Over the past few years, Bitcoin has transitioned from digital cash for individuals to digital gold for custodians. So far, this hasn't affected its price from continuing to grow year after year. However, once the growth of paper Bitcoin starts to outpace that of real Bitcoin, that will surely stall out, and the value may even fall over time.
What Is Paper Bitcoin?
Simply put, paper Bitcoin is Bitcoin owed to people, but not necessarily backed by an equivalent amount of real on-chain Bitcoin. Wherever there's a discrepancy between Bitcoin owed to people and Bitcoin owned and liquid by the people that owe the Bitcoin to the other people, that's paper Bitcoin.
Any and every trusted custodial service has the potential to have paper Bitcoin. All it needs is the inability to verify the supply of Bitcoin owned vs. owed.
Something like Wrapped Bitcoin (WBTC) is an example of a trusted custodial system where you can actually verify those two numbers: anyone can see their Bitcoin deposit addresses, and anyone can see the number of WBTC.
Something like an exchange, an ETF, or other custodians are examples of prime candidates for paper Bitcoin: no one knows how much Bitcoin is really in there. Of course, if they publish proof of reserves, or if someone independently locates their addresses, that limits the ratio of paper Bitcoin they can have. If they have regular audits, that further limits the discrepancy. But in all cases, the general public doesn't know for sure the total amount of real Bitcoin held, and definitely doesn't know the amount of paper Bitcoin.
With traditional exchanges, the discrepancy is limited by the liquidity necessary to service withdrawals through on-chain transactions. Off-chain transfers between exchanges, however, don't necessarily need any actual Bitcoin, depending on the type.
Why Is There Paper Bitcoin?
Paper Bitcoin exists because it can. When you use custodians, its capacity to exist is present. If Bitcoin had no need for custodians and was always used and held on-chain, it wouldn't be possible.
But now that paper Bitcoin is possible, it will always exist. Why? Because custodians can't resist.
Think about it: to fully match customer deposits 1:1, a custodian needs to have as much Bitcoin as it owes to customers. But if it holds less Bitcoin than it owes, it makes the same revenue at reduced cost. Who wouldn't want that?
The remaining funds can be lent out elsewhere, or even sold. Then we end up with an FTX situation, which as we remember, was undetected by the public until CZ caused a bank run.
And the more paper Bitcoin of any kind is accepted as real Bitcoin off-platform, the smaller the percentage of actual Bitcoin will be.
But How Does This Affect the Price?
Prices don't go up when people buy Bitcoin. They go up when they run out of Bitcoin at that price. Then the scramble is on to get more Bitcoin to sell, which is only available at the next higher price. And so on.
If the ability exists to create paper Bitcoin, then that can be sold instead of the real thing. If someone buys Bitcoin on an exchange, the exchange doesn't necessarily themselves need to hold any more Bitcoin now. They may feel the need to partially increase their holdings, but not fully.
We may get to a point where all new demand for Bitcoin is equaled (or even exceeded) by the supply of new paper Bitcoin. In that case, lots of new buying wouldn't move the price at all.
Good: "Slow Bank Run"
The best thing for the price of Bitcoin would be a "slow bank run" where customers slowly start to move their funds off platform to self-custody.
This depletes custodians' supply of Bitcoin, until eventually they don't have any more to give to customers. But because this is slow enough, they have the chance to acquire real Bitcoin to pay back depositors, and don't default. This drives up Bitcoin's scarcity, and drives up the price, as exchanges would much rather pay a higher price than default entirely.
Very Bad: "Fast Bank Run"
If users withdraw too quickly, however, that can be very bad.
First, exchanges just can't process all withdrawals and will have to pause them. They can stall by claiming technical issues while they scramble to buy enough to cover withdrawals, but the clock is ticking. If they can't cover withdrawals in time (or just don't have enough capital), then panic sets in.
If users fear that Bitcoin on exchanges may become worthless by not existing, the value of paper Bitcoin drops to zero, and real Bitcoin that's on exchanges gets priced alongside it, and all Bitcoin's price takes a massive hit. Exchanges default, and Bitcoin's own network is unable to handle the transaction load. The resulting death spiral could be very problematic to Bitcoin, to say the least.
How Do We Solve Paper Bitcoin?
In short, to solve the problems associated with paper Bitcoin, there's two solutions: either scale the blockchain so that everyone is able to self-custody both for storing their money and for spending it, or migrate fully to decentralized exchanges and protocols which wrap Bitcoin without the ability to wrap more than they control on-chain.
See my article on avoiding the Bitcoin death spiral.
https://inleo.io/@thedessertlinux/avoiding-the-bitcoin-death-spiral-d1m
Bitcoin's security, sustainability, and sovereignty are all threatened by the rise of paper Bitcoin. But its price is as well. Those who want to preserve Bitcoin's store of value attributes would do well to combat this phenomenon's rise.
Posted Using INLEO