Coinbase bankruptcy rumors spark worry: Could customers lose crypto?

Posted: 12 May 2022 12:20 pm
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Rattled crypto markets find new worry in Coinbase’s flagging of bankruptcy risks. But are Coinbase users’ crypto investments really at risk?

It’s been a pivotal week for cryptocurrencies, with many investors waking up to the real risks presented by investing in digital assets.

Coinbase flagged to users that their crypto assets could be at risk if the exchange was to go bankrupt. The warning came as part of the company’s 10-Q filing with the Securities and Exchange Commission, where it explained that if customers were treated as “general unsecured creditors,” their crypto assets could be subject to bankruptcy proceedings.

Is there a real risk this could happen?

Coinbase bankruptcy rumors

Quickly after the company’s SEC filing, Coinbase CEO, Brian Armstrong, tweeted to reassure users that “your funds are safe at Coinbase, just as they’ve always been.”

It’s understandable that customers are concerned, but is there actually a basis for this fear?

Coinbase said that the reason for the warning was a new requirement introduced by the SEC for companies that hold crypto assets for third parties. The new guidance is designed to encourage investors to look closely at the financials of companies that hold their digital wallets. Essentially it states that custodially held crypto assets may be considered property of a bankruptcy estate, so assets held on behalf of customers could be subject to company bankruptcy proceedings.

This does not mean that Coinbase is at imminent risk of bankruptcy. The company’s Q1 results were underwhelming, but it still ended the quarter with $6.1 billion in cash and equivalents.

Crypto values have plummeted in the past week. Terra’s LUNA coin saw a 98% decrease in value, according to CoinMarketCap, after its sister stablecoin UST fell below its $1 peg. Overall, the market has fallen 5.94% in the past 24 hours.

But exchanges, like Coinbase, aren’t particularly exposed to price volatility themselves. This is because they make their money from trading commissions, not from the value of crypto assets. As markets editor Luzi Ann Santos said, “Trading volume would need to evaporate to put them at risk of being unable to pay their monthly expenses and default on their debt.”

Custodial vs. noncustodial

What Coinbase’s warning has done is bring into focus the security of third-party assets. New crypto investors may not necessarily be aware of who holds their assets at any particular time and the risks associated with custodial services.

A custodial wallet is a service that owns your private key to your wallet and holds your assets in the specific wallet in custody for you. As the SEC filing stated, “custodially held crypto assets” could be considered part of a company’s bankruptcy estate. If that were the case, customers could lose their crypto assets if an exchange were to declare bankruptcy.

However, custodial services can prevent incidences where investors’ private keys are compromised or lost and they lose access to their assets. Exchanges often have processes in place that mean investors should be able to recover their accounts.

Protecting your assets

One alternative option for crypto owners would be to use a noncustodial wallet, which gives the owner complete control over your private keys. Typically more suited to experienced traders and investors, noncustodial wallets mean there are no intermediaries and you are responsible for the management and protection of your private keys and seed phrases.

Looking ahead, choosing the “right” cryptocurrency exchange is likely to become an even higher priority for crypto investors. Asset protection will be determined by the security processes in place. For example, exchanges with cold storage solutions — a way of holding cryptocurrency tokens offline — provide an extra layer of protection.

Similarly, understanding the custodial status of crypto assets and the third parties involved can help investors to make a more informed choice. As crypto assets aren’t covered under any national financial protection measure such as FDIC insurance in the US or Financial Claims Scheme (FCS) in Australia, it’s important that investors understand the risks associated with where their assets are held.

Interested in cryptocurrency? Learn more about the basics with our beginner’s guide to Bitcoin, dive deeper by learning about Ethereum and see what blockchain can do with our simple guide to DeFi.

Kate Anderson owned cryptocurrencies as of the publishing date.

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