The $GME and wallstreetbets saga has been the story of the year so far in 2021, and it has brought a lot of attention to cryptocurrency (bitcoin in particular) and defi as potential solutions to the myriad problems in traditional markets that were exposed in recent weeks.
While it's true that cryptocurrencies have the potential to solve these problems, it's also quite possible - if not likely - that large financial institutions will be able to control and manipulate bitcoin and other cryptocurrencies in the same exact same way that they currently manipulate stocks, commodities, and other traditional assets.
Allow me to explain.
I'm going to focus on the key initial problem with $GME which is the fact that more than 100% of the outstanding shares of the company were sold short. Here's a quick and extremely simplified example of how that happens:
$GME Example
Imagine a very simplified broker / exchange which we'll call RH that starts with one retail customer who we'll call Alice. Let's say that Alice deposits one share of $GME into her RH account that she actually owned (pretend that people actually own shares of stock). Then RH has one actual share and Alice's account shows that one share in her balance.
Now RH (or their hedge fund customers) want to short $GME and push the price down, so RH "borrows" Alice's share and sells it to a new retail customer we'll call Bob. Now both Bob and Alice show a balance of one share of $GME in their accounts (a total of 2 shares) even though RH only has one actual share.
Then they want to short it more, so RH once again "borrows" that same share from Bob (which was previously already borrowed from Alice) and sells it to retail customer Carol. You can hopefully see that this can go on an on basically creating and selling any number of "fake" shares and pushing the price down in the process.
The main way that this would be exposed is if the customers asked to take custody of their shares and withdraw them from the exchange. The exchange doesn't actually have those shares, and so it would be revealed that the shares purchased by Bob and Carol were fake. Of course, no one ever takes personal custody of stock shares (I'm not sure if that's even possible), so no one is the wiser.
The end result of this is that while there are a set number of $GME shares that exist in total, financial institutions can and do create and sell as many fake shares as they want, so if you sum up everyone's balances of $GME shares across all exchanges it will come to significantly more than the number of shares that actually exist. For some additional proof of this, see the following article: https://www.coindesk.com/dole-stock-crisis-reigniting-push-blockchain
Ok, we get it, traditional markets are screwed up and manipulated, but doesn't bitcoin fix this? Well, let's take the exact same scenario above, and replace "RH" with "Binance" and "share of $GME" with "bitcoin" and see what happens:
Bitcoin Example
Imagine a very simplified broker / exchange which we'll call Binance that starts with one retail customer who we'll call Alice. Let's say that Alice deposits one bitcoin into her Binance account that she actually owned (people do actually own bitcoin). Then Binance has one actual bitcoin and Alice's account shows that one bitcoin in her balance.
Now Binance (or their hedge fund customers) want to short bitcoin and push the price down, so Binance "borrows" Alice's bitcoin and sells it to a new retail customer we'll call Bob. Now both Bob and Alice show a balance of one bitcoin in their accounts (a total of 2 bitcoin) even though Binance only has one actual bitcoin.
Then they want to short it more, so Binance once again "borrows" that same bitcoin from Bob (which was previously already borrowed from Alice) and sells it to retail customer Carol. You can hopefully see that this can go on an on basically creating and selling any number of "fake" bitcoin and pushing the price down in the process.
The main way that this would be exposed is if the customers asked to take custody of their bitcoin and withdraw them from the exchange. The exchange doesn't actually have those bitcoin, and so it would be revealed that the bitcoin purchased by Bob and Carol were fake. Of course, most people never take personal custody of bitcoin (even though it is certainly possible), so no one is the wiser.
The end result of this is that while there are a set number of bitcoin that exist in total, financial institutions can (and maybe do(?)) create and sell as many fake bitcoin as they want, so if you sum up everyone's balances of bitcoin across all exchanges/wallets it could possibly come to significantly more than the number of bitcoin that actually exist.
Not Your Keys, Not Your Crypto
The above example can also be used with commodities like gold and silver (see the latest #silversqueeze trend) and is meant to illustrate that large financial institutions and exchanges can manipulate any asset that is held and traded at those institutions on behalf of customers. Bitcoin and cryptocurrency are no exception.
As an interesting exercise, you might also try the above example using dollars instead of bitcoin and a bank instead of Binance to help understand how fractional reserve banking works and the consequences of a "bank run" such as the one at the beginning of the great depression, but I'm not going to go into that in this post.
The key thing to understand is that the entire scheme hinges on the fact that the vast majority of customers hold and trade their assets at these financial institutions and are either not able or rarely choose to ever withdraw them.
This is precisely where bitcoin and cryptocurrency has an advantage over other assets. It is not only possible, but MUCH easier for people - anyone - to take personal custody of their cryptocurrency AND it is also possible to trade, lend, and borrow against cryptocurrency without ever having to transfer it to a centralized exchange.
This is what the "not your keys, not your crypto" movement is really about. If the majority of people keep their crypto on centralized exchanges, then it allows those exchanges to control and manipulate those cryptocurrencies just like they do with traditional assets. If the majority of people's "bitcoin" is just their balance on a centralized exchange, then the 21 million cap of total bitcoin that will ever exist is meaningless, since the exchanges can "create" and "sell" far more than that.
For the first time in history there is a class of assets that anyone in the world with an internet connection can hold and use without having to ask permission or cede control to a financial institution, but that will all be for naught if people don't choose to take advantage of it.
It means taking time, learning, and generally taking personal responsibility for your assets - which can be difficult and scary, I know - but it is vitally important to ensuring a future where large financial instutions are unable to constantly and consistently control and take advantage of the general population.
Not your keys, not your crypto (or your stock, or your silver, or your dollars). Thanks for reading.
@yabapmatt