What happens to my funds if a crypto exchange goes bankrupt?

The Celsius and Voyager bankruptcy filings have raised questions about what happens to investors’ crypto when a platform goes down.

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Traders hoping to recoup their funds from failing cryptocurrency exchanges anytime soon may be disappointed, legal experts tell CNBC.

Crypto trading and lending firms Celsius and Voyager Digital filed for bankruptcy this month, leaving user assets trapped inside their platforms. Both companies froze customer accounts after an influx of withdrawals caused liquidity problems.

Celsius operated much like a bank, taking customer deposits and lending them out or making risky bets on so-called decentralized financial products to generate high returns.

Voyager had a similar model. The company has been caught up in the collapse of high-profile crypto hedge fund Three Arrows Capital, which itself went bankrupt after defaulting on a $660 million loan from Voyager.

Such interconnectedness left the crypto market vulnerable to contagion, with major companies falling like dominoes as a crash in token prices dissipated excessive leverage in the system.

Is my crypto secure?

Cryptocurrencies are unregulated, which means they don’t offer people the same protections as money held in a bank or shares in a brokerage firm.

For example, the US Securities Investor Protection Corporation insures traders up to $500,000 in cash and securities if a member broker runs into financial difficulty.

The Federal Deposit Insurance Corporation, meanwhile, provides bank depositors with protection of up to $250,000 in the event of default by an insured lender.

Similar programs are in place in the UK and the European Union.

With no laws governing crypto-assets, there’s no guarantee that investors would be able to recover their funds if an exchange were to freeze someone’s account — or worse, crash altogether.

“There is no such pattern like this at this point” for crypto, said Daniel Besikof, partner at Loeb & Loeb.

“It wouldn’t surprise me if that happened,” he added. “This will increase calls for stronger regulation.”

What happens if an exchange fails?

For the moment, it is not yet entirely clear. While there are examples of crypto firms filing for bankruptcy overseas — Mt. Gox in Japan, for example — such an event is unprecedented in the United States.

Creditors of Mt. Gox, which went offline in 2014, are still waiting to be repaid billions of dollars worth of cryptocurrency.

The problem with centralized crypto platforms is that they can mix funds from different clients to make risky bets, according to Daniel Saval, an attorney at Kobre & Kim. Such mixing can lead to a decision that the assets are owned by the exchange, not the users.

“Users may be surprised to learn that in a bankruptcy scenario, crypto and funds held in their accounts may not be considered their property,” says Saval.

“Exchanges often aggregate crypto and funds from different clients into the same wallet or storage account.”

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What happens to customer funds in the event of bankruptcy will very much depend on the company’s user agreement and how it used their assets, Besikof said.

Celsius’ terms of service state that funds deposited with the company “may not be recoverable” in the event of bankruptcy. The company filed for Chapter 11 protection last week, revealing a $1.2 billion hole in its balance sheet and owing users about $4.7 billion.

Celsius claims to have $167 million in cash. But it still won’t allow customers to withdraw their funds and hasn’t said when it will reopen withdrawals.

Voyager claims its customers’ dollars are held in an FDIC-insured account at the Metropolitan Commercial Bank in New York – however, this claim has been disputed by legal experts and the bank itself. The FDIC only offers fund protection in the event of a bank failure, not a crypto exchange.

For its part, Voyager says it is working through a “reconciliation and fraud prevention process” with its banking partner, after which users will be able to regain access to their money.

Voyager also outlined a plan to repay users with crypto in their accounts, Voyager stock, and the company’s own token, as well as any debt collected from Three Arrows Capital.

Celsius and Voyager have engaged Kirkland & Ellis, the prestigious law firm, to represent them in court.

“Investors holding crypto assets through Voyager Digital and now Celsius have been placed in a difficult position, with their accounts frozen, lawsuits suspended, and the value and timing of any recovery unknown,” Besikof said.

“There is a lot of work for them in bankruptcy court before these issues are resolved.”

Celsius and Voyager have filed for what’s called Chapter 11, a form of bankruptcy protection that allows companies to restructure their debts. The goal is to ensure that there is still a viable business at the end of the process.

There’s a good chance Celsius and Voyager users will be treated as ‘unsecured creditors’, legal experts have said, a categorization that puts them in the same basket as a company’s suppliers and contractors. .

This means they would likely be at the back of a long queue of creditors lining up for payment from the legal process – behind banks, employees and tax authorities.

In a May regulatory filing, Coinbase said its users would be treated as “general unsecured creditors” in the event of bankruptcy.

“In general, most customers of cryptocurrency exchanges are unsecured creditors, so when an exchange collapses, secured creditors are paid first, along with legal fees,” said Dustin Palmer, director. CEO of the consulting firm Berkeley Research Group. “Customers will be paid last on a prorated basis. In a typical bankruptcy, it’s pennies on the dollar.”

“Clients will likely have to wait for the bankruptcy process to be completed before receiving compensation, and bankruptcy typically lasts for years,” Palmer added. “Lehman took years. Some Mt. Gox clients, for example, still haven’t received compensation.”

Saval added that customer recoveries in bankruptcy proceedings “could be further diluted by other unsecured creditors such as sellers, lessors and plaintiffs.”

How can I protect my crypto?

Investors can choose to move their crypto from an exchange to so-called “self-custody” wallets.

This is where someone is responsible for their own private key, a secret password required to access a crypto wallet.

Such a decision, however, carries its own risks. If a crypto holder loses their private key, they may never be able to recover their funds.

There have been countless examples of people who have lost hard drives or USB drives containing crypto hoards worth millions.

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