Cryptocurrencies, especially bitcoins, have shown tremendous growth so far when compared to gold and the U.S.Dollar. In June 2020, the price of bitcoin has increased by 27.8% year-on-year, while gold and the U.S.dollar have grown by 16% and 5.4%respectively. Investors’ interest in cryptocurrencies continues to grow with every passing day. A large number of investors are increasingly trading in crypto and its derivatives. Sadly, it is not just the investors who have vested their interest in the crypto market, but also the hackers and the fraudsters. Recent scams include the DeFi protocol Balancer hack and the Wirecard scandal. The sheer volume of trade makes crypto exchanges very lucrative to swindlers. At times, these abused exchanges end up filing for insolvency or bankruptcy.
Hence it is for the benefit of both the investor and the crypto firms to understand the risks involved in crypto trades before investing. Why are the crypto exchanges vulnerable? What happens when the crypto exchange becomes insolvent? Finally, how to choose the right exchange?
Why are crypto exchanges vulnerable?
Technological risks, price volatility, and legal status are the three long-standing risks with cryptocurrencies. Trading volume, inadequate security, and flaws in smart contracts are reasons why the exchanges are vulnerable to hacks. Exit scams and avaricious employees roil the trust of investors and result in crypto exchange insolvency. The equivocal legal processes surrounding cryptocurrencies makes it harder to contest the insolvency cases. Establishing something as intangible as bitcoin, conjured by solving some cryptic puzzles, as an asset or a property owned by the investors, is challenging.
Crypto companies declare insolvency — inability to pay their obligations — in such scenarios. But, what happens to customers’ assets when the crypto firms fail? Will they get their crypto-assets back or have to forget them forever? How difficult is the situation for the crypto firms and their customers?
A crypto firm can overcome insolvency by selling assets, borrowing money, or by getting merged or acquired by other companies. If all of these fail, they can state bankruptcy and work with the legal system in resolving the debt.
On the other hand, the customers’ plight is more involved. Insolvency and property laws determine the customers’ rights when the companies fail. But what are the applicable laws? — identifying these is quite complex.
First, many countries do not consider cryptocurrencies as an asset or a property. Recent Russian court’s stand against bitcoins is one such case. Secondly, very few countries have laws tailor-made for cryptocurrencies. Thirdly, there is no single international law referred to as a fallback. Finally, the decentralized nature of cryptocurrencies makes it difficult to establish jurisdiction for the insolvency cases.
For instance, in case of the infamous Mt. Gox bankruptcy, the Japanese court ruled out bitcoins as property since the customers were not able to establish exclusive ownership. But, in Italy’s Bitgrail case, the Italian court considered the altcoins as the investors’ assets owned by the firm, and hence ordered the CEO of the firm to return the assets to their rightful owners.
Two aspects stand out while deciding on the crypto insolvency cases. First, the jurisdiction under which these cases fall and second whether or not the crypto assets are property.
Several international laws exist to determine the jurisdiction of the crypto cases. While some assert the customer-custodian agreement takes precedence, others emphasize the custodian’s place of registration is supreme. In some cases, jurisdiction differs between insolvency cases, and other disputes that the customer might have with crypto exchanges.
Establishing the correct court of law is vital to ascertain whether the cryptocurrencies are property or mere contractual obligation.
Determining whether the cryptocurrencies are property
Some countries consider cryptocurrencies as contractual obligations, and the custodian is bound to return these assets when the investor demands. In such a scenario, the firm has a right to reject the customer’s claim citing bankruptcy, which leaves the investor to file a claim for damage against the crypto exchange.
On the other hand, if the court of law considers the cryptocurrencies as property, the customers will then have the right to demand them back from the insolvent company. But what makes the cryptocurrencies one’s property?.
The term property is widely interpreted as something tangible in several countries, and the possessor of which is considered its owner. But, this definition does not fit the cryptocurrencies.
Secondly, many property laws mandate exclusive possession of the property to establish ownership. But, when the customer makes an exchange as the custodian of their crypto assets, they end up either sharing the private keys to operate their accounts or transfer their assets to the custodian’s account. Hence, there is always a shared possession of the crypto properties.
Finally, many exchanges use a single account for storing the crypto assets of all their customers, thereby complicating the assertion of ownership. Since the cryptocurrencies are fungible, when all holdings are in the same address, exchanges tend to settle one customer’s token requests with another customer’s assets. For instance, the crypto exchange might choose to honor one customer’s request of 0.5 bitcoins with the UTXOs of 0.3 and 0.2 bitcoins from another customer. The more the tokens change hands, the more difficult it becomes to establish ownership.
As the laws are not quite delineated and also murky at times for cryptocurrencies, settling disputes can be difficult and time-consuming.
How to vet the crypto firms?
Consequently, the prospective investor has to do rigorous research while deciding on the crypto exchanges. Here are a few questions, answers to which will aid in choosing the right firm.
What is the purpose?
It is essential to define why to engage with a crypto business – To buy, sell, trade crypto? Long-time investment? For those invested in trading directly in crypto-assets, spot exchanges are where they can buy, sell, and trade bitcoins, ether, and other altcoins. For those who are looking for additional investment options, some exchanges offer derivatives of cryptocurrencies — futures and options — whose value is determined by the price of underlying spot crypto-assets.
How secure are the crypto firms?
Crypto exchanges are the most lucrative targets of hackers due to the sheer volume of trade. Both crypto-assets and sensitive customer data are susceptible to hacks. Exchanges that focus on security have measures such as accessing their websites only via secure protocols. These exchanges will mandate using more than one factor to log into their site. They employ cold storage for storing the customer deposits and provide regular and real-time alerts to the customers for their trade.
Are the crypto exchanges partnering with third parties?
Some crypto firms partner with third parties for various aspects of the trade. The prospective customers must know the extent of third party involvement. Some companies tie-up with other firms for wallet service, while some exchanges like Binance allow users to stake their assets in a third party stake network via their staking services.
How thorough are the KYC/AML checks?
KYC/AML checks done by the crypto firms vary based on the type of their business, countries they operate in, and also how eager they are to sound ‘easy to operate’ for their customers. Every customer will also have a preference for the KYC process. While some will prefer exhaustive checks despite being time-consuming, others would choose ‘easy to operate’ over an elaborate and thorough verification process. Some companies need KYC proofs at the time of account creation, while some need them while moving funds. Some firms even ban customers from certain countries.
Are these crypto companies reputable?
It is critical to assess the reputation of the firms before investing. Some firms might be frequent victims of hacks or are involved in exit scams. It is prudent to learn about the company’s reputation from various sources — news articles, credible crypto websites, talking to fellow crypto-enthusiasts.
How transparent are these firms?
Transparency and not withholding information goes a long way in establishing the credibility of the crypto firms. It is vital to know how open the crypto companies are in providing information about their firm — the owners, the place of registration, operating locations, assets held.
Are the crypto businesses insured?
If the crypto companies are insured, it is further assuring to the potential customers of their compensation when the firm goes belly up.
What cryptocurrencies does the firm offer?
Most crypto firms deal with popular currencies such as bitcoin. But, they become pickier when it comes to altcoins. So it is vital to know the choice of assets offered by the crypto company. While deciding on crypto exchanges, it is essential to check the altcoins traded, specific trading pairs, etc. before investing.
What are the transaction fees?
Some crypto firms charge money for withdrawals and also have a limit on withdrawals. Some of them offer convenient cryptocurrency buying options and ask for deposit fees in return. The crypto exchanges also charge a percentage of the amount traded on the exchange as trading fees. Hence, it is in the customer’s benefit to check the transaction fees in advance.
How easy is it to use fiat alongside crypto?
If buying and selling crypto using fiat money is critical, it is worth looking at the on and off ramps offered by the exchanges. Some platforms mandate payments to be made only via bank accounts. The firms allowing multiple payment methods can have varying transaction fees based on the payment method. It is also vital to know some countries ban the trading of crypto with fiat.
In addition to these, checking the exchange’s trading volume, the difference in their currency prices compared to others, and whether they offer leverage trading is beneficial. Perusing the user and custody agreements of these exchanges will give the potential customers an insight into how their assets will be stored — in pooled or segregated addresses. Additionally, the contract should clearly state the customer as the owner of crypto assets, while the exchanges remain the custodians.
Incidentally, the customer service, easy to use websites, and quick turnaround times for deposits and withdrawals are also a huge selling points for the crypto exchanges.
Yet, it is prudent not to have large amounts of cryptocurrencies stashed away with the exchanges for an extended period, despite all the meticulous research. Ambiguous cryptocurrency laws make the reparations difficult in crypto exchange insolvency cases. In the end, investors have to discern the risks associated with the benefits and exercise due diligence while choosing the crypto exchanges.