deceptive, because the ‘cold wallets’ do not address any of the above-described problems, including the legal ownership, and liquidation risk in leveraged financing. Cold wallets, if implemented properly, protect against the external hackers, but does nothing to the intrinsic risks of internal structural problems.
But people cheered and thanked Binance for saving the market by showing transparency in reserves, failing to understand a basic fact: keeping customers deposited in a cold wallet as reserves is no indication that funds are safe in an event of bank run or liquidation. It just means that at the moment of showing the funds are not stolen or lent out to an external party. Customers still don’t really own their deposits; the exchanges are still doing leveraged unregulated digital currency banking at the risk of customers; and the exchanges are still doing all other even worse things as discussed below.
And even worse – exchanges being their own central banks
As if the unsupervised financing schemes with all kinds of leverages wasn’t enough, major digital currency exchanges started to print its own money.
So digital currency exchanges’ problems are deeper than just unregulated banking problems, because they literally create out of thin air their own tokens, pump up prices, and use them as ‘reserves’, and even then, only with fractional reserves.
Banks never had that kind ‘power’.
Sometimes the money-printing is done using a blockchain that the exchange has just spun out from itself, but often even such a cover is not present.
Why does an exchange create its own blockchain? Again, there is a very convenient pretext: people have been misled to incorrectly assume that the Bitcoin blockchain does not scale and therefore an ‘improved’ blockchain is necessary, when the opposite is true.
But a digital currency exchange can be supercharged to build its own blockchain anyway. This is not surprising given how easy it is today to create a blockchain using all the open-sourced codes accumulated since the release of Bitcoin, and how lucrative it is to have your own blockchain especially if you are an exchange that has allured to your own platform millions of people who are in full FOMO mode hoping to get rich quick.
Remember banks create credit-based money by doing leveraged lending. Digital currency exchanges already do that, only without regulatory supervision. But it went much worse.
With just the regular leveraged lending, at least the assets that are being leveraged (for example, BTC, ETH, etc.) are created and supplied from an independent source. Whether those assets themselves are real or have value is at least a separate question to be answered by others who are not part of the exchange, like the dollar to the banks. For example, commercial and retail banks may be creating credit-based money, but the base currency such as the U.S. dollars is not created by the banks themselves, but by a higher authority, the central bank.
Once an exchange starts to literally create its own money, however, it becomes its own central bank.
Even with the external assets such as BTC, ETH, SOL, the situation is far worse than regular banks and fiat money. The value of a fiat money is mostly independent from banks, because it is largely determined by a nation state’s economy, not subject to market pumps. In contrast, the digital currency exchange may choose whichever and how many digital currency coins or tokens it wants as a part of its reserves. If this itself is not harmful enough, the fact that digital currency exchanges play a pivotal role in pumping the prices of these digital currency assets certainly is. And the harm goes even beyond that, because not only do the digital currency exchanges pump the prices of their reserve assets, but they also do cross-lending and double-accounting to create a reciprocal magnifying effect.
As a result, the whole system becomes self-referencing, self-reinforcing and procyclical, a hallmark of an artificial bubble.
And even more – exchange being the market manipulator
Just think of all the market manipulations that are in the stock market, pump and dump, poop and scoop, order spoofing, insider-trading, frontrunning, etc., and multiply that by many times. If licensed professionals in a highly regulated industry (stock market) can do that, just imagine what would happen with digital currency exchanges.
But there’s something else that few people realize. Digital currency exchanges also get to decide who is the winner in the market. This has further distorted the market that is already strangely rigged.
Digital currency exchanges have had influence or even colluded with the miners for their own interests. The exchanges are not mining nodes of an external blockchain, and are not supposed to do that. But the history of the digital currency exchanges shows that they did just that.
This was most prominently shown during the Bitcoin forking. When the miners disagree, a hard fork is formed. As a practical matter, upon the occurrence of a fork, it is the exchanges that decide which chain retains the original ticker. Unlike what the public believe, there is no de novo truth in this matter. It is in the hands of the exchanges, and they make the decision based on their best interest, not the truth itself. And this is exactly how BTC, a severely distorted version of the original Bitcoin got to retain not only the original ticker BTC but also the wide public reference of being the ‘Bitcoin’.
The exchanges thus played a major contributor’s role in the crypto world’s near unanimous exclusion and suppression of the real Bitcoin (BSV), when it is demonstrably true that BSV has real utility and extremely low CoT. The exchanges also helped to create the public’s erroneous belief that BTC was the real Bitcoin. Both these two factors concomitantly made room, in fact creating an ideal environment, for the disastrous speculative Ponzimistic crypto world.
On top of it
And on top of it, there are the irregularities in an unregulated business. Just think about it, a system that combines central banks, retail banks, trade exchanges, market makers, brokerages, analysts, marketing, asset management and investment, all mingled together with no requisite separation, placed under centralized owners with no identifiable legal entities registered in a reputable jurisdiction, operating without any legal and regulatory oversight, not even proper business-grade auditing, and controlled and managed by people would don’t understand or don’t care how legal monetary and finance systems work.
That makes a power-function to kill, constituted of multiple multiplications to magnify the effect:
Cult (of tech-buzzwords) x Ignorance x Greed x Recklessness x Cleverness (of manipulations).
But it didn’t matter. Investors’ money, even that from top VCs and home offices, just poured in. A crazier and more foolish scene cannot be imagined.
Is it legal?
The law will eventually answer this question. However, it is not like the people who created digital currency exchanges are unaware of legal problems. Circumvention is the name of the game.
In this respect, Coinbase (NASDAQ: COIN) is by and large not the worst at all, but in fact maybe the best, due to its root and establishment in the United States. Other exchanges are on much shakier ground than Coinbase.
However, even if the exchanges did not do shady leveraged business, they may still be illegal because they are trading assets that are unregistered securities. See most digital currencies are illegal securities.
The fact that Coinbase itself is listed on NASDAQ does not mean that its digital currency trading business itself is under the oversight by the SEC the way a stock exchange is. As a result, people don’t realize that regulators lack the oversight of these digital currency trading platforms, and investor protections for digital currency investors are not the same as that are built into traditional financial services.
The situation with other exchanges is either the same or even worse. A key difference is that Coinbase was forced to make such disclosure because it is a publicly traded company listed on a stock exchange in the US. Even though its digital currency trading business itself does not meet any special regulation, the company itself is subject to regulations just like any other publicly listed companies.
Other digital currency exchanges, however, all enjoy their outlaw status thanks to even weaker regulatory supervision.
Exchanges are not miners
As Dr. Craig S. Wright (a.k.a. Satoshi, the inventor of Bitcoin) points out in the article Peer-to-peer electronic cash, there are essential differences between the miners and digital currency exchanges such as Binance and Coinbase.
Bitcoin miners are not a “money services business” or “MSB” under the Bank Secrecy Act (BSA) administered by FinCEN, because other than the mining fee itself, no money is ever transmitted or paid to/from a miner. A miner is therefore not a money transmitter, nor a money broker. Rather, a miner’s role is infrastructural, and it’s truly independent from the transactions.
The exchanges are not miners. Not only are exchanges not part of the miner network, but also they don’t even settle transactions on-chain under normal conditions. They create virtual accounts for their customers but hold the bitcoin of customers in a collective (pooled) custodial account.
As a result, customers who do trading on digital currency exchanges do not transact on-chain at all. Instead, they’re just allowing the exchange to reallocate numbers from one virtual customer account to another while continuing to keep the bitcoins in the collective custodial account. Only when the customer transfers bitcoin out of the exchange to an external address will the transaction be settled on-chain.
An exchange is thus both a money transmitter and a money broker, doubly qualifying as a “money services business (MSB)” under the Bank Secrecy Act (BSA). Therefore, leaving alone the question of securities laws, a digital currency exchange’s business operation should comply with BSA.
Yet the exchanges have enjoyed the freedom from both securities law and BSA so far.
Exchanges won’t voluntarily go away
As said, centralized digital currency exchanges built their virtual accounts model due to the necessity when the original Bitcoin blockchain wasn’t capable to support low-cost transactions and on-chain tokenization based on smart contracts.
Now that the real Bitcoin blockchain has solved the earlier problems, shouldn’t the centralized digital currency exchanges just go away?
They should, but they won’t voluntarily. Everything is entrenched with existing business models, interests and incentives.
Given this condition, it should not be very surprising that digital currency exchanges intentionally and persistently reject the blockchain that has extremely low CoT, namely Bitcoin Satoshi Vision (BSV) that is based on the original design of Bitcoin by Satoshi. (But the irritating and confrontational personality and style of Craig Wright, BSV’s leader, also made it very convenient for others to find motivations of such actions.)
However, it should be noted that, even if an exchange had decided to list BSV, it won’t change the overall picture now. That time has passed already for exchanges. This is because, even though BSV itself can allow every transaction to be settled on-chain with negligible cost and no impact on its capacity, the exchanges are not going to make such an exception for BSV. Making such an exception would cause an inconsistency in the exchange’s system, and may also expose the secret of what the exchange does.
Besides, doing the right thing for the customers in this case is simply not a digital currency exchange’s priority. The priority of a digital currency exchange is to profit from speculative trading, rather than fairly representing useful assets. This in itself may not seem to be so egregiously wrong, but one should remember that if a stock exchange did what digital currency exchanges did, it would be in big trouble because stock exchanges are highly regulated.
Digital currency exchanges are essentially doing a business that should be highly regulated but has not been. So they get away, at least for now.
It is time to focus on the true blockchain and distributed ledger technology
Trading speculative assets on insecure exchanges is not a good future. Unfortunately, it’ll take disasters like the collapse of FTX, perhaps even something much worse, for people to wake up to this fact.
The true Bitcoin blockchain as envisioned by Satoshi does not depend on unregistered centralized digital currency exchanges. In fact, it will advance faster and more healthily without them.
Despite the above described dire condition, the blockchain ship can still be steered to the right direction, with the proper recognition of the true values and utilities in a productive economy ranging from consumer to enterprise.
First, Satoshi left BTC but didn’t quit from Bitcoin. He continued to devote himself to making the real Bitcoin and Bitcoin Blockchain work for the benefit of the world. He has invented the subject matters of hundreds of patents and patent applications for technologies related to or derived from the original Bitcoin. He leads a team of over 200 researchers and engineers building the only platform in the world that is truthful to the original Bitcoin whitepaper.
Second, the anomaly in the crypto world wasn’t all deadly, because it unintentionally created a condition that, although adverse, allowed the real Bitcoin to grow healthily outside of the toxic Ponzi environment. The real Bitcoin Blockchain did grow in such a disciplined condition, steadily building a global ecosystem of entrepreneurs, developers and products that are remarkably uninfected by the get-rich-quick pandemic suffered by others. See The moral sentiments of Bitcoin.
Third, steering the ship toward the right direction does not mean throwing everyone else off the deck. It is to lay a better foundation for all developments in the field. There are many intelligent groups working on good ideas of blockchain applications. If these ideas are built on a correct foundation, they can be truly useful and productive. All applications on Ethereum, the biggest smart contract platform, can easily migrate to the base layer Blockchain of the New Internet. Migration has been made easy using a Transpiler that converts Solidity to Bitcoin scripts automatically. The innovative Transpiler makes the refactoring many times easier than re-coding.
Even BTC, Ethereum and some other existing blockchains may find their own usefulness with the New Internet, benefiting from a much broader, more efficient and more productive new environment. Although they are not capable of forming the base layer of the New Internet, they may be either absorbed into the unified IoV and become overlay networks, or they may each find a place on an application layer to continue to serve its own purpose and customers. Such questions will be naturally answered by the market itself, not politics, although the law will always play a role.
The technology is ready for the New Internet. People need to open their eyes to see what opportunities lie ahead.
The New Internet on blockchain
The new internet will integrate IPv6 and Bitcoin blockchain at the base layer. See The New Internet & Blockchain, for its history, architecture, and what problems it can solve.
The New Internet will not rely upon digital currency exchanges, though it may accommodate them if they come in an improved decentralized form built directly on the base layer blockchain rather than fake L2 solutions with recentralization.
As far as the capital flow, information flow and talent flow are concerned, the existence of digital currency exchanges in their current form restricts the New Internet development.
On the other hand, exchanges, if they have any economic and financial reasons to exist, may also find the New Internet a far better ecosystem and environment to be in. Although speculative trading cannot form a foundation of an economy, a healthy economy may support and even benefit from speculative trading to a certain degree. There are all the reasons to focus on the development of the New Internet on a truly scalable and extremely low-cost blockchain.
After 20 years of hard work, including the years of preparation before the release of Bitcoin, both the theoretical and implementation foundations have been laid, and many tools and applications have been built. Now, if only the 1/10 of the resources and talents currently in the crypto industry could wake up and move over to the development of the New Internet on blockchain, a far better future would be built quickly, at least as fast as the old Internet was built.
Follow CoinGeek’s Crypto Crime Cartel series, which delves into the stream of groups—from BitMEX to Binance, Bitcoin.com, Blockstream, ShapeShift, Coinbase, Ripple,
Ethereum, FTX and Tether—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.
New to blockchain? Check out CoinGeek’s Blockchain for Beginners section, the ultimate resource guide to learn more about blockchain technology.
