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September 13, 2022

The Case for Decentralized Exchanges

Crypto Exchanges and Bankruptcy

From March 2020 through November 2021, the price of Bitcoin increased from $3,000 to an all-time high of $69,000. As with all asset classes, however, a rise in value doesn’t last forever, and Bitcoin today trades in the low $20,000 range. This latest collapse of the Bitcoin price has caused a wave of insolvency threats and bankruptcy filings, putting billions of dollars of investors’ coins at risk.

When a corporate entity files for bankruptcy, its creditors are separated into classes, depending on the types of claims they hold against the bankrupt entity. The class in which a creditor is placed determines the order of distribution and amount of money that creditor may recover from a pool of the bankrupt entity’s assets, known as the “bankruptcy estate”. Distribution to creditors can be accomplished through a Chapter 7 liquidation of the bankrupt entity’s assets and wind-down of its operations, or through a Chapter 11 plan of reorganization by which the entity survives, reorganizes and pays its creditors a percentage owed over time. Generally, after payment of costs to administer the bankruptcy estate, senior classes, such as creditors with perfected liens against the bankrupt entity’s assets, get paid first, while junior classes such as unsecured creditors are paid last from whatever is left after senior classes get paid in full, often leaving unsecured creditors with pennies on the dollar, or nothing at all. Typically, equity interests—shareholders—receive no value. This structure caused considerable panic in the cryptocurrency space when, on May 10, 2022, the biggest centralized cryptocurrency exchange in the United States, Coinbase, filed its quarterly report with the Securities and Exchange Commission. In its filing, Coinbase declared that, in the event of a bankruptcy, all of the cryptocurrency which investors hold in their wallets on the exchange may become part of Coinbase’s bankruptcy estate, and the investors may be treated as general unsecured creditors. This nightmare for investors prompted Coinbase’s CEO to immediately issue a statement to reassure investors and prevent a run on the exchange, claiming Coinbase was not in any danger of filing for bankruptcy.

Frozen Wallets And Uncertainty

While Coinbase has not filed for bankruptcy despite the recent downturn in the cryptocurrency market, many exchanges and crypto-related financial entities have not been so fortunate. In early June of this year, centralized cryptocurrency exchange and lending platform Celsius Network announced a freeze of all customers’ account withdrawals and transfers of cryptocurrency to prevent a total collapse of the exchange. Later in June, Singapore-based crypto hedge fund Three Arrows Capital became insolvent, and a British Virgin Islands court has ordered its assets to be liquidated. Three Arrows Capital owed cryptocurrency brokerage Voyager Digital Ltd. over $660,000,000, and its insolvency caused Voyager to also suspend all withdrawals of customers’ funds, and eventually file for bankruptcy protection itself on July 5. As of September 13, Voyager is attempting to sell its assets pursuant to section 363 of the Bankruptcy Code, but it is highly unlikely that its customers will be able to recover the full value of their investments once the sale is complete. To top off the recent spate of cryptocurrency exchange collapses, on July 4, Singapore-based exchange Vauld announced a freeze on all withdrawals, trades, and deposits, while it explores bankruptcy options. These entities have hundreds of thousands of customers between them, with billions of dollars’ worth of cryptocurrency frozen until further notice.

Trading on a Decentralized Exchange (“DEX”) Remedies These Concerns

A DEX is an exchange where investors maintain complete control over their cryptocurrency without relying on a third-party intermediary to hold their coins or conduct trades. No account creation or identity verification is required. Trading is accomplished peer-to-peer directly from one investor’s wallet to another. The key aspect of a DEX is that an investor must first connect their own wallet to the exchange, which they can disconnect at any time, rather than use the exchange’s wallet to hold their coins. A cryptocurrency wallet is not a wallet in the traditional sense, because the coins are not actually stored on the wallet. Instead, a cryptocurrency wallet holds the “public and private keys”, which allow an investor to access their cryptocurrency that is stored on the blockchain. The “public keys” are like a bank account number. They are the address to where cryptocurrency can be sent. The “private keys” are like a password or pin number, and allow cryptocurrency to be transferred from one wallet to another. If a person obtains the private keys to a wallet, they can transfer the cryptocurrency out of that wallet. As long as an investor keeps their private keys secret, they maintain sole access and control over their cryptocurrency because no one can transfer coins from that wallet without the private key.

A cryptocurrency wallet can be in the form of a physical object, similar to a USB stick that connects to the computer. Some popular examples of physical wallets are a Ledger Nano device, or a Trezor device. These are known as “cold wallets” because they aren’t connected to a computer unless the investor physically plugs them in. Consequently, when a cold wallet is held in storage, it is not connected to the internet and cannot be hacked into. Alternatively, wallets can be in the form of a computer application, or a “hot wallet” such as Metamask. These wallets are also safe because the investor is provided with a private key when initiating creation of the wallet. Wallets on a centralized exchange also have public and private keys. However, the main difference is that the account holder on a centralized exchange is not the only person who can access their wallet. The centralized exchange operators can also access their wallet at any time and for any reason. Moreover, a hacker of a centralized exchange has access to other investors’ cryptocurrency because everyone’s coins are held in a centralized pool of assets.

The Conclusion

The DEX is “trustless”, in that no investor need rely on a third-party intermediary at any time to conduct trades. Due to this distinction, a DEX arguably is a much safer and more effective, albeit a more complicated, method of trading cryptocurrency. This trading protection offered by a DEX, especially if centralized exchanges continue to file bankruptcy at the pace seen over the last two months, will become even more significant. Learning how to use a DEX is a necessity for any serious crypto investor concerned about security for its investment.