Note: This article was originally published on Zonotho, a financial education start-up, in December 2019. This article came out of discussions with many newbies about how to secure one’s Bitcoin and the various exchange hacks that have taken place in the space.
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One of Bitcoin’s biggest advantages over traditional finance is that you can safely store your Bitcoin in a digital Wallet, without the need for a bank. However, many new users choose to store their Bitcoin on exchanges, without being aware of the risks.
In this article, we’ll unpack what those risks are. And in the next article, we’ll look at how you can keep your Bitcoin safe by setting up your own digital Wallet.
Risk #1 – The exchange could get hacked
Exchanges store millions in user funds which makes them attractive targets for thieves, and they get hacked so often and for so much that not even the largest exchanges in the world can be considered secure.
In the first half of 2019 alone, nearly $200m was stolen from high profile exchanges. Unlike banks, exchanges are not typically insured, and they have no central bank to bail them out. If they get hacked you are unlikely get your money back.
For instance: In 2014, MtGox was hacked for $460m and until today, five years later, those who lost money haven’t gotten a cent back.
Risk #2 – Your account could get phished
Even if the exchange doesn’t get hacked, all it takes is for a hacker to get your login details to steal your money. Exchange phishing is extremely common and can take the form of e-mails or even fake websites that look identical to the actual exchange. 2-Factor Authentication helps and is recommended, but even 2FA may not save you from a clever trap.
You might think: “I’m not stupid enough to fall for that”. Everyone thinks that… until they do.
Risk #3 – The exchange breaches any laws or regulations
As of 2019, regulation of digital currencies is a gray area in most countries. Even unintentionally, an exchange could breach money transmission laws, and it’s unclear what will happen to user funds in this case. In the worst case, they could be seized by the authorities.
In 2018, Bitfinex stopped offering service to US customers due to regulatory concerns and US customers were forced to move their funds. In 2019, Binance announced it would do the same. If the regulatory environment changes tomorrow, your funds are at risk.
Risk #4 – The exchange has custody of your funds
In Bitcoin, the golden rule is: “Not your keys, not your coins”. Ultimately if the exchange has your coins, they control them. They can charge whatever fees they want (and usually they do).
Typically they will not even let you withdraw your funds unless you submit personal information. Even if you comply, they may block withdrawals for no good reason. They can even lock your account, something that is impossible if you control your own Wallet.
So what can you do about this?
Simply put, there are almost no advantages to storing your Bitcoin on an exchange, but plenty of risks.
Bitcoin fixes this.
In the next article, we’ll talk about how to set up your own Bitcoin Wallet and move your Bitcoin off the exchange and into your own personal custody.