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Bitcoin is Uninsured: A Misconception

Op-ed - Bitcoin is Uninsured: A Misconception

Faced with the growing need to justify the fees, delays, chargebacks and centralization of power that are behind modern fiat currencies, one argument that Bitcoin detractors are turning to more and more to attack the alternative is that Bitcoin is uninsured. As Forbes writer Tim Worstall writes, for example, “Sure, it’s true that real world banks (which is a useful analogy for Bitcoinica) get robbed all the time and this doesn’t stop people using bank notes. But banks are backed up by governments: everywhere has deposit insurance. So, if some robber were to make off with all of the cash that, say, JP Morgan had then all the depositors would be made good by the government deposit insurance as JP Morgan goes bust. Bitcoin, of course, does not have this back up.”

However, this argument is flawed in a number of ways, the largest of which is that the concept of a currency being “insured” is meaningless. Insurance is not an inherent property of a currency, it is a type of contract that can be made between any pair of individuals or organizations. The conceptual error that Worstall, and others who make this argument, are making is that of having what can be termed a hierarchical worldview: seeing “the government” as a special entity in itself, as something which is an inherently higher level process than the mere individuals and businesses that are operating in a sandbox set out by government laws. The reality is, the government is an entity just like any other, and claiming that the US dollar is fundamentally secure and Bitcoin is fundamentally unstable because one has the government backing it and the other does not is incorrect – governments are fallible too, and judging by the high bond yields of many countries on the market, investors do not have nearly the same confidence in the government debt that backs up the power of institutions like the FDIC that Worstall does. The Bitcoin investment industry has been offering insurance contracts such as credit default swaps for months now, and if you want a MtGox, Bitcoinica or any other deposit insured all you have to do is either find someone offering insurance for your deposit already or simply make a post on the Lending forum and just ask for someone reputable to sell you such a service. You can even purchase slices of insurance from multiple providers to minimize your overall risk. It is a core feature of Bitcoin as a whole that its value, its security and even its basis of existence are backed not by any centralized institution but by immutable mathematical algorithms on the one hand, and society itself on the other. Safety is found in diffusion of risk, not a rigid framework of power.

There is also a practical point to be made. FDIC government insurance is not insurance for the US dollar as a whole, it’s insurance for bank deposits. If you lose a hundred dollar bill, whether to a thief, scammer or simple carelessness, you’re out a hundred dollars; there is no insurance to protect you. If you lend money to someone and he defaults, there is no insurance to protect you. One might argue that as a consumer using US dollars electronically it’s all protected by the banking system and therefore ultimately by the FDIC, and you can do a chargeback to recover your money from accidental or malicious losses, but this is not true for everyone. If you are a merchant, for example, and you get a fraudulent chargeback from a customer there is no protection. Theoretically, you can go to court over the issue, but the costs of doing so are so high that practically it is simply not worth it. Thus, with regard to the online payments infrastructure our system does not even offer any insurance at all; instead, it simply shifts the risk from one party to the other, at the cost of delays and fees that are unacceptable in an internet-connected society. In a way, this artificial “merchant beware” system is even worse than the alternative of buyer beware: while consumers can comparison shop and refuse to deal with shady merchants, merchants cannot practically pick and choose their customers.

Lastly, Worstall is wrong in comparing Bitcoinica to a bank. Bitcoinica is a high-risk margin trading platform specially designed for people who are willing to take 100% losses over price fluctuations that take place once every two months, so the risk of losing your account balance due to platform failure is merely a small addition to a risk that is already there. If you want your money to be secure, with Bitcoin you do not need to use a bank at all; an offline or brain wallet setup (or a combination of both through multi-key transactions) is a far better alternative, and has even lower risk than a deposit in a bank account. While a bank depoit is safe unless the government collapses or the FDIC is shut down, your private key stored written down in a treasure chest will retain its value as long as there is at least one person connected to the internet who cares enough about Bitcoin to mine and support the network.

Bitcoin as it stands is indeed more risky and unstable than the US dollar, but most of this risk can be attributed to Bitcoin’s small scale, not any inherent weakness of the currency. As Bitcoin continues to gain in popularity, and attracts a more and more mainstream audience, its banking industry will continue to develop to meet the needs of its customers, and eventually even traditional insurance companies will be willing to set up arrangements with institutions like Bitcoinica to compensate depositors in the event of bankruptcy or theft.

Of course, keeping your bitcoins stored at a third party investment or speculation service is not risk free. But nothing is. It is a basic law of economics that every investment that generates a profit (or interest rate) also carries a risk, and any system that claims to offer one without the other is guaranteed to be either a pyramid scheme or a Martingale-like setup that is mathematically designed to hide risk away by concentrating it into a small chance of total collapse. Bitcoin gives you the freedom to invest your money in whatever way you want, and accept the risks that go along with an investment, or store your money for personal use without relying on any institution whatsoever. It’s up to you to decide which of the available choices is right for you.