Investors should be aware that as cryptocurrency “exchanges” and brokers evolve, risks exist regarding investors’ holdings with exchanges. Recently, a new risk was disclosed regarding potential bankruptcies of exchanges and investors’ holdings. Unlike equities and other marketable securities, cryptocurrency exchanges are not covered under the same existing federal laws. “Investor assets” at those exchanges may not, in fact, be owned by the investors.
In its 10-Q disclosure for the fiscal quarter ending on March 31, 2022, Coinbase Global, Inc., (“Coinbase”) the largest cryptocurrency exchange in the United States by trading volume, disclosed that “custodially held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors.” As of March 31, 2022, Coinbase was the custodian for over $256 billion of customer assets. SEC Chairman Gary Gensler noted on April 4, 2022, “Unlike traditional exchanges, currently centralized crypto trading platforms generally take custody of their customers’ assets.”
While Coinbase and other crypto exchanges have made trading crypto more accessible to retail investors, there are potential risks that exist to using those exchanges. Coinbase’s disclosure highlights the risk that if Coinbase initiates bankruptcy proceedings, Coinbase users could become general unsecured creditors with respect to their crypto holdings. This could result in Coinbase customers losing all or substantial value represented by their Coinbase accounts as other Coinbase creditors recoup their debts. To be clear – the disclosure indicates that “customer accounts” might actually be considered Coinbase assets for bankruptcy purposes and “customers” are really just lenders to Coinbase.
Understandably, significant concerns have been raised by the Coinbase disclosure. Potential legislative solutions may ultimately come, but in the meantime clients may wish to consider alternative solutions. One solution is for crypto investors to hold their investments in self-custody wallets. Coinbase.com defines a self-custody wallet as “a wallet where your private keys are stored locally on your device, giving you full control over your funds.” This means that Coinbase does not hold the cryptocurrency, but rather the individual investor does. If the investor loses the private key to his or her self-custody wallet, then the assets in that wallet may be lost forever.
For investors seeking to transfer their crypto investments from Coinbase to a different wallet, there will be no tax consequence as long as the same investor holds the assets.
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This publication is for general information only. It is not legal advice, and legal counsel should be contacted before any action is taken that might be influenced by this publication.
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