December 8, 2022
  • December 8, 2022

Evolution of Bitcoin Custody Fediment

By on March 12, 2022 0

What do the infamous Mt. Gox exchange, the latest cryptocurrency restrictions agreed to by global regulators, and my departure from the bitcoin exchange space after eight years have in common?

The answer is bitcoin custody (how and where you secure your bitcoin) – how it was, how it will be if nothing changes, and how it can evolve for the better if we take the right steps. To understand why, we have to go back to the beginning, or at least the beginning of my bitcoin trading journey.

In 2013, when Coinfloor was about to become a reality, the bitcoin exchange space was dominated by Mt. Gox, the Tokyo-based exchange colossus.

Many people kept their bitcoin on Mt. Gox until the day it all disappeared. Users could no longer access their hard-earned or purchased bitcoins. For reasons that are not yet entirely clear, much of the capital held with the platform has disappeared, and to date the subset that has been recovered has yet to be returned to its rightful owners.

This Mt. Gox drama was one of the main reasons why our exchange, Coinfloor, was created. We wanted to bring trust back to the exchange space and secure the holding of bitcoins on an exchange. At the time, many thought that having users keep their bitcoin safe on exchanges was a noble goal. But I now realize that this goal has simply created a different risk for exchange client coins.

You see, eight years ago, after Mt. Gox, no one trusted exchanges to hold their money, but wanted better ways to buy bitcoin. They would buy their bitcoin and quickly withdraw it from exchanges as quickly as possible. Now, eight years later, there are dozens of decent exchanges and brokers that make it easy to buy bitcoin, and trust in the exchanges is strong. Ironically, as a result, the percentage of bitcoin holders holding their bitcoin on exchanges is at an all-time high.

You might think that’s not a problem, but that’s where global regulators come in, through an organization called the Financial Action Task Force (FATF). The FATF is an unelected international advisory body that issues guidelines designed to prevent the majority of countries deemed financial crimes. Although no country is obligated to enact any of their recommendations, the potentially devastating effects on international trade of ignoring them means that their proclamations are consistently implemented by nearly every country in the world. So when the FATF “advises” a country to adopt a regulatory position, you can assume that it will be implemented. In June 2019, they released guidelines for cryptocurrencies which included a controversial provision called the “Travel Rule”. This rule advocates that all cryptocurrency exchanges and bitcoin brokers only allow cryptocurrency transfers to parties they can properly identify. The challenge is that the identityless nature of cryptocurrencies makes adhering to these guidelines, while allowing customers to withdraw to their own wallets, difficult at best and impossible at worst.

So, once again, we are heading towards a future where huge cryptocurrency exchanges prevent their customers from taking ownership of their own coins. But this time it will be due to an overabundance of regulation rather than a lack thereof, as was the case in the days of Mt. Gox.

Over the years, I have watched the direction of the regulatory journey and the growing disinterest of many investors in taking control of their coins. It seemed obvious that this was going the wrong way and needed to be resolved if we didn’t risk escaping the fiat frying pan into the fire of bitcoin held hostage in the exchanges.

“But why is holding most of my bitcoins on an exchange a problem?” you ask. Simply put, if a regulated third party has control of your bitcoin, no matter how trustworthy they may seem, they may be compelled to prevent you from taking custody of your bitcoin. With the latest FATF rule, we are already seeing countries like India, South Korea and Estonia seek to speed up regulation to this effect and we can expect more to follow. If left unchecked, the end result could be that a majority of bitcoins are stored on a handful of centralized exchanges – barring Bitcoiners from self-sovereignty.

This is a concern because Bitcoin will only succeed if all of its major components – mining, payments, software development and custody – remain strong and decentralized. For someone dedicated to seeing Bitcoin fulfill its potential to separate money from the state and thereby create a fairer world through a more efficient economy, nothing can be more important than strengthening the foundations of Bitcoin. . Helping protect these key bitcoin areas was a big reason I decided to sell my business and leave the bitcoin exchange space, why I sought to become a member of the board of directors. Bitcoin Developer Incubator ₿Trustand why I am also involved in resolving the custody issue with my support at FediMint.

FediMint is a new custody method that allows users to form groups where members watch each other’s bitcoins. It is still in the early stages of development but shows great promise. It leverages smart technology and the very human circles of trust we all possess, to provide a custodial solution that’s more convenient than holding bitcoins on a third-party exchange and less expensive and complex than most custodial solutions. self-guard. FediMint has the added benefits of improving user privacy, scaling bitcoin, reducing on-chain usage fees, and can provide an exchange-free bitcoin custody solution that is equally viable for people in the western world. than for the rest of the world.

FediMint has three simple but powerful elements:

The first is that FediMint is designed for use by pre-existing groups where members already have a high level of trust in each other. Families, close friends, small villages, community groups, etc., are all examples of groups with strong second party relationships. This contrasts with the distant third-party relationships offered by an exchange or the first-party relationship offered by self-custody. This setup also has the added benefit of often being exempt from most regulatory considerations, as third-party dealings and lack of profit would mean this is considered a non-commercial activity.

The second part is to divide the guard challenge into two. It does this by recognizing that within a given group, some will be more capable of protecting the group’s bitcoin than others. The most capable “group guardians” do the heavy lifting – hosting the group’s wallets and processing transactions – while the other group members have a super-simple app that offloads all the complex stuff onto the group guardians. Note: This may sound unusual, but it’s already a common occurrence today. Anyone who has been in the bitcoin space for a while has likely encountered a time-poor or less tech-savvy relative or friend asking them to buy, sell, hold or transfer bitcoin on their behalf, acting as well as his bitcoin tutor. As a longtime bitcoin exchange operator, I’ve heard so many anecdotal examples of what’s going on that I wouldn’t be surprised if the majority of bitcoin “owners” are already acquiring their bitcoin through the intermediary of tutors – but there is no way of knowing for sure.

The final part of FediMint is the use of two powerful technologies, federations and chaumian e-cash mints, to remove any weak point and maintain complete privacy for all users, and this is the reason for the unusual name of FediMint. A federation is a mechanism that shares custody of the group’s bitcoin among all custodians. This ensures that a majority of guardians must act to complete a transaction and that a failure of a minority of guardians can be tolerated by the system without affecting its operation. Chaumian e-currencies are a cryptographic tool allowing federation guardians to process transactions on behalf of any member of the group without knowing who it is or how much they have. This ensures financial privacy even though group members have delegated the complicated task of managing their bitcoin holdings to guardians.

Taken as a whole, the FediMint system offers a custody solution superior to any other:

* Protocols exist to deal with many shortcomings of naïve personal guarding, but they add more expense and even more complexity.

† The costs of setting up and operating a FediMint are similar to those required to properly set up and operate a multisig hardware wallet, but the cost can be shared among all members of the federation group.

†† Federation Guardians could potentially recover a user’s bitcoin if lost, forgotten, or died using their existing relationships with a trusted second party (i.e. friends or relatives). family) to verify the identity of the user.

††† Sovereignty is delegated to trusted third parties, making it less perfect than true self-custody. However, it is likely that the process of backing up a hardware wallet private key will involve trusting third parties such as friends and family or even third parties such as banks or safe deposit boxes, which will make the actual difference between second and first party custody less important.

When I was first introduced to FediMint by its inventor (who is called “Elsirion“) in mid-2021, I immediately saw that this was a practical solution to the Bitcoin custody challenge. I now support the FediMint project and encourage every Bitcoiner to do the same. With time and with effort, we can help FediMint become an essential part of the infrastructure that allows Bitcoin to scale to global adoption while remaining decentralized and robust. Help achieve this goal and prevent Bitcoiners from losing the access to their own parts is a truly noble goal.

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This is a guest post by Obi Nwoso. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.