Billions in users’ funds in danger from crypto bankruptcy

A regulatory blindspot leaves traders open to losses should a centralised cryptocurrency exchange go bust

Coinbase logo among bitcoins – Photo: Shutterstock                                 
Steep quarterly losses for Coinbase have added to recent tensions in the crypto market – Photo: Shutterstock
                                

The revelation that a staggering $256bn of customers’ funds could be at risk if Coinbase, the NASDAQ-listed centralised exchange (CEX), went under has sent shockwaves through the cryptocurrency sector.

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Coinbase shares plummet

Things were already looking bad for Coinbase, founded by Brian Armstrong and Fred Ehrsam and one of the largest cryptocurrency trading platforms globally.

Quarterly reports published on 10 May outlined declining figures in almost every conceivable way. Total trading volume was down 44% against Q4 2021 figures, largely driven by a decline in the retail segment. Worse still, overall net revenues were the lowest in 12 months, dropping 56% on the quarter.

The bottom line: Coinbase has raked up net losses of $430m in 2022 so far.

Tepid results were hardly unexpected, given the broader crypto market trends. Nor are the results necessarily a poor reflection on Coinbase as a business. As the sole publicly listed CEX, the exchange’s financial performance is subject to greater scrutiny than its competitors. The company also noted that “we gained trading volume market share in seven of the top 10 assets traded on Coinbase (including BTC and ETH).”

At best, these were mixed results, but controversy was stirring for another reason. Initially reported by Fortune, Coinbase’s SEC filings posted on the same day hid a crucial detail with rather significant implications for Coinbase’s customers.

“Because custodially held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors,” the filings stated.

Furthermore: “As of March 31, 2022, we held $256bn in custodial fiat currencies and cryptocurrencies on behalf of customers. Supported crypto assets are not insured or guaranteed by any government or government agency.”

Put simply, if Coinbase goes bust, it could take customers’ custodial funds with it. The disclosure caused a mild uproar online, forcing Armstrong to mitigate the situation in a series of Tweets.

Exchange policies lack weight

Preliminary research by Currency.com showed that few of the major centralised exchanges have a concrete policy in the event of bankruptcy. No observable policies could be found in the terms and conditions of Binance, FTX or Gate.io (pending further research).

In April 2020, KuCoin announced a partnership with the Singapore-based asset custody platform Onchain Custodian, although coverage specifics are not readily available.

Bitstamp’s terms of use states: “Whilst Bitstamp uses reasonable care in the appointment of its banking providers, in the event of a banking provider becoming insolvent or entering into an insolvency process in a relevant jurisdiction, Bitstamp may have only an unsecured claim against the banking provider, and members’ fiat currency balances may be at risk subject to any protections provided at law in the relevant jurisdiction.”

This policy does not relate to bankruptcy of Bitstamp itself, nor does it refer to crypto assets help by the exchange, but it nonetheless exposes an element of risk for users’ fiat held in custody by Bitstamp, given that it uses these banking providers to facilitate “the receipt of fiat currency from members and payments to other members”.

Crypto bankruptcies: should we be worried?

Centralised exchanges profit from trading fees. Thus, their financial performance is closely linked to the size and quantity of trades being executed on the platforms. Basic logic tells us a bearish market is bad news for the CEXs.

The good news is, not a single CEX has yet to go bankrupt in the US or UK. Nor has any exchange gone under solely because of adverse market conditions.

However, QuadrigaCX did file for bankruptcy in 2019. In one of the most bizarre crypto stories to date, Canada’s one-time largest centralised exchange went bust after chief executive Gerald Cotten passed away in India, taking access to more than $200m in user funds with him.

The Japan-based exchange Mt. Gox, once among the largest bitcoin trading platforms globally,  declared bankruptcy in 2014 amid a slurry of hackings, system failures and fraud allegations. Between 650,000 and 800,000 BTC were estimated to have been lost.

Mark Karpeles, chief executive of defunct bitcoin exchange Mt Gox, attends a news conference after a trial on charges of embezzlement in Tokyo, Japan July 11, 2017. REUTERS/Alamy
Mark Karpeles, chief executive officer of Mt. Gox, faced embezzlement charges following exchange’s collapse – Photo: REUTERS/Alamy

So yes, not only are crypto bankruptcies possible, there are concrete historical precedents, and they have not been kind to customers.

Custodial matters

These issues get to the core of how centralised exchanges operate. It comes down to the question of ownership, or lack thereof. When trading on a CEX, funds are usually stored in a custodial wallet. Most major exchanges, including Coinbase, Binance, Kraken, Bitstamp and FTX, operate in this way.

In Binance’s own words: “This means a third party will hold and manage your private keys on your behalf. In other words, you won't have full control over your funds – nor the ability to sign transactions.”

Some exchanges, including Coinbase and KuCoin, offer a non-custodial wallet that operates in the same way as any other third-party wallet, while Binance, Bitstamp, Kraken and FTX do not.

But while third-party, non-custodial wallets can be used on exchanges, casual users are more likely to take advantage of custodial options, because of their user friendliness. As we now know, this could expose them to losses as an unsecured creditor.

Why aren’t funds protected?

In the US, deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC), while the federally mandated Securities Investor Protection Corporation (SIPC) protects stocks, bonds and other securities for up to $500,000.

These safeguards would not cover a crypto bankruptcy. Kraken plainly states that “cryptocurrency exchanges do not qualify for deposit insurance programmes because exchanges are not savings institutions”.

On the other side of the Atlantic, the UK Financial Conduct Authority (FCA) requires authorised entities to ringfence user funds, while the Financial Services Compensation Scheme (FSCS) can step in to cover losses of up to £50,000. None of these regulations applies during a crypto bankruptcy.

This exposes a blindspot in the shared vision among the regulators, who have been largely preoccupied with cracking down on money laundering and other malicious behaviour, rightfully so. But if nothing else, the recent turmoil in the crypto markets has shown that consumer protection should extend beyond purely malicious activity.

For its part, the European Union’s Markets in Crypto-assets (MiCA) proposal does acknowledge this blindspot to some degree. The MiCA, intended to unify crypto regulation across the EU’s 27 member states, states: “Crypto-asset service providers that hold crypto-assets belonging to clients or the means of access to such crypto-assets shall make adequate arrangements to safeguard the ownership rights of clients, especially in the event of the crypto-asset service provider’s insolvency, and to prevent the use of a client’s crypto-assets on own account except with the client’s express consent.”

But MiCA is only a proposal and even if approved, would not be implemented before 2024, leaving a hole in the safety net in relation to cryptocurrency bankruptcies for now.

How to safeguard yourself

So, are users protected if exchanges go under? That would be a no, not really. Insolvency protection has emerged as a clear blindspot among the regulators. Given the glacial pace regulators have moved at so far, there is no guarantee that customer protections will be enhanced in the short term. Cryptocurrency and bankruptcy just seem like separate issues for now.

But there are measures users can take to safeguard themselves in the event of a centralised exchange bankruptcy. First and foremost, holding your funds in a personal wallet instead of an exchange-controlled custodial account is paramount. Currency.com does not recommend a particular brand, but popular options include the Trust Wallet and Exodus hot wallets, or the Ledger Nano X hardware wallet for cold (offline) storage.

Even Coinbase users can safeguard themselves by using Coinbase Wallet, the exchange’s own non-custodial product.

Elsewise, the standard due diligence checks on any crypto service provider should be performed. Seek out underlying financials, read the terms and conditions and track down genuine user reviews before using a service.

Currency.com has reached out to a range of exchanges, including Binance, Krn, Gate.io, Bitstamp and FTX for input. 

FAQs

There is currently a lack of regulatory and insurance measures for customers should an exchange go bankrupt. The EU has made some proposals. If approved, they would not be implemented before 2024.

While custodial wallets are easier to use, the exchange retains control over your private keys and funds, leaving you exposed to hacks and possible bankruptcies. Non-custodial wallets give users full control over their funds.

The material provided on this website is for information purposes only and should not be regarded as investment research or investment advice. Any opinion that may be provided on this page is a subjective point of view of the author and does not constitute a recommendation by Currency Com Bel LLC or its partners. We do not make any endorsements or warranty on the accuracy or completeness of the information that is provided on this page. By relying on the information on this page, you acknowledge that you are acting knowingly and independently and that you accept all the risks involved.
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