Crypto Trading Platforms and Bankruptcy: Are Investors Protected?

By Danny Newman

Cryptocurrency investors, who were already in the icy clutches of the so-called “crypto winter,” now have another reason to shiver.

Insolvency issues are cropping up with some frequency among crypto companies, which is shining a light on the lack of legal clarity surrounding aspects of this unregulated industry. For example: Whose property are crypto assets held in a custodian-controlled account in the event of a bankruptcy filing?

Two recent bankruptcy filings and a Securities & Exchange Commission filing have added urgency to that question; and while the answer gets slowly sorted out, some investors will find themselves caught in the crossfire. Voyager Digital, a public company, and Celsius, a private company, have both recently filed for bankruptcy protection and both crypto custodial platforms may be trying to treat customers’ assets as their own.

In their May 2022 Securities Exchange Commission filing, crypto giant Coinbase Global, Inc. indicated that, in an insolvency event, it could treat customers’ assets as corporate assets. To quell investor concerns, Brian Armstrong, Coinbase’s Chief Executive, quickly “clarified” in a tweet that Coinbase was nowhere near filing bankruptcy and that investor funds are safe. However, his tweet did not expound on the company’s SEC assertions regarding investor status in the event of a bankruptcy filing—no matter how remote.

The bankruptcy filings and the SEC disclosure highlight something SEC Chair Gary Gensler has frequently warned investors about; crypto exchanges lack federal regulation and oversight as compared to traditional financial services organizations

What does this mean for investors whose funds are under a custodian’s control? It means they could be treated as unsecured creditors, and would likely receive pennies on the dollar, at best, in the event of a bankruptcy.

A novel situation

In bankruptcy filings for more traditional brokerage institutions or banks, this situation cannot arise; regulations require that traditional brokerages keep client assets separate and apart from company assets and bank deposits are insured for up to $250,000 by the FDIC. Not only does this help ensure the return of customer money, but it keeps customers out of the fray if bankruptcy negotiations become protracted or contentious.

For customers of unregulated cryptocurrency platforms, however, bankruptcy puts them directly in the middle of the dispute for a couple of reasons. The largest one is the lack of clarity surrounding bankruptcies for crypto companies and the status of customers, which has not yet been addressed by any bankruptcy court. The other stumbling block for customers is the long road ahead for the bankruptcy negotiations due to the highly complex nature of restructuring crypto platforms. As a result, significant litigation is likely, and the process could take years.

To make matters more complicated, determining who owns the crypto assets will likely depend on interpretations of applicable non-bankruptcy state laws and/or interpretation of previous bankruptcy cases in different industries that may or may not be good analogs. For instance, some states have done more to address crypto issues, and have more clarity, and some states may have money transmitter laws, or other laws, that could play a role. This means bankruptcy courts could come to different conclusions based on varying state laws, not to mention potential differences in the bankruptcy jurisprudence of their particular region.

What should investors do now?

The SEC has been warning about the unregulated nature of cryptocurrency trading platforms, but the Voyager Digital and Celsius bankruptcy filings, and more to come, will likely give investors more pause and reason to protect themselves.

For crypto investors who currently participate in the market, the relatively simple answer is to hold your crypto assets yourself. Crypto assets held by a custodian are typically controlled by that custodian, which puts them at risk for the bankruptcy issues Voyager Digital and Celsius customers are facing.

You can, however, store your own crypto assets in a wallet rather than a trading platform. Depending on the business model, not all crypto platforms allow you to store your own assets, so you will first need a platform that allows for self-storage. Then you can choose between either a “cold” or “hot” wallet.

A cold wallet is offline. The most common type is on a hardware wallet that connects to the internet only when you are transacting. A paper wallet is also a form of cold storage involving a printout of the relevant information needed to perform a crypto transaction. A hot wallet is an app that allows for storage online, which carries a hacking risk, however small.

If you have a lot of crypto assets, you may want to use a combination of storage options. It is clear that leaving assets in a trading platform is risky and should be avoided if possible until the question of how they will be treated in a company’s bankruptcy is settled – and that may take years. In the meantime, if you have assets stored with any trading platforms that have or do file for bankruptcy in the coming months, contact a lawyer and don’t just assume you can successfully withdraw the assets at your convenience. 

This update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions about the issues raised here, please contact Danny Newman or the attorney with whom you normally consult.

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