The Devastating Impact of Bankruptcy to Crypto Investors

Blockchain is one of the fastest evolving, controversial and important technologies of the modern era. Diverse industries recognize the benefits of a decentralized distributed ledger, one whose data is both highly secure and readily accessible to anyone with an internet connection. New blockchain-related companies are created daily, each offering its own cryptocurrency “coin” with its own specific purpose. The meteoric rise in value of Bitcoin and other cryptocurrencies over the last several years has facilitated tremendous interest in the blockchain sphere, not just for companies or government entities that see the benefit of the technology, but also for the institutional and individual investor who sees the potential for massive profits, returns far exceeding a typical stock trader’s ten or even twenty percent return at the end of the year. Cryptocurrencies, in contrast, have increased in value by one-thousand or even ten thousand percent on a regular basis. With such huge investment potential, cryptocurrency may understandably blind investors to the very real risk of a bankruptcy filing, particularly those lacking the tech-savviness to understand and account for the underlying fundamentals of the technology. Recently, that bankruptcy risk has come to roost for crypto investors.

The Investment Basics

The initial purchase of cryptocurrency is usually made with widely accepted government-backed currency (“fait”) to buy the coin, such as U.S. dollars, Euros, etc., currency similar to a stock purchase. The investment strategy is also similar to buying stock. When it comes to the products and services offered by blockchain-related companies, the hope of the investor is that those offerings will become adopted by the masses, increasing the demand, and thus, the value, of the purchased cryptocurrency. And like stock offerings, many cryptocurrencies have a fixed supply. For example, there will only be 21 million Bitcoins in circulation once all are mined. Such a finite supply has a direct correlation to the price, as demand increases.

The Crypto Exchanges

Cryptocurrency trading, like stock trading, is largely done on exchanges. The most popular exchanges in the United States are Coinbase and Gemini. These exchanges are convenient and easy to use. They operate under Know Your Client (“KYC”) standards, so uploading your identification and social security number is usually required to create an account. Once an account is created, the investor simply links their checking account or debit card to their crypto account and purchases coins as they would stocks on E-Trade or Robinhood. Once the coins are purchased, they are held in a “wallet” on the investor’s account. The investor can transfer the coins from one exchange wallet to a wallet on another exchange or to a wallet not linked to any exchange. All kinds of log-in security features and authentications are offered so that investors perceive their coins are safe, particularly from nefarious Internet hackers, but that is not always the case. Moreover, unlike FDIC insured deposits at certain financial institutions, cryptocurrency exchanges enjoy no similar investor protections.

Coinbase and Gemini are known as “centralized exchanges.” For a centralized exchange to operate, it needs liquidity. In other words, there must readily be coins to buy and sell on the exchange. Liquidity is provided either by casual investors who transfer the coins from outside wallets onto their exchange wallets, or by the creators of the cryptocurrency itself. The latter may pay a fee to the exchange and transfers a very large number of coins to that exchange for other people to trade. The key factor in determining whether an exchange is “centralized” is how cryptocurrency is stored and traded on that exchange.

Hackers and Bankruptcy Concerns

On a centralized exchange, investors’ coins are stored in their designated wallets, but the wallets are ultimately controlled by the operators of the exchange. The system gives the appearance that the coins are held in that investor’s personal account on the exchange. That, however, is generally not the case. The coins are actually held in a “centralized pool” comprising all investors’ coins. This renders the coins more susceptible to hacking, such as occurred in the recent case of centralized exchange Mt. Gox. Mt. Gox was “hacked” and more than $460 million in cryptocurrency was stolen from investors’ wallets in 2014, causing it to file for bankruptcy protection. Investors lost access to their coins for years, while the bankruptcy court sorted through the complicated claims reconciliation process.

Moreover, an investor trading on a centralized exchange does not actually trade their cryptocurrency for another cryptocurrency. Rather, trading on a centralized exchange is an exercise in database management, in that the exchange uses an IOU (“I owe you”) trading system to implement trades. When a trade is complete, the exchange processes the data and reconciles it in the investor’s trading history, but it is only a “representation” of the cryptocurrency traded, similar to a book entry in an account receivable ledger. The trade isn’t realized until the coins are in full control of the investor. In other words, an investor’s cryptocurrency trade on a centralized exchange is not owned by the investor until the crypto is removed from the exchange or the cryptocurrency converted into fiat currency and deposited to the investor’s checking account. If the centralized exchange’s management chooses, it can suspend trading of a cryptocurrency at any time, without any regulatory oversight or intervention. Management can also suspend withdrawals of a cryptocurrency at any time, leaving investors without access to their coins. This happens much more often than people realize and is usually associated with a precipitous crash in value of a certain cryptocurrency or, as in recent months, the collapse of the entire cryptocurrency market. To address these existential concerns, decentralized exchanges (“DEX’s”) were created, and their popularity is growing at an exponential rate. The workings and benefits of a DEX will be addressed in Part 2 of this Client Alert.