Misconceptions About Bitcoin Exchanges

There is a common misconception I hear when talking to people who are newer to bitcoin. It concerns exchanges and how they fit into Bitcoin. People hear about the blockchain, and how transactions go on it; they assume that when they log on to their exchange of choice and make a purchase of some bitcoin, that a transaction has been added to the blockchain ledger.

This isn’t an unreasonable assumption. But in reality, exchanges have nothing to do with Bitcoin, the network, or the protocol. They are their own entity, operating however they please. That isn’t to say that an exchange couldn’t operate in a way so that every trade that happened on their platform had some corresponding entry in the blockchain. But it would be slow and costly to do so.

When you buy bitcoin on an exchange, what is happening? I’m going to generalize; some exchanges may work differently than this. But on the whole, this is what’s going on: Before you decided to buy, someone else decided to sell. Before they could sell their bitcoin on the exchange, they had to give their bitcoin to the exchange. The exchange requires that the seller have bitcoin in their account on the exchange, in order to place the sell order. So the seller would have told the exchange that they want to deposit some bitcoin into their account, and the exchange would provide them with an address to send the bitcoin to. When the exchange verifies on the blockchain that the funds have been sent to the address that they provided, they add the amount received to your account balance. The seller now no longer has control of that bitcoin, as far as the bitcoin network is concerned. The owner of the bitcoin is now the exchange. Now that the bitcoin is with the exchange, the seller can put in a sell order up to the amount that they deposited.

Now you come along looking to buy. Depending on the exchange, you may be required to deposit USD (or whatever currency you’re buying with) before you can put in a buy. Other more customer-friendly exchanges will offer to let you buy the bitcoin instantly and will begin the process of moving your money over from your debit card or bank account when you make the purchase. In either case, after the trade happens, what the exchange is doing internally is just as simple as subtracting some numerical amount from the seller’s account, and adding some numerical amount to your account. But no bitcoin moved as far as the bitcoin network is concerned. No activity has occurred on the blockchain. Because both before the trade, and after the trade, the entity holding the bitcoin remains the same: the exchange.

The only time you have bitcoin, is when you request to withdraw the bitcoin off of your account with the exchange. At that point, you’ll give the exchange your address, and they will send bitcoin to you and subtract the numerical amount out of your account balance with them. Once that transaction broadcasts out and then gets confirmed in a block, then you have bitcoin.

So what do you get when you buy bitcoin on an exchange? Paper bitcoin. An IOU from the exchange. Not the real thing. If anything happens to that exchange (assets seized, bankruptcy, the owner dies suddenly¹) there isn’t much anyone can do to make you whole again. This kind of problem gave rise to a saying in the bitcoin community:

“Not your keys, not your bitcoin”

I don’t think it’s inherently bad that exchanges work this way, it’s the simplest way for them to work. But it can become a problem if the exchanges get greedy.

Unpopular Opinion: The supply of #Bitcoin is higher than 21 million. Exchanges leverage the existing supply of any #crypto asset in much the same way banks leverage the supply of fiat money. The only protection is to hold your own crypto. Not your keys, not your crypto.

— Weiss Crypto Ratings (@WeissCrypto) May 25, 2020

What WeissCrypto is insinuating here that exchanges are not holding 100% of their reserves. So if all of their customers tried to withdraw all of their funds at once, the exchange would not be able to fulfill all the requests. In order to force exchanges to be honest, it would be best for the bitcoin economy if more people did not leave bitcoin on exchanges.

When I first got into bitcoin, I didn’t understand why you would withdraw bitcoin from an exchange. It seemed riskier to me than leaving it on the exchange. I figured that the people at the exchange were experts at storing and protecting crypto assets, and I was not. So I thought if I was managing my own bitcoin, the odds of me losing it was higher than if I left it on the exchange. But as I began to look into what would be required to self-custody bitcoin, I realized it wasn’t as difficult as I had imagined. And to be sure, there is a potential for loss if it’s not done carefully, but it can be done carefully.

Now I understand that the reason you withdraw it from the exchange is that if you don’t, you don’t have bitcoin. You have an IOU of bitcoin from an exchange. An exchange that may fail, or get hacked, or suffer any other of a number of bad endings. And in that event, your IOU will not be worth much. There is no FDIC insured bitcoin account. If the exchange goes under and you don’t have your bitcoin, it is unlikely that you will ever see that bitcoin.

I don’t think there’s an imminent danger to your bitcoin if it’s currently sitting on an exchange. But I do think that it reduces your risk for you to store your own bitcoin, and I think it forces exchanges to conduct themselves more carefully. If your bitcoin is currently stored with an exchange, I would encourage you to research what it would take to store your own bitcoin securely. I’ve written some thoughts about that here.