In the world of cryptocurrency, exchange platforms act as intermediaries allowing investors to buy and sell assets while making money through commissions and transaction fees. Any assets purchased may be held in either non-custodial or custodial wallets. If a customer chooses a custodial wallet, the platform holds and manages the assets through a private key, which is a string of characters that serves as a password. If a key is lost or forgotten, it may be impossible to recover, resulting in the permanent loss of the asset. In contrast, assets held in non-custodial wallets remain under the customer’s control with a private key.
Exchange platforms also function similar to traditional securities brokers that facilitate the trading of investment products that are not typically held in the beneficial owner’s name. However, brokerage firms must be members of the Securities Investor Protection Corporation (“SIPC”), which is a non-profit corporation that protects investors’ cash and securities when brokerage firms fail. When a firm files for bankruptcy, SIPC provides insurance coverage that will help replace or restore the customers’ cash and investments. There is no SIPC or equivalent protection for cryptocurrency.
This poses a potential risk for customers of cryptocurrency exchange platform firms when assets are held in custodial wallets. Should a firm file for bankruptcy, customers’ investments held in custodial wallets might be considered property of the bankrupt company. If so, then immediately upon the bankruptcy filing, users of custodial wallets would not be able to sell their assets or move them out of the platform without court authorization. Since companies facing bankruptcy usually try to keep an anticipated filing quiet in order to prevent creditors from taking adverse actions, customers may unexpectedly lose control over their crypto assets.
Furthermore, a debtor may use or sell its property either in the ordinary course of business or with court authorization. While the Bankruptcy Code provides some safeguards for parties-in- interest when a debtor seeks to sell assets, including the right to adequate protection such as periodic cash payments or replacement liens, it’s unclear how these protections would apply to the customers of a bankrupt cryptocurrency exchange platform. It’s conceivable that a debtor holding cryptocurrency in custodial wallets on behalf of its customers could sell off those assets without customer consent.
In addition, these customers may not have any priority claim to the sale proceeds; instead, such proceeds may simply be distributed in accordance with the order of priority set out in the Bankruptcy Code. In all likelihood, customers would be treated as general unsecured creditors who will not receive any recovery until all other creditors are paid in full, with any resulting recovery yielding pennies on the dollar.
Given these risks, some industry observers have advised cryptocurrency investors to move their assets into noncustodial wallets, where the exchange platforms have less access and control. While this is a viable option, some traders may prefer custodial wallets and the convenience of not having to remember or store their private keys. For those weighing their options, it is helpful to consider how an actual bankruptcy of an exchange platform bankruptcy may play out.
First, this is an untested area of law, so it’s uncertain if bankruptcy courts will find that cryptocurrency held in custodial accounts should be treated as the platform’s assets in bankruptcy. But, from a practical standpoint, it’s also unclear if debtors would actually benefit if customers’ assets are deemed property of a bankruptcy estate. In general, a debtor seeking to continue its business post-bankruptcy will want to avoid doing anything that will alienate customers because they are the lifeblood of a debtor’s business. Rather than selling off customers’ assets, the debtor might go to great lengths to reassure customers that their crypto assets are safe.
Alternatively, if a sale were contemplated, it might be more appealing for the debtor to sell its entire business, or at least its customers’ accounts, to competing platforms rather than liquidate the cryptocurrency held in custodial wallets. This type of going concern sale should leave customers unimpaired, while hopefully generating enough revenue to provide large recoveries to other creditors. In addition, this type of sale would also avoid flooding the crypto market, which could happen if there were a massive sell-off of crypto assets held in custodial wallets and which would result in both a decline in trading prices and value.
Second, as noted above it’s unclear whether customers could successfully argue for adequate protection, but customers would certainly have standing to object to any proposed asset sale on that basis. Although adequate protection is more commonly granted to secured creditors, there may be a colorable argument that, in the event a debtor seeks to sell off assets held in custodial wallets, customers have an interest in those assets and are, therefore, entitled to adequate protection. Again, the law is untested, but merely raising these objections (and not necessarily winning them) may be enough leverage for customers to negotiate more favorable treatment because the debtor and its creditors may want to avoid an unfavorable ruling and/or expensive litigation. Helpfully, account holders could mitigate legal costs by forming an ad hoc group that hires one set of professionals to pursue the group’s interests. More generally, acting together in a group may give such customers a stronger position throughout the bankruptcy case when compared those who act alone.
In conclusion, although the bankruptcy of exchange platforms is yet another risk of investing in cryptocurrency, the quintessential risk-seeking cryptocurrency investor may not be so easily frightened. Even so, users of custodial wallets should continue to monitor the financial health of their currency exchange platform. No doubt, the possibility of an exchange platform seizing its customer’s assets to pay off other creditors in a bankruptcy is probably less likely than a crash in the value of an investor’s cryptocurrency holdings.