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What Will Happen To Coinbase Users If The Crypto Exchange Goes Bankrupt

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EDITOR'S NOTE: Investors who enter the crypto markets should be well aware of the risks. Crypto is a speculative asset class. Under normal market circumstances, whether boom or bust, your gain or loss should be a natural consequence of the market process, no matter how drastic the consequences can be. Apparently, that isn’t always the case. In its last quarterly earnings report, and a disastrous one at that, Coinbase mentioned that in the event of a bankruptcy, crypto holders will be become “unsecured creditors” and their assets will become inaccessible. Let’s hear that again: if the crypto exchange goes bankrupt, customer funds will be seized. So, in addition to crypto being a risky asset class, the very platform and exchange is itself a major risk. Wasn’t absolute and immutable ownership and autonomy from centralized governance a major part of crypto’s appeal? In this case, concerning deposits and assets, Coinbase is functioning more like a bank minus customer protections. The lesson to be learned here is that when assets are neither tangible nor accessible but mediated by a party other than oneself, ownership is illusory. This goes for crypto as well as all other paper assets (including paper gold and silver) that come with a claim for nominal ownership but not the privileges that owners have a right to exercise over their own property.

Hidden away in Coinbase Global’s disappointing first-quarter earnings report—in which the U.S.'s largest cryptocurrency exchange reported a quarterly loss of $430 million and a 19% drop in monthly users—is an update on the risks of using Coinbase’s service that may come as a surprise to its millions of users.

In the event the crypto exchange goes bankrupt, Coinbase says, its users might lose all the cryptocurrency stored in their accounts too.

Coinbase said in its earnings report Tuesday that it holds $256 billion in both fiat currencies and cryptocurrencies on behalf of its customers. Yet the exchange noted that in the event it ever declared bankruptcy, “the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings.” Coinbase users would become “general unsecured creditors,” meaning they have no right to claim any specific property from the exchange in proceedings. Their funds would become inaccessible.

That shouldn’t happen.

An individual’s ownership of cryptocurrency is supposed to be immutable and absolute; that's one of the key selling points touted by blockchain evangelists everywhere. But when a user creates a Coinbase account, they often end up storing their cryptocurrency in a wallet controlled by Coinbase, which means the individual is giving away at least part of their control over their own funds.

Access to a crypto wallet is governed by a private key, which is a long string of characters that effectively acts as a password. Without the key, the cryptocurrency in the wallet can’t be accessed. On Coinbase, the exchange holds the private key and lets users access the funds within the wallet using a more conventional password. The setup makes it easier for users to enter their accounts, by remembering an easier password.

Yet it means that when push comes to shove, Coinbase ultimately governs whether a user gets access to those assets.

In comments shared on Twitter, Coinbase CEO and founder Brian Armstrong said the exchange had “no risk of bankruptcy,” and that the disclosure was made due to new rules set by the U.S. Securities and Exchange Commission regarding public companies that hold crypto assets on behalf of others.

“This disclosure makes sense in that these legal protections have not been tested in court for crypto assets specifically, and it is possible, however unlikely, that a court would decide to consider customer assets as part of the company in bankruptcy proceedings even if it harmed consumers,” Armstrong tweeted, while reassuring users that “your funds are safe at Coinbase.”

Coinbase does offer a self-custody wallet, titled “Coinbase Wallet,” in which users know their private key, and a Coinbase Wallet—or any crypto wallet—is not required to trade crypto on Coinbase. But by admitting that crypto assets aren't secure in the event of a bankruptcy, Coinbase is also highlighting a major difference between storing your funds with blockchain exchanges, versus keeping cash with traditional banks.

Bank accounts in the U.S. are protected by deposit insurance offered by the Federal Deposit Insurance Corporation. In the event a bank fails, the FDIC steps in to protect deposits up to $250,000, preventing depositors from going broke along with the bank. Crypto exchanges don't offer that same protection—which is the primary reason why crypto enthusiasts advise investors to hold their cryptocurrency in a personal wallet, rather than on an exchange.

Coinbase shares fell 15.6% in after-hours trading after the exchange released its earnings, dragging the crypto exchange's stock price down to 80% below its Nasdaq debut in April 2021. Besides reporting a declining user base and lower than expected revenue, trading volume on the Coinbase exchange declined from $547 billion to $309 billion in the first quarter, over the same period last year. Coinbase warned that trading volume was likely to decline further in the current quarter.

Originally published on Fortune.

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All articles are provided as a third party analysis and do not necessarily reflect the explicit views of GSI Exchange and should not be construed as financial advice.

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