Binance, the largest crypto exchange in the world, paused BTC withdrawals on May 7, citing a "congestion issue" on the Bitcoin network.

Though the situation did not last long, the exchange then issued a second pause on May 8, as a large backlog of withdrawal requests appeared once more.

Binance quickly reopened withdrawals soon after, noting that it "replaced pending transactions with a higher fee" to make sure the queue was processed in time.

But what does it all mean? What happened to the Bitcoin network that caused Binance to pause withdrawals, and how can crypto exchanges avoid this scenario in the future?

The Bitcoin blockchain is the world's largest cryptocurrency ledger, processing BTC transactions as they come in and settling them at the rate of one block every ten minutes or so.

Bitcoin blocks are limited in digital size, so there are only so many transactions you can fit in each before filling every block that's coming in. As such, Bitcoin has a dynamic fee system in which the highest fee transactions are prioritized. Every transaction that's been requested but has not yet been included in a block stays in a "queue" called the mempool.

Normally, transactions stay in the mempool for at most a few hours, depending on the fee each user is willing to pay. But, if there's a large amount of demand for Bitcoin block space, the mempool starts filling up with pending transactions that can be stuck for days or even weeks.

The culprit? Meme coins and NFTs.

Understanding Bitcoin Ordinals

Bitcoin is quite limited in what it can do: You can pretty much just send BTC around. Tokens, NFTs and other blockchain uses are usually done on more advanced smart contract blockchains like Ethereum. But recently, a new project called Ordinals developed a trick to create "inscriptions," a form of non-fungible data representing text, images or even PDF files.

Then, BRC-20 tokens appeared. These tokens use the underlying Ordinals tech to create fungible tokens just like on Ethereum. Caught up in the recent meme token fever, people started to create more and more BRC-20s, which reached a combined $1 billion market cap.

But despite the hype, there is a dark side. Enrico Rubboli, CEO of Bitcoin sidechain project Mintlayer, explained that since BRC-20s are sharing space with regular BTC transactions, they "strain the network, drive up fees and slow down transaction times."

Why Binance Had to Pause Withdrawals

For Binance, this caused problems. Alex Strzesniewski, founder and CEO of AngelBlock, a crypto crowdfunding platform, explained, "Bitcoin had an astounding 444,000 transactions in the mempool — a record for unconfirmed transactions, which led to a spike in fees. For exchanges like Binance that work like a well-oiled machine, especially when it comes to deposits and withdrawals, the last thing they want to do is lose money."

Every Binance withdrawal has a fixed fee that is usually just a bit over the actual blockchain transaction fee — the difference is the exchange's profit. When Bitcoin transaction fees skyrocket, that profit is basically gone and each withdrawal generates a loss.

What's more, all previous transactions sent out with a lower fee could get stuck, locking up much of the exchange's capital and grinding the usually smooth flow of funds to a halt. That's why the platform mentioned "replacing transactions with a higher fee," as one needs to adopt special techniques to unblock past transactions.

While the profit and congestion motive can be one reason why Binance decided to halt withdrawals, Berk Ozdogan, CSO at Dexalot, a decentralized exchange, has another theory. "Withdrawal pauses typically happen when the exchanges can not sustain the withdrawals for a given asset because they are utilizing the deposited funds for purposes other than user settlement," he said.

The practice of "rehypothecation," or using customer funds for other purposes, is quite common with centralized finance. In traditional finance, there are strict limits and disclosure terms, but with crypto exchanges, there's less oversight.

"It is well known that Centralized Exchange operators in Web3 have been utilizing client funds for many of their own activities . . . Given that the large blockchain networks ledgers are public, this activity was also in plain sight for everyone to see," he added.

The collapse of FTX, another crypto exchange, was a case of rehypothecation being pushed to negligent levels. We can't know for sure what spurred Binance to pause withdrawals, but given their short nature, it's likely that congestion was truly the deciding factor.

Making Sure You're Never Caught in a Pause

How can users avoid these situations in the future? Rubboli believes that the issue of high fees should be cut down at its roots. "Layer 2 solutions like Mintlayer improve upon BRC-20 use-cases and enable Bitcoin to be utilized for more than just simple transactions. By shifting network traffic from the base Bitcoin chain to a scalable connected network, Mintlayer facilitates the operation of DeFi apps within the Bitcoin ecosystem without congesting the network," he said.

Strzesniewski maintained that the episode will compel Binance to shift its focus to alternative solutions, such as the Lightning Network, a Bitcoin scalability technology designed for small instant payments. As for the users, "I think the old rule in crypto applies here — only keep on CEXs what you're actively trading," he added. "If you're using an exchange platform as a wallet, you're unnecessarily increasing your risk and exposure."

For Ozdogan, the true solution is to do away with centralized actors entirely. "One of the top reasons why decentralized exchanges make sense is the fact that settlement is typically instantaneous and all activity is pre-funded," he explained. "Realistically, the only way to guard against this type of a liquidity crisis is to develop and push decentralized solutions forward."

Decentralized exchanges and self-custody of assets, if adopted en masse, can avoid the rehypothecation "epidemic" that's currently causing mass bank failures in the U.S. But to get there, the cryptocurrency industry still needs a long time to mature.

(Sadie Williamson is the founder of Williamson Fintech Consulting.)

A composition showing crypto currency with the Binance logo