The Dangers of Bitcoin Exchanges and Bitcoin Banks

By Kyle Torpey Oct 2, 2014 7:10 AM EDT

NEW YORK (InsideBitcoins) — When most people first enter the Bitcoin ecosystem, they are usually looking forward to the idea of being their own bank and not having to worry about bank fees and payment censorship.

While this emphasis on decentralization is definitely found in the base Bitcoin protocol, many who are trading or storing bitcoins on an exchange or online wallet are not actually gaining much from the Bitcoin protocol. In fact, they are using their bitcoins in the same way that they currently use their dollars, euros, or other forms of fiat currency.

Who holds the private keys?

When it comes to ownership of bitcoins, private keys are the most important part of the game. Whoever holds the private keys attached to a certain number of bitcoins is the one who actually has control over where those bitcoins will end up in the future.

While there are plenty of private Bitcoin wallet solutions available on the market right now, a large chunk of Bitcoin users are not actually in control of their own private keys. This means they aren’t really in control of their bitcoins, either.

Coinbase, Circle, and other mainstream wallets

Most of the major wallet providers, who are also going after a mainstream audience, do not give their users control over their private keys. While this actually makes Bitcoin a more convenient payment option in certain situations, it also comes with many of the problems found with traditional payment providers such as PayPal.

Coinbase has already decided to shutdown accounts that get involved in online gambling, and it’s likely that we’ll continue to see this form of censorship from centralized payment solutions built directly on top of Bitcoin. If you want to use Bitcoin as a censorship-resistant payment method, then you’ll need to use a wallet provider that gives you control over the private keys.

How else can you trade on an exchange?

One of the main issues with allowing Bitcoin users to always have control over their private keys is that it makes Bitcoin exchanges rather difficult to operate. After all, investors need to be able to instantly trade their bitcoins on a server rather than waiting ten minutes for a trade to be executed directly on the block chain. At the same time, we’ve seen plenty of exchanges disappear with customer funds overnight due to the fact that the traders were not in control of their private keys.

One solution currently in the works for the exchange scenario is voting pools. This is a feature of the Open Transactions project, and it creates a situation where exchanges have an incentive to audit each other rather extensively.

In the voting pools system, bitcoins from a number of different exchanges are put together in one pot. Each exchange is then audited by all of the other exchanges in the pool due to the fact that one exchange trying to cheat would leave all the other exchanges in the pool without enough bitcoins to cover their customers’ funds. Watch the video below for a full breakdown on voting pools from Justus Ranvier:

You can follow @kyletorpey on Twitter.

  • Tom Harding

    Great article. If you’re new to bitcoin, make sure you control the private keys to most of your holdings. If you don’t see the need, you haven’t yet understood what really makes bitcoin different.

  • TheRockTrading exchange provides instant BTC deposits with 0 confirmations through GreenAddress multisig wallet. This let the trader being in control of its bitcoin, until the last minute, without risking to lose opportunities in the market:

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