What happens to Your Investment if Crypto Wallet goes Bankrupt?

With Crypto platforms like Celsius, Voyager failing one by one, and the second largest crypto exchange, FTX filing for bankruptcy protection after suspending account withdrawals. Investors are scrambling to protect their crypto assets. Sequoia Capital immediately wrote off its investment in FTX to zero. Is nothing really recoverable? What is the chance of investors getting some money back if a crypto exchange goes bust? 

What happens if Crypto Wallet goes Bankrupt?

Most crypto exchanges, including the ones in trouble - Celsius, Voyager and FTX, operate hot wallets on a custodial basis.  That means that the investors give the exchanges custody of their cryptos in return for a mere debit entry on their wallets. If the crypto wallet / exchange goes bankrupt, the investors will rank last as unsecured creditors, which means that they will likely get nothing at the end of the bankruptcy.

It is safer to store cryptos in non-custodial cold wallets, but they are much harder to operate and trade. They are good for long term investors who are in cryptocurrencies for the long haul and will not trade them day in day out. Read on to see how investors can protect themselves from crypto bankruptcies. 

As a creditor, the crypto platform may have poor record keeping and it is prudent to issue a statutory demand to the platform if it is filing for bankruptcy. Please see:

https://docpro.com/blog80/all-you-need-to-know-about-statutory-demand . 

What is a Cryptocurrency?

Cryptocurrency is a digital or virtual currency secured by cryptography, making it nearly impossible to counterfeit or double-spend. Each coin is fungible - i.e. it has the same value as any other coin of the same type at any given moment, as known as fungible. Bitcoin and Ethereum are prime examples.

NFTs or Non-fungible tokens, on the other hand, are non-fungible. They are unique tokens that represent intellectual property rights and have different values.

To sell or purchase cryptocurrencies, most investors will use an exchange platform and wallet. Like securities brokers, most investors find it easier to give custody of their cryptos to the exchange and they can trade in and out of the cryptocurrencies with ease. Otherwise investors will need to deposit their cryptocurrencies every time they sell and withdraw every time they buy. This is very time consuming and incur additional transaction costs. It may also mean that investors, especially short term investors, may miss the perfect buying / selling opportunities. 

What Rights do Investors get with Cryptocurrencies? 

Cryptocurrencies investors, unlike NFTs investors, generally do not get any of the underlying intellectual property rights (copyright, patent and trademark) of the cryptocurrencies. Investors will get the value of interchangeable tokens which can be transferred to lend out. There are two main ways to own crypto:

1. Through a Crypto exchange / hot Crypto wallet: Active crypto investors mostly use large exchanges, such as Binance and Coinbase. They give custody of their crypto assets to the exchange, and the buyers and sellers of the cryptocurrencies would get matched within the exchange. The user experience is similar to a bank / brokerage firm but without regulatory protections.
   
   
2. Through a private cold Crypto wallet: Long term crypto investors prefer to hold digital currency in their own wallets. It’s considered the safest and most private way to store crypto.

The rights of investors are generally under contractual terms of the cryptocurrencies, exchanges and wallets. If the investor is in a non-custodial wallet, then the investor holds all of the rights associated with the cryptocurrencies. If the investor is using a custodial wallet, then the terms and conditions of the wallet site determine who owns the rights. In some cases, it is a mixture of the two. 

Do I Need a Crypto Wallet?

Crypto investors generally need to have wallets for the storage of cryptocurrencies. Investors can choose to hold cryptos in a hot wallet or in a cold wallet, or even a combination of the two. Investors will need to balance between security (cold non-custodial storage) and convenience (hot custodial storage) to keep their cryptocurrencies safe and allow them to trade with ease at the same time.

What's the Best Crypto Wallet? 

With the world’s second largest crypto exchange, FTX, facing a liquidity crisis, there does not seem to be any platform that is completely safe. Investors will need to understand more about the wallets and store their cryptos to protect their investments. Investors will need to balance between safety and convenience when deciding what is the best crypto wallet for them.

Most crypto exchanges offer their users custodial hot wallets. A hot wallet is an app or a platform connected to the internet for storage. The private keys of cryptos are owned by the platform or software. Investors do not have to spend extra money on purchasing devices, lowering the investment threshold. This is the most low-cost and convenient way to own and trade cryptocurrencies, yet the custody of the cryptocurrencies is given to the exchanges. This means that the crypto assets are co-mingled with the assets of the exchange and the investors will rank last as unsecured creditors in case of bankruptcy.

The safest way to keep crypto is through a non-custodial cold wallet. It is offline storage, which is usually stored through a physical device. This also means that the custody of the crypto assets lies with the investors and is segregated from the risk of the exchange. 

The greatest risk of cold storage lies not with the investors themselves - they may lose their private keys and thus be unable to recover their crypto assets. We have all heard of the infamous story of an engineer throwing away a hard disk with US$200 million worth of bitcoins. In addition, if the owner of the crypto assets pass away, the beneficiaries may not know about them unless they are properly recorded in the will. 

Hot Wallet vs. Cold Wallet

The greatest advantage of a hot wallet is its ease of use without constantly switching online and offline for transactions,. This is perfect for day traders, who can transact instantaneously at low costs, unrestricted by time and space. 

The main risks associated with the use of a hot wallet are:

(i) Hacking Risk

Most hot wallets use decentralized finance (DeFi) programs, which are blockchain technology that use open-source code to enable financial transactions. Because they are public, anyone can view them to find vulnerabilities and hackers may exploit them to steal funds from users or the exchange. There seems to be an endless list of platforms and bridges that have been hacked - Coinbase, FTX, Solana, Nomad, Wormhole, Binance …. the list goes on, with cryptocurrencies have been stolen from wallets on these platforms.  

(ii) Bankruptcy Risk

FTX is the biggest bombshell after the bankruptcy of Voyager and Celcius. This could be the Lehman moment of cryptos that may lead to the collapse of other crypto platforms. These platforms have stopped users from withdrawing both cash and cryptos. Most of these platforms use hot wallets which means that investors give custody of their cryptocurrencies to the platforms which are co-mingled with the other assets. In addition, these are unregulated financial institutions and any cash held with them will not be treated as deposits. As a result, investors are unsecured creditors and will rank last in bankruptcy proceedings. The most likely outcome in the event of bankruptcy of an exchange is that investors will get nothing at the end. 

A cold wallet can help to minimize the above risks. It is similar to a physical wallet / safe in real life accessible through private keys. As investors have 100% control over the wallet, which is segregated offline from the exchange, both credit risk and risk of data breach are low. However, if the physical device is destroyed or lost, the users will not be able to access their assets’ private keys. Thus it is important for investors to store the cold wallet private keys in a secured location such as a safe deposit box. 

Advantages and Disadvantages of Hot Wallet vs. Cold Wallet:

Are Crypto exchanges regulated? Are investments protected by the government?

Although most crypto exchanges operate like a bank or a brokerage firm, taking investors’ deposits and lending them out, allowing investors to buy and sell cryptocurrencies, or speculate on decentralized finance products to get high yields. They are not regulated, meaning investors do not get the same protections they would get with deposits held in a bank or securities in a brokerage firm.

In the US, the Federal Deposit Insurance Corporation protects bank depositors of up to US$250,000 if a bank fails and the Securities Investor Protection Corporation protects investors of up to $500,000 in cash and securities if a broker becomes insolvent. Many jurisdictions around the offer similar protections to investors. Unfortunately, these protections are not offered to crypto investors.

Regulators have not really figured out the best way to regulate crypto trading. cryptocurrencies are generally regarded as being akin to currencies, thus like most FX transactions, they are generally not regulated. However, regulators from around the world are looking at regulating tokens as securities after the recent failures in the crypto industry. So watch this space on how cryptos will be regulated in the future.

Conclusion

Given there are both advantages and disadvantages of storing cryptocurrencies in hot wallets vs cold wallets, investors will need to weigh the risk and safety of their investments vs the ease of trading to decide which wallet is most suitable for them. In general, hot wallets are more suitable for short-term traders whereas cold wallets are safer for longer-term investors who plan to buy and hold crypto assets.

Related Document Template:

Download DocPro's template for Statutory Demand: A Statutory Demand is a formal written demand  for payment of debt. Creditors should issue a statutory demand to the crypto platform if it is filing for bankruptcy.

Please note that the information contained in this article does not constitute legal advice. As the laws of each jurisdiction may be different, you may want to speak to your lawyer.