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- In 2022 and 2023, several cryptocurrency platforms filed for bankruptcy.
- Cryptocurrency exchanges use their assets to pay off debts and legal fees, so their customers are usually the last in line to get paid.
- Decentralized custody, decentralized wallets, or opening a non-custodial wallet in addition to a custodial wallet can give you better control over your crypto assets.
Cryptocurrencies are decentralized digital assets that, unlike traditional fiat transactions, do not involve intermediaries (such as banks or other financial institutions) when being transferred from one side to another.
While setting up a cryptocurrency wallet through an exchange or using an external wallet can often keep your assets safe, cryptocurrencies may not be protected against events like bankruptcy.
What happens if a cryptocurrency exchange goes bankrupt?
In the event of insolvency, crypto customers with custodial assets are typically last in line to receive payment. In other words, those who store crypto in non-custodial or self-custodial wallets will not be affected because they own the private keys.
The story is different for those who use an exchange's custodial wallet.
“First, assets held by the exchange will be sold to cover debts owed to creditors and legal costs,” explained Nick Saponaro, founder and CEO of crypto-payments platform Divi Labs. “Only after that will users be paid, if there is anything left.”
How to protect your cryptocurrency in case of bankruptcy
If you are tied only to a custodial wallet through the platform in the event of bankruptcy, it will likely be up to the exchange to settle fees. But in general, there are three preventative strategies you can use to protect your assets from bankruptcy:
You can: Set up a custodial wallet and simultaneously open other non-custodial crypto wallets (so you can move assets back and forth at your convenience) Use decentralized custody or store your crypto assets through a decentralized (DeFi) wallet.
Consider a custodial wallet
There are two main types of cryptocurrency wallets: custodial and non-custodial. Custodial wallets are typically online wallets managed and controlled by a third party. Non-custodial wallets can be established either connected to the internet or via an offline storage device (such as a USB drive) and give you full control over your private keys.
“Users have a choice: they can choose to have a third party manage their funds or they can manage their own funds through self-administration, and each option has its own benefits, caveats and risks,” Saponaro said.
Custody wallets are a convenient and secure way to store cryptocurrency, but users who only use this type of wallet may run into problems in the event of bankruptcy. Since you can have multiple cryptocurrency wallets, one solution is to open a non-custodial wallet in addition to the exchange's custodial wallet.
This way you can mitigate risk by storing your crypto assets in multiple places, plus you can move your crypto balances between them if needed.
If you're using an investment platform that doesn't offer its own custodial option, or if you choose the non-custodial route where you set up a wallet where you have full control over your private keys, you're better off finding an external wallet before buying cryptocurrency. However, if you're dealing with an exchange that offers its own custodial cryptocurrency wallet, you don't need to set up a wallet before buying (unless, of course, you want to take advantage of both custodial and non-custodial storage).
Whichever wallet option you use, you'll need to manage both a public and private key. Your public key acts like a digital address and is used to identify you when others send you crypto assets, while your private key is used to sign transactions and secure your assets.
Pros and Cons of Custody Wallets
As mentioned above, custodial wallets are managed by a third party (such as a cryptocurrency exchange) and usually give you easier access to the custody but limited control over the wallet. There are several other pros and cons to consider:
If you're new to crypto or prefer a convenient storage option, custodial wallets are a great place to start – they are managed by a third party, freeing you from the responsibility of both selecting and continually monitoring your crypto wallet.
Additionally, if you lose your wallet password, it can usually be reset without any issues (losing the password for a non-custodial wallet could lead to significant financial losses depending on the amount of cryptocurrency contained in the wallet).
Several of the best cryptocurrency exchanges, including Coinbase, Binance, and Gemini, offer their own custodial wallets.
Custody Wallet Alternatives
If you don't want to go the managed route, there are two other options you can use to protect your assets.
When it comes to crypto and bankruptcy, custodial wallets aren't an issue and can be a great way to successfully onboard newbies in a field that traditionally requires a high level of technical expertise, Saponaro added.
“The problem is the same as with all custodial finance: you have access, but you inevitably lose control,” he explains.
Sapanaro highlighted two options.
1. Decentralized Management
This non-custodial option allows you to store your crypto assets in a “hot wallet” or a “cold wallet”: Hot wallets are essentially online software, while cold wallets allow you to protect your assets through hardware and offline devices.
2. Decentralized Wallets
According to Saponaro, these wallets are self-custodial, giving control to the user: “Decentralized wallets like DiviWallet (sometimes called DeFi wallets) offer similar services to custodial solutions, but do not have access to users' keys.”
Examples of non-custodial crypto wallets include MetaMask, Exodus, Trust Wallet, and Wasabi Wallet.
Conclusion regarding cryptocurrency exchange bankruptcies
Cryptocurrency held through exchanges or investment platforms may not be protected in the event of bankruptcy: these assets would first be used to cover legal costs and creditor liabilities, extending the time it takes for customers to receive repayment (although repayment is not guaranteed).
If you want more control over your cryptocurrencies, there are many different types of storage options available to you, including decentralized storage and DeFi wallets. And even if an exchange only offers a custodial wallet, you can still transfer your assets to an external wallet if needed.
The method that works best for you will ultimately depend on how much control you want over your assets.