Coinbase’s recent revelation about the risk of user funds becoming lost should the exchange go bankrupt has highlighted the need for consumer vigilance when choosing crypto platforms.
Coinbase CEO Brian gave users a glimpse of what could happen to their assets should the exchange go bankrupt, highlighting the stark differences between crypto exchanges and traditional stock brokers.
According to Rule 15c3-3 of the U.S. Securities and Exchange Commission (SEC), stockbrokers must keep customer assets in a separate account from brokerage assets.
If a customer’s stock disappears through theft or crime, stock accounts generally carry insurance able to replace the lost stock, up to $500K. In addition, should the company go bankrupt, the customer’s accounts can be moved elsewhere.
Since Coinbase’s announcement, it has become evident that some crypto exchanges combine funds from customers with the exchanges’ own funds.
“I don’t think there’s any reasonable way for a retail crypto consumer to have confidence that their broker or trading venue is custodying their assets in a bankruptcy-remote way unless they get a very specific disclosure that they are,” said Tyler Gellasch, a former SEC employee, now head of the Healthy Markets Association.
Zero-fee brokerage Robinhood Markets said in a disclosure to the SEC when it filed for an initial public offering that it believed that customers’ assets should be kept separate from the company in bankruptcy.
“This view has not been tested in court, so there is some risk which would apply to crypto held on any platform,” said a Robinhood spokesperson.
Exchanges keep mum
While Coinbase’s CEO allayed users’ fears on Twitter, assuring them that $256 billion of user funds were safe, crypto exchanges FTX US and Gemini declined to comment on whether user funds were at risk. Binance.US and Kraken did not respond to questions.
“I do not think customers understand the legal nature of the custodial relationships… In fact, the exchanges are lulling the consumers with language claiming that the consumer ‘owns’ the coins, when in fact the legal treatment is quite likely to be different in bankruptcy,” says Georgetown University law professor Adam Levitin.
Customers may get back ‘pennies on the dollar’
Investors would be considered “general unsecured creditors” if the exchange goes bankrupt, meaning they would be the last to be paid, should any funds remain after paying priority creditors.
“Customers should assume that a platform’s bankruptcy would expose them to significant delays in recovery, at the end of which they may only get back just pennies on the dollar,” said Cornell Law School Professor Dan Awrey.
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