by elmads

Introduction

In my previous blog titled “How to Spot a Legitimate and Safe Investment Broker”, I’ve specifically shared my personal ways how find a broker to trust and place our hard-earned money, for marketable security investment purposes.

As I would love to incorporate that method with cryptocurrencies, it just doesn’t secure a higher certainty of reducing crypto investing risks to this wild west of an emerging asset class. Thus, the creation of this blog.

With the recent FTX fraud induced crash, people have become more hesitant now to invest with cryptocurrencies. Despite this, there are still some who has the confidence with this emerging asset class, and it is not of blind conviction, but of understanding of the underlying core technology where these coins are built upon. And, where risks and rewards are taken into consideration – on how to mitigate potential loss of our hard-earned money, and basically on how not to get involved with FTX like moments in the future.

FTX Crash

For us to understand why the fall of FTX has been a major blow in the cryptocurrency industry, we have to know first what happened with FTX and what it is. A short Summary.

It starts with one person, and that’s Sam Bankman-Fried. This person started his employment in a trading firm named Jane Street Capital, where he made millions of dollars by taking advantage of the price differences of Bitcoin from one country to another (arbitrage). He bought Bitcoin in the US then sold it in Japan pocketing a 10% gain with the differences in prices.

How was that possible? he started this in 2017, in a time where the cryptocurrency industry was still developing and the infrastructure for trading was still minimal. Sam Bankman-Fried short acronym for SBF, saw this massive opportunity and banked a lot of money from it.

With his trading money, SBF started his own cryptocurrency trading firm in 2017 named Alameda Research. It is a like a hedge fund where they make money through trading and utilizing other financial strategies – such as leverage – to boost returns . After 2 years of starting Alameda Research, SBF built another company named FTX.

Unlike Alameda Research, FTX is not a trading firm, it is a cryptocurrency exchange where crypto investors use the platform to buy, hold and sell cryptocurrencies and fiat money (USD, GBP, JPY and others).

To put it simply, just think of it like this:

• FTX – is the Amazon Market Place where people buy and sell products online.
• Alameda Research – are the individuals or a group of individuals that buy and sell products in various online market places (e.g. Facebook Marketplace, Amazon, eBay and Etsy to name a few) to make a lot of money.

What then happened? what caused the collapse? This story is too long and can be too complex for some to understand, but generally, it has something to do with the mismanagement of money, greed, lies and fraud.

• Mismanagement of Money – SBF transferred $10 Billion of the FTX money (the crypto exchange) received from its customers to Alameda Research (his trading company) for trading purposes. This is a clear violation of FTX guidelines and this is not allowed without them disclosing such information to their FTX customers and without the agreement of their customers. Clearly, they violated one of the basic laws of a operating a financial firm.
  
  To give you context, let’s take an oversimplified example by using the traditional Filipino savings group practice the “Paluwagan” – where it is pooling savings funds common among close friends and colleagues with the purpose of saving and making a lump sum for certain financial goals such as bigger purchases at the time of scheduled redemption or pay-out.
  
  Basically, whoever handles the money of the “Paluwagan” should keep it safe and secured, but instead this person used the pooled funds for other investment purposes without the knowledge of the persons involved in the savings group.

• Greed – SBF used FTT coin (FTX’s own made coin) as collateral to raise more capital through debt. As I’ve written previously, SBF transferred $10 billion worth of money of his FTX customers to Alameda Research for trading purposes. What Alameda Research did was not just to use and trade the received money from FTX, but also shift the risk game to the highest gear by adding debt/leverage in their operation. They took large amounts of debt, in return the creditors asked for a collateral. Alameda Research was able to provide it and used tokens issued by FTX.

The unfortunate part of using FTT coin as collateral is that it is a coin made by SBF’s FTX exchange. In short, they can easily manipulate the supply of the coin and give it an illusion of monetary value.

Generally, it’s like me saying that I have rims of coupon bond paper that’s worth $10 million dollars in fiat money (USD, GBP, JPY and etc). I’ll give you these rims of coupon bond paper as collateral provided that you agree to loan me $10 million US dollars. Why would you agree? well because I’ve established my credibility to everyone in the world, have proven something already, I have connections and a lot more – a well prepared mask.

• Lies – He claimed that the balance sheet of FTX is healthy, when in fact its total liabilities were worth $8.9 Billion, while its Assets were worth $900 million. This means that FTX’s equity is worth Negative $8 Billion.

This is just a short summarization of SBF, himself and his companies’ downfall. If you want to know more about what transpired with the FTX fiasco, you can watch one of my personal go to Youtube channel that tackles anything about Science, Tech & Business – ColdFusion TV.

“So what can we learn here? well if you’re an investor only put in what you are willing to use. This story also shows that in a bull market with cheap money, anything goes. Even the smartest experts become drunk with the idea of making millions, they’re willing to throw hundredths of millions of dollars to a 30-year-old and his polyamorous friends – some of whom have next to no experience. Really with this whole thing it seems no one knows what they’re doing.

Although there might be a deeper aspect of play here, in the depths of US politics. Although we can’t draw nothing conclusive, at the very least the political lobbying and possible corruption is concerning.

The whole thing reminds me of 2008. Firms making up financial products, taking on huge risks and passing it to others. It’s crazy because cryptocurrency was supposed to stop this, but I guess where there’s money to be made you always get bad actors.”

-Dagogo Altraide the founder and owner of ColdFusion TV (Science. Tech Business) Youtube Channel.

All eyes are currently with FTX, but this is not the end yet, as there are other firms who have a direct investment exposure in cryptocurrencies and who are overly leveraged. Companies and businesses that either filled for bankruptcy already (Blockfi and Voyager are examples) or are underway to filling one in the near future.

Today’s cryptocurrency market environment is said to be its “Great Financial Crisis”. Contagion of leverage and greed that led to its downfall, same as with the 2008 Global Financial Crisis caused by the Banking & Real Estate industries.

How to protect your cryptocurrency investment

By this time, you already know that FTX is a cryptocurrency exchange. For retail investors like ourselves, we need market exchanges for us to be able to invest in cryptocurrencies, same as with marketable securities (e.g. Stocks & Bonds).

We cannot remove exchanges in the investment process as they are an integral part of the market, same as with brokerage firms. Therefore, if you’ve been investing in cryptocurrencies for these past couple of weeks, months or even years, then you might be one of the persons who got caught up with this FTX fiasco.

Is there even a way to know how safe a cryptocurrency market exchange is? though some crypto exchanges are regulated in other countries, they’re still not strongly regulated yet unlike other financial asset classes (Stocks, Bonds, Real Estate and Commodities). Most companies who directly dabble with cryptocurrencies are not even mandated yet to publicly share their financial statements and reports to everyone.

As I’ve discussed in my previous blog “How to Spot a Legitimate and Safe Investment Broker”, I emphasized that looking into a company’s financial reports and statements are important to see its financial health and plans moving forward.

The cryptocurrency industry is like the wild west of western U.S. in its frontier period characterized by roughness and lawlessness, where regulations are not properly in place yet – anything can still go awry – but eventually this space will continue to improve and be secured moving forward.

“With that in mind, how will we be able to secure our hard-earned money invested in cryptocurrencies? is there still even a way?“

Yes there is, and it’s through cold wallets. But before we delve deeper about this, we first need to understand what is a cryptocurrency wallet.

Cryptocurrency Wallets

Crypto wallets are digital wallets specifically for cryptocurrency storage purposes. It utilizes the blockchain technology to protect and secure the coins inside the wallet.

• Blockchain Technology, also know “The Blockchain” is a shared database or ledger among the nodes of a peer-to-peer computer network. The blockchain legitimizes a person’s ownership of coins based on the wallet where it is stored.

This sounds complex to comprehend, but understanding this technology is very important. Knowing it gives us the understanding why blockchain is said to be one of the most secured, if not the most secured, digital ledger worldwide.

I’ll link down below the simple and comprehensive explanation of 3Blue1Brown YT channel regarding the blockchain technology and how Bitcoin works.

If you want to read “The White Paper” written by Bitcoin’s anonymous founder Satoshi Nakamoto, I’ll share the link down below. In here, Satoshi detailed his original plan and protocol for Bitcoin.

https://www.ussc.gov/sites/default/files/pdf/training/annual-national-training-seminar/2018/Emerging_Tech_Bitcoin_Crypto.pdf

There are two common types of cryptocurrency wallets, the Hot Wallet and Cold Wallet. We’ll start with the former.

• Hot Wallets – This is the wallet that we automatically have when we open an account in a cryptocurrency market exchange (e.g. Binance, Coinbase & Kraken). NOTE: Every wallet has its own designated Public Key & Private Key.

The hot wallet is easy to use and set up. It only requires an internet connection for us to be able to access and mange our digital assets.

The drawbacks:

1.) Our digital assets are stored in crypto exchange and we don’t have access to our private keys – a high risk for a cybersecurity exchange theft. “But I thought the blockchain is secured? how come they are able to access the “Private Keys”?” It’s not the blockchain that is being hacked here but the exchange itself.

“This is because exchanges generally hold cryptocurrency in reserve for liquidity and the private keys for many of their customers. This makes them an attractive target for hackers.

Thieves target exchanges for access to the cryptocurrency keys. If you don’t store your private keys on an exchange, they cannot be accessed, and your cryptocurrency is safe—at least from an exchange hack.”

-investopedia

Private Keys are like passwords to access our digital assets. Without it, no one will be able to transfer your digital assets from one wallet to another.

You see, “Private Keys” are encrypted strings of numbers between one and 2²⁵⁶ or 115 quattuorvigintillion (a quattuorvigintillion is 1 followed by 75 zeros). It would take centuries, possibly millennia, to break the encryption with our current technology. What more if we do it individually, trying to guess someone else’ private keys? It’s like squeezing water from a stone, it’s impossible.

The blockchain is said to be not hackable to this day. The only thing that can be stolen are the “Private Keys”, not the blockchain. It’s like a heavily secured home (blockchain) and its home keys (private keys), no one will be able to go in and out such home without a key. Therefore, the thief will focus on the person or persons who keep safe the keys, as there is no way for them to be able to access the heavily secured home.

2.) Cryptocurrency exchanges are also firms that can collapse if mishandled. With hot wallets, we trust our chosen cryptocurrency exchange to keep safe our digital assets including the private keys designated to our own hot wallets.

FTX is waving at us. haha!

• Cold Wallets – These are the off the internet, off the exchange hardware wallets. It is the complete opposite of Hot Wallets where it is connected online via the internet, for users to access the digital assets on an exchange.

There are two types of Cold wallets, which are Paper Wallets & Hardware Wallets. The latter is where we’ll focus as this is the widely used type of cold wallet.

Cold Wallets are physical devices, commonly resembling a USB drive. It has its own Public and Private Keys stored in it, but unlike Hot Wallets, the Private key in this wallet is accessible to us alone. Not unless we share our Private Key numbers to others which is a complete mistake. By doing so, we’ll be giving away the passcode of our cold wallet, making it widely accessible for theft.

Known Cold Hardware Wallet brands as of this writing, December of 2022 are Trezor, Ledger and SafePal to name a few.

Downside:

1.) Illiquid – Our digital assets in this wallet cannot be used for transactions or trade as it is off the internet. We first need to connect it in a laptop or phone, then connect it via the internet, before we are able to send the digital coins to our Hot Wallet of our own chosen Cryptocurrency Exchange.

2.) High Price – Hot wallets are free of use when you open an account in cryptocurrency exchanges, but cold wallets aren’t. We have to purchase one in order to have one.

3.) Full Responsibility and Accountability – No third party firm will be able to withhold the transfer if you transfer your digital assets in the wrong account or address.

If you lose your hardware wallet, its seed phrase or leak your private keys, nobody can help you when you can’t access your fund or if it gets stolen.

Having a hardware wallet gives you the full responsibility and accountability on how you handle your cryptocurrency assets.

To understand the accountability part clearly, let met give you a scenario. We have a guy named Cris who will invest his hard-earned money, for the first time, in a cryptocurrency specifically Bitcoin.

Step 1.) For Cris to be able to invest in Bitcoin, he needs to choose a cryptocurrency market exchange. He did his research and decided to open an account via Binance.

Additional information: below are the top cryptocurrency exchanges globally as of December 2022

Step 2.) After Cris registered and opened an account with Binance. He now has a Hot Wallet managed by Binance Cryptocurrency Exchange.

Step 3.) Cris purchases his first Bitcoin via the Binance exchange. His Bitcoin digital asset is currently stored and handled by Binance.

Step 4.) Cris bought a Trezor Cold Wallet as he wants to lessen the risk of losing his digital assets. He feels uncomfortable leaving his digital assets in Binance Crypto Exchange, therefore he’ll be transferring his Bitcoin from his Binance Hot Wallet to his Trezor Hardware Wallet.

Step 5.) Cris transferred and secured his Bitcoin in his Trezor Hardware Wallet

If Cris wants to trade or use his Bitcoin he’ll need to do the 2 simple steps below.

Step 1.)

Step 2.)

As I’ve shown you, having your own cold wallet gives you the complete responsibility with your coins, if you commit any transfer related mistakes, no one will be able to help you at all.

Not your keys, not your coins. Not your keys, not your Crypto

The statement above is a well known saying in the cryptocurrency space. This entails that serious cryptocurrency investors cannot be certain of their digital coin holdings that are stored in a wallet that they don’t personally have the keys (Both Public and Private Keys).

It’s true, and this has been strongly proven by the recent FTX bankruptcy, and also the multiple cryptocurrency exchange hacks in the past.

You see, even if you were one of the investors who used to buy cryptocurrencies in the FTX exchange, but transferred your digital coins from the FTX exchange to your own hardware wallet, then you’ve certainly got out unscathed from the collapse.

However, if you just left and stored your coins in the FTX hot wallet, then I’m deeply sorry for what happened with your hard-earned money.

Cryptocurrency exchanges and other aspects of it are not heavily regulated yet. This means that your invested money in any crypto exchanges (Binance, Coinbase & Kraken) are not financially protected and insured by a governing agency (I’m not sure with other countries). Here in the UK, cryptocurrency exchanges like Binance UK is not protected by the Financial Services Compensation Scheme (FSCS). Below is FSCS’ stance on cryptocurrencies taken from their own website

Try to check the cryptocurrency market exchanges and crypto brokers of your country, if they are protected by any governing body in the event of a bankruptcy. In the Philippines, check if some cryptocurrency exchanges are PDIC insured.

Let’s Sum It Up

Tread the cryptocurrency waters lightly. If you’ll be investing seriously in crypto and will be allocating a portion of your net worth on it, then it is a must to store your digital assets in your own wallet with your own private keys.

Understand that there are always risks in every investment most especially in this space.

Definitely money can still be made here, but in investing we shouldn’t just focus on our potential investment gains, we must also learn how to manage the risks.

It’s the same with life, we shouldn’t expect that it will always be rainbows and butterflies, that’s just hopeless optimism. Instead, we must recognize that it’s also a brutal world, and things can get messy at time to time.

It’s understanding its realities, on learning how to be flexible with each of its extremes, the depressive and exuberant states. And from there, we mitigate and handle the risks and maximize opportunities.

The Resilient & the Antifragile.

Antifragility is beyond resilience or robustness. The resilient resists shocks and stays the same; the antifragile gets better.

-Nassim Taleb

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.