Safety Check: If Crypto Custodian Fails, Clients May Not Get a Full Payout

A recent paper from academics at Leiden Law School suggests that if a crypto exchange or crypto custodian goes bankrupt, investors could well lose control over their stored coins. This happened in Japan’s Mt. Gox exchange collapse, and more recently with the failure of Italy’s BitGrail exchange. Thus, it could happen again. 

Indeed, the paper implies that even users of United States-based exchange Coinbase could have problems reclaiming their crypto in the event of insolvency — because Coinbase doesn’t segregate blockchain addresses. So, the question still stands: “Is there a risk you could lose your Bitcoin” if an exchange or custodian goes bankrupt? 

“Absolutely, there is a risk,” Edgar Sargent, a partner at Susman Godfrey law firm, who was hired by CoinLab to sue Mt. Gox, told Cointelegraph. Outcomes vary depending on jurisdictions and applicable law, but the default position is that this is a debt incurred by the exchange, and in the event of the firm’s bankruptcy, a Bitcoin (BTC) investor will have to get in line with other creditors, said Sargent.

Evan Thomas, an attorney with Osler, Hoskin & Harcourt LLP, told Cointelegraph: “In the Mt. Gox case, the remaining BTC was treated as assets belonging to Mt. Gox, not assets belonging to customers. So, the BTC could be used to pay debts to Mt. Gox’s other creditors.” However, Coinbase is different from Mt. Gox, presumably because, at the very least, it’s a U.S.-regulated entity. 

Moreover, in a 2019 amended user agreement, Coinbase added rules specifically concerning property rights over crypto-assets deposited with the exchange: “Title to digital currency shall at all times remain with you and shall not transfer to any company in the Coinbase Group.” But that may still not be sufficient to protect users, suggested the Leiden Law School paper, which generally explores the legal risks involved in depositing cryptocurrency with crypto-custodians, such as crypto exchanges, stating:

“Coinbase has full control over the private keys to deposited Bitcoins. It can effectively access crypto-wallets and their content. This may not only increase the risks of hacks or mismanagement, but also lead to disputes about the ownership over crypto-assets deposited with Coinbase, since control over the private key (and therefore the possibility to dispose of Bitcoins) may indicate that Coinbase is the owner of such Bitcoins or that ownership has been transferred to it. In the absence of proper segregation, allocation of cryptocurrencies to individual customers may become problematic.”

U.S.-based Gemini, another crypto custodian, by comparison, guarantees that the crypto assets in its custody accounts will be segregated from any other assets held by Gemini. “This segregation [i.e., Gemini’s] contrasts with the Coinbase contract, which does not promise to segregate customers’ crypto-assets with separate blockchain addresses, but instead allows shared blockchain addresses,”…