Excluding the Treasury Department’s budget, American taxpayers pay more than $150 billion annually to support the Federal Deposit Insurance Commission (FDIC), Consumer Financial Protection Bureau (CFPB), Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC).

These agencies create and enforce financial regulations, and the institutions they regulate pass compliance costs to customers—who are also the taxpayers that pay for the regulation. Although there is often no cost-benefit analysis performed before financial regulations are put in place, they are, in theory, there to protect consumers.

So, what do Americans get for their money?

Despite ever-increasing budgets and breadth of oversight, these agencies consistently miss overt, large-scale fraud and money laundering operations like FTX. (A cynical person might note that millions of dollars in political donations were caught up in the money laundering operation, which only serves to reinforce the point.)

At the same time, regulators have refused to clarify compliance requirements for new financial technologies, even when industry leaders practically beg them to do so. Then, with no proactive guidance provided to innovators who have approached regulators with a spirit of collaboration, regulators choose to “regulate by enforcement”—bringing costly enforcement actions against entities who had no way of knowing where the boundaries lie. 

Although the situation is worse now, widespread awareness of regulatory dysfunction began with the Madoff scandal in 2008. In the aftermath, market participants and hedge funds increased their use of custodians and third-party administrators as it became clear that relying on effective regulation to prevent fraud is unwise.

Which brings us to Bitcoin.

In almost all cases, when consumers get burned by financial fraud, the fraud stems from negligence or lies told by a counterparty controlling the consumer’s money—whether in a fund, a cryptocurrency exchange, or elsewhere.

However, people who invest in Bitcoin have an option for mitigating counterparty risk: They can memorize or write down the “private keys” that can be used to broadcast valid transactions that include their personal bitcoin.

This is casually referred to as “holding” bitcoin in “self-custody.” Although useful shorthand, this formulation does not accurately describe what is really going on when someone “has” bitcoin in “self-custody.” This isn’t just a semantic argument—it’s an important distinction. Much of the confusion among regulators about how Bitcoin fits into existing models of money transmission and asset custody arises because Bitcoin represents a financial innovation that does not conform easily to traditional regulatory frameworks.

Consumers do not need to be aware of these details to benefit from the safety that self-custody provides them. However, by taking their bitcoin into self-custody, they remove funds from the control of an institution that could lose them, whether through negligence, fraud, or regulatory failure.

Those with a background in traditional finance may be surprised to learn that Bitcoin exchanges not only make self-custody possible, they encourage it. Most Bitcoin companies do not make money by holding bitcoin on behalf of their customers (unless they are lending the bitcoin and earning interest, which entails risk to which the consumer must opt in). Many companies publish self-custody guides and write software to make the process easy and safe. Some even publicize the percentage of bitcoin sent off their platform and into self-custody as a point of pride. 

Some firms offer multi-signature services, where funds are controlled by multiple private keys that must be combined in order to broadcast a valid transaction. Keys can then be held by trusted advisors, family members, and friends, reducing the risks associated with an individual bearing the sole responsibility of keeping their funds safe. 

New consumer-friendly products and technologies are making self-custody easier. However, even today, self-custody has become the standard for consumer protection in the Bitcoin and cryptocurrency industries.

Regulators, however, have yet to accept this industry standard and understand how it helps them fulfill their mission. Instead, they seem to be gearing up for a regulatory battle over self-custody, referring to self-custody software with a strange, new, and apparently pejorative term: “unhosted wallets.” The Treasury Department is “working to address the unique risks associated with unhosted wallets,” stated Treasury Deputy Secretary Wally Adeyemo in 2022.

On April 10, Consensys received a Wells notice from the SEC claiming that its popular cryptocurrency wallet, MetaMask, violates securities laws. Just last week, the U.S. Attorney’s Office in the Southern District of New York charged the two co-founders of Samourai, a Bitcoin mixing technology and service, with conspiracy to commit money laundering and operate an unlicensed money transmitting business. Last year, the Department of Justice levied similar charges against the developers of Tornado Cash, another open source cryptocurrency privacy tool.

Next, the FBI posted a memo on April 24 warning Americans against using money transmitting services not registered as a money services business (MSB). The agency further encourages Americans to “avoid cryptocurrency money transmitting services that do not collect Know Your Customer information from customers when required.” 

As a result, two other Bitcoin companies, zkSNACKs and ACINQ, announced they will no longer serve users in the United States due to regulatory ambiguity and the burdens associated with being regulated as an MSB.

These actions taken by the DOJ, SEC, and FBI have had a chilling effect on the nascent Bitcoin industry, and they have also confused consumers. Some are concerned that heavy-handed regulators might soon target noncustodial wallet providers, even though doing so is inconsistent with current FinCEN guidelines and would result in businesses shutting down or moving overseas.

Such actions are totally out of step with a mandate to protect consumers, prevent crime, and prosecute criminals while allowing free people to participate in free markets and maintain privacy. A recent study estimates that 20 percent of Americans own cryptocurrency. Limiting their freedom to hold their assets in self-custody would expose them to bad actors and counterparty risk.

Regulatory agencies have a poor track record of preventing counterparties from mismanaging and stealing client funds, especially in the cryptocurrency industry. Within that environment, self-custody emerged as an industry best practice to prevent loss of savings. 

Regulators are public servants. They serve the public, not the other way around. Their actions must be carefully calibrated to aid consumers, not crowd out, co-opt, or ban protective technologies. The consumer benefits of self-custody are clear, and they deserve to be recognized.