What Happens If a Cryptocurrency Exchange Files for Bankruptcy?

Bankruptcy expert and Georgetown law professor Adam Levitin has just published a post on how customers would fare if a cryptocurrency exchange were to go bankrupt in the US. The short answer is badly. Cryptocurrency exchange members, often misled by the exchange itself, likely labor under the misapprehension that they still “own” the coins they’ve entrusted to the exchange. While possible legal arrangements vary, for the overwhelming majority of customers, that is almost certainly false.

I strongly encourage anyone dabbling in crypto or with friends and family doing so to read Levitin’s short and very readable piece.

The risk of exchange failure is real, and particularly so with cryptopcurrency exchanges. Brave New Coin listed 50 cryptocurrency exchanges that had gone bust in the past 11 years as of mid 2021 and warned:

Unfortunately crypto exchange failures or hacks often generate a perception that there was something wrong with the coins that got hacked. Typically, though, it is not a cryptocurrency that failed or a bitcoin failure, but instead it is basic mismanagement, outright founder criminality and/or mass government shutdown orders that are to blame.

According to Darwinist theory, failed crypto exchanges should result in the quality of the products and services of the exchanges that remain being higher than it would have been if these poorly managed exchanges had survived. As VC Marc Andresen said in a tweet soon after the now legendary MtGox failure: “MtGox had to die for Bitcoin to thrive. Its former role from early Bitcoin days has been supplanted by better, stronger entities.”

The theory goes that markets mature and get stronger through a process similar to natural selection, where bad or “unfit” services are bankrupted in one way or another, getting out of the way to make room for the good, or “fittest” services to thrive. If the theory is sound, then this long list of failed crypto exchanges should mean that the exchange sector is healthier than it has ever been – but the fact that so many exchanges continued to sink in 2020 along with all their depositor’s funds, is not reassuring.

Brave New Coin apparently missed a few rotten apples. CoinTelegraph found that 75 cryptocurrency exchanges had failed “so far” 2020….as of October 7.

Now to Levitin’s discussion of the consequences for hapless customers. Let’s start with the key point, when the exchange goes bust, your coins are almost certainly part of the bankruptcy estate, and you have to get in line with all the other creditors of the exchange to make your claim and eventually find out what if anything you get back. As Levitin elaborates:

First, the custodially held cryptocurrency is property of the bankruptcy estate—that’s the new legal entity that springs into existence upon the filing of the bankruptcy…

But wait, you bluster, the custodial agreement clearly says that I am the owner, that it’s my property, that I retain title to it. Yup, but that’s not how the law actually works. Just because they wrote that doesn’t mean it’s true.

For starters, the idea of “ownership” is a little more tricky. It’s not a binary concept in law. Legal thinking generally conceives of ownership as a bundle of sticks, and the sticks can be separated and doled out to different folks. For example, I might “own” an estate called Blackacre, but I can rent the back 40 to you, lease the westfold to your cousin, give you brother fishing rights in the stream, your sister an easement to cross the forest, and the bank a mortgage (that’s a contingent property interest). I still “own” Blackacre, but lots of other folks have property interests in it. Same story with crypto….

At the very least, the cryptocurrency exchange has a possessory interest in the cryptocoins. If that’s all there is, you might get your coins back, but it won’t be immediate or automatic, and you won’t be able to trade in the interim.

Things get much worse, however, if the exchange has any right to use the cryptocurrency—to rehypothecate it or to use its staking rights—that too is property of the estate. Not to pick on Coinbase, but under its staking arrangement it gets a 25% “commission” on any staking rewards and it indemnifies the customer for any slashing losses. The shared gains and internalized losses sure looks like an investment partnership there.

But even if the exchange can’t use your crypto in any way, things could still be bad. If the exchange can commingle customers’ coins and is not obligated to return a specific cryptocoin (e.g., #25601), but just a cryptocoin—and that’s typically how this works—then the entire cryptocurrency deposit, root and stem, is property of the estate.

The situation is no different than with your bank account—you have a general deposit—an unsecured claim for a dollar value, rather than a right to specific bills, as you would with a specific deposit in a safe deposit box. Put in fancier terms, if the obligation isn’t to return the same or altered/improved good, then it’s not a bailment, but a sale, which makes the crypto property of the debtor and the customer a creditor.coins and not others.)

Levitin goes on to explain that the cryptocurrency being part of the bankrupt estate means you as the customer are subject to the “bankruptcy stay”. All creditor claims, such as your “I want my money back!” are frozen until the court sorts things out. Creditors might petition the court to lift the stay but it would take time, cost money, and unless the exchange had only a custodial interest in the cyptocurrency, probably not work. Levitin also describes why the long list of exceptions to the automatic stay aren’t operative with cryptocurrencies.

Oh, and it gets worse:

Not only are the customers likely mere creditors, but they are also likely general unsecured creditors, which means they will have to wait at the back of the line for repayment with everyone else. They will share on a pro rata basis whatever assets are leftover (if any) after the secured creditors and the priority creditors (including the expenses of running the bankruptcy) get paid, and any payment might not be for quite a while. That’s not a happy to place to be. Recoveries could be pennies on the dollar…

What’s worse for the cryptocurrency exchange’s customers, is that their claims will be for the dollar value of the coins as of the date of the filing of the bankruptcy, so any future appreciation will go to the debtor and thus be available to first to repay higher priority creditors.

Even more fun, you might be subject to a clawback if you were a customer of the exchange and made an unusual-looking withdrawal before the collapse:

Once in bankruptcy, the cryptocurrency exchange can clawback certain pre-bankruptcy transfers, like redemptions by its customers as voidable preferences. If the transfers were made to unsecured creditors in the 90 days prior to bankruptcy, they are preferences. The only issue is whether an exception or defense applies. The only obvious exceptions would be the de minimis amount exception or the ordinary course exception, but the ordinary course exception requires that the withdrawal be made in the ordinary course of the customer’s business, not just the exchanges. Does the customer generally withdraw its funds? There’s some risk here.

In case you haven’t noticed, the idea that you as a cryptocurrency exchange customer are somehow safer in the Wild West of cryptobroland than in dealing with bank and securities firms is bunk.

And remember a key point from Levitin: the customer agreements can’t be relied upon to describe your rights or protections accurately. Caveat emptor.

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  1. Larry

    Thanks for the share and excellent summaries. Sharing with all my crypto curious contacts. I seriously doubt anybody reads the agreements on these accounts nor understands how bankruptcy proceedings of an exchange can harm them. I don’t have a sense of how much money the crypto curious are putting into this. Is the average punter just putting in $100 to mess around with it? My brother-in-law is in that category.

    1. Yves Smith Post author

      I have no idea about amounts of “investments” or their distribution. Treating it as a something to dabble with, either for amusement or to be able to talk to cryptobros without being much exposed, is on the order of a cheap hobby, like taking a cooking class.

      But the big point here is that the agreements routinely mislead customers. You see that in a lot of walks of life. In NYC, rental agreements often assert rights the landlord absolutely does not have, like trying to forbid taking in a roommate. Another one is some merchants say “No returns.” They can’t assert that if they accept credit cards. The merchant agreement allows the buyer to return the product for bona fide reasons that are spelled out in the Visa and Mastercard merchant contracts, like it is defective or what was delivered was not what you bought. You send it back to them and put in for a chargeback and they have to honor it.

    2. Tom

      I would estimate 80% or so are very small – a couple hundred dollars or less. It scales exponentially from there with the top 1% having tens of millions. The distribution looks pretty similar to traditional wealth – with the caveat that “whales” will typically self custody or use multiple exchanges and custody solutions rather than rely on one provider so it won’t show up the same way in exchange assets. If they do use a single provider it will be an actual custody service rather than an exchange ((Coinbase and Gemini dedicated custody solutions typically).

    1. Yves Smith Post author

      An exchange is never never decentralized. There has to be at least a central ledger to accumulate and match buy and sell orders.

      The fact that these exchanges takes fees from the “trading pool” means information about the token has been given to the exchange and a court can get that too. Fer Chrissake, how do you get $ or other coins unless you have told the exchange who you are??? Please think about the mechanics rather than falling for cypto magic speak.

      I stopped with the first one because the marketing claims are bullshit. See the bolded language. If your coin has gone into a “trading pool” you most assuredly have surrendered ownership:

      Uniswap is a decentralized exchange operating on the Ethereum blockchain. It allows for instant swaps of any ERC-20 asset with one click trades. It is trustless, permissionless and operates on the back of underlying liquidity pools. These pools allow anyone to create a market by supplying two underlying tokens. In return they receive a 0.3% trading fee anytime the trading pair is used. Uniswap does not have its own token meaning users receive their fees in the form of the assets they provided to the pool.

      This could not be more clear. It’s a transfer from the owner to the pool.

      The IRS also started a crackdown last year. It’s still a bit rough but the big part is it will be pretty much impossible to spend crypto on anything legit in the real world without waving a big red flag in front of the IRS:


      1. bold'un

        From the link:
        “In general it is a simple process to make a trade, you pick the asset you want, and the asset you want to trade for it, follow the steps that generally involve you sending your assets to a smart contract and picking a destination wallet address, and it takes care of the rest. Your new assets are deposited at the address you chose.”

        AFAIK, you would be at risk for the duration of the transaction, but not before or after. Clearly when you first exchange USD for crypto you are visible, but thereafter you can do crypto1/crypto2 swaps to hide your tracks. Crypto1 may be traceable and Crypto2 may be traceable, but I doubt the swap is so traceable, say if it is included in a many-to-many settlement. If I do a swap today and next week the exchange goes under, it is not clear to me that there is any reversal required, just like a bankrupt bank would not revisit recent Forex transactions.

        1. Yves Smith Post author

          The text does rebut anything I said and in fact proves it. You have to expose the coins you want to trade and your identity to the central ledger operator to effect the trade. If you trade and the ledger owner goes BK, you are exposed to clawback.

          1. sawdust

            A few important clarifying points on Uniswap, since there appears to be confusion on both sides here. These statements do not apply to Coinbase, which is more classically a centralized orderbook.

            From a KYC perspective:
            Neither Uniswap Labs (the company) or Uniswap protocol/pools (the system of smart contracts that govern the trading pools) KYC anyone. Anyone who uses Uniswap contracts will expose their wallet address to everyone because they will record a transaction on the blockchain for anyone to see. You may also expose your IP address (and browser info, etc.) to Uniswap Labs if you choose to access the protocol through their website. Most people do use their website because it has a nice interface but you do not have to (I can talk directly to the smart contract or use a different front end).

            The KYC happens when I onramp or offramp my crypto into Coinbase. I KYC when I send my money to coinbase. They will send crypto to a wallet on my behalf (if I ask) but they know my identity is associated with that crypto wallet address and anyone can see what that wallet does. I could choose to wash that money and anonymize it if I wanted. Coinbase would know I have anonymized the funds by sending to an intermediary which would then move the money to another wallet but no one can figure out which wallet my crypto went to. Doing this with smaller amounts of $ is quick/easy, its harder and longer with more $. Throughout Europe and probably other regions I understand there are ways to exchange cash for crypto without KYC.

            From a trading perspective:
            A pool on Uniswap is not matching buy and sell orders; there is no such thing as a limit order. It’s not an exchange, it is a liquidity pool (called an automated market maker). A pool on Uniswap holds 2 assets. If you have one of those assets you can swap that asset for the other asset. You must take the current ratio the pool is offering. If you exchange a lot of one asset, the pool will become lopsided (hold much more of one asset than other) and the algorithm will change the swap ratio in an effort to incentivize reversion to the 50/50 balance.

            To provide liquidity you must deposit both assets in equal amounts into the pool. Then you get a ‘pool token’ saying that you hold so many ‘pool units.’ That is essentially an IOU on the tokens in the pool. At any time you can redeem the underlying two assets. But this is backed 1 to 1 by the underlying tokens. And Uniswap Labs can’t take that away or get in the way of redemption because redemption is controlled by computer code on the blockchain. That is the decentralization part. They aren’t even the ones that issue the IOU. The blockchain contract is. You could see in my wallet that I’m holding some ownership in the pool (the IOU token) without ever needing to see the transaction. When someone trades into ‘your’ pool they aren’t trading with one person specifically but rather with the entire pool. Providing liquidity in a pool would slowly lose the provider money without incentives (i.e. there is a reason traditional exchanges are not set up this way, it is inefficient). So there’s a small fee collected each time someone uses the pool (the 0.3%). That fee is distributed pro-rata to pool IOU owners. If Uniswap Labs were to go bankrupt or be compelled by an entity to cease operations, Uniswap Labs could not ‘drain’ the pool and take custody of the pool assets. Because the computer code does not allow this. The pool was designed to work a certain way with computer code, and we can verify what it is capable of doing by examining the code. They (Uniswap Labs, IRS, etc.) could shut down their website, but I could still withdraw my funds. Of course, I could be under a legal/tax obligation to send the funds somewhere but I’d have to initiate that transaction. And unlike Coinbase, these assets are backed 1 to 1 by what they represent. Coinbase can tell me I hold crypto without it being true (just numbers in a database backed up by nothing) – Uniswap pools do not.

            1. Yves Smith Post author

              Thanks for the additional detail but Adam Levitin is not persuaded. Via e-mail:

              If there’s no custodial holding, then there shouldn’t be any clawback risk. How these P2P exchanges actually work isn’t so clear to me, especially in regarding to payment clearing. If I am selling you Bitcoin for payment in cash, there are different clearing times. Unless there’s an escrow that we both trust, one of us could just steal from the other. Likewise, even with crypto-to-crypto trades, the clearing isn’t at the same speed, so I’m not sure quite how this works. I know there are escrow services, but I don’t know their operational details (or why anyone would trust them any more than they’d trust someone else).

              The KYC point is kind of key—it’s very hard to convert crypto to fiat without going through a centralized exchange like Coinbase, and that does create exposure to clawbacks. Now if you’re hold and use an unhosted wallet, you should be fine, just don’t lose your key.

              The trading perspective point below. I don’t know if I follow it all, but that should say a lot. These are Rube Goldberg solutions, and there will surely be problems that someone hasn’t seen. But even if your correspondent is right, yes, he’ll be able to withdraw the funds, but that’s not the end of the story. Those funds could still be clawed back as a preference (the whole pool token all but guaranties that the underlying crypto assets are property of the bankruptcy estate), and more immediately he would be subject to a turnover order from the bankruptcy court (assuming he can be identified). Fail to comply with that and you’re going to be sanctioned, and that could even mean jail time until you comply.

              Courts are going to need to figure out how to deal with smart contracts and decentralized organizations, but my money is on the Leviathan, not the cryptos.

              fwiw, I think a big part of the Coinbase business model is built on arbitraging mining fees based on their economy of scale. The cost of mining doesn’t depend on the transaction size. A $1 transaction is the same as a $1 million transaction. So if there were 1,000 separate trades, there’d be 1,000 separate mining fees. But Coinbase, by commingling its custodial holdings, is able to combine transactions, thereby reducing mining fees. And for transactions it can execute “on-us,” there’s no mining necessary. It’s all on Coinbase’s ledger, not the blockchain. But Coinbase is still going to charge its customers as if there were a mining fee based on the prevailing fee rate, rather than on what it actually has to pay to execute the transactions.

              1. sawdust

                That mostly makes sense to me with respect to legal side of things. FWIW there’s still a lot of misconception here about how clearance ‘must’ work on a network like ethereum based on legacy finance heuristics but that’s tangential to the overall points. You don’t need escrow or intermediate custody. The trade happens if both people simultaneously swap the assets they promised, and doesn’t if one party doesn’t pony up.

                We’ll see how the political and legal struggle plays out. VC firms are pretty heavily invested across the board, particularly a16z (tens of billions) so I try to be careful to characterize cryptos as unaware or unwilling to buy the regulation they need. Maybe it;s more leviathan vs behemoth. Not saying this is good (it’s mostly not) but I’m personally not picking a winner yet.

                1. Yves Smith Post author

                  You can’t simultaneously swap. There are time lags. HFT is profitable due to infinitesimally small time lags. And you can’t have the exchange take its cut unless they intermediate. You have no way to force payment of the fee otherwise.

                  And I never said anything about regulation. This post is about risks in bankruptcy, which is completely separate matter from regulation (remember the purpose of the BK court is to tear up legal agreements and come to an equitable financial settlement of what is left in the bankrupt estate). And VCs are very inattentive to that. But other readers have pointed out that crypto operators are finding they are having to reinvent the wheel, that the way securities and banking transaction processes work the way they do are the result of decades, even centuries, of having to build in protections.

      2. Tom

        Uniswap and other decentralized exchanges operate very differently from centralized exchanges like Coinbase. I haven’t dug into to bankruptcy mechanics on Uniswap and others but I will this morning. With that said, there is no order book and the decentralized exchange does not actually have possession of tokens supplied to pools via smart contract. Practically speaking, I don’t think a bankruptcy court could clawback tokens from a bankrupt decentralized exchange – they wouldn’t be able to find most customers since they interact as anonymous wallet addresses. It’s also worth remembering that users of decentralized exchanges are far more aware of risks of crypto and need to have baseline knowledge of crypto to access them in the first place.

        The analysis on bankruptcy for centralized exchanges is exactly right. With that said, there is no reason for a small(ish) retail user to use anything but the top five centralized exchanges. And the risk of any of them seeing bankruptcy is very very low.

        1. Yves Smith Post author

          The “trading pool” mechanism and the collection of fees belies what you say. The exchange takes possession to extract the fee. You and I both know “honor system” for payment of transaction fees exists nowhere in finance.

    2. Mikel

      It’s not decentralized OR “democratized”.

      I heard a friend on a group call with a crypto seller. Reminded me of MLM schemes.

  2. Mak

    A good article.

    It boggles the mind that any cryoto holders would store their holdings in a custodial way with an exchange. The one advantage of crypto ( if there was one) is the ease in which you can digitally hold possession of the ‘asset’.

    Back in October I eventually got around to digging up my backups and finding my loose Bitcoin change that I had literaly left on my digital desktop. The ease in which I could store the digital ownership neglected in offline storage for six years cannot be understated. An exchange and custodial ownership only makes sense for the naive or day traders. It is all a con otherwise.

    I made an 100 fold ‘profit’ on my loose change but 100x $20 isn’t that amazing.

    1. Yves Smith Post author

      Yes but people like me worry about devices failing (not that I would do crypto, but I agree that if the logic is anonymity, WTF an exchange or a wallet?). I’ve had more than one hard disk crash where my backup disk, even though backed up regularly, had bad areas and I lost data. And I don’t trust “the cloud” as a de facto journalist, and I would imagine hard core crypto types might be leery too (although many are likely hard core techies and have more robust physical backup methods).

      1. Tom

        Device failure doesn’t lead to loss of crypto funds. Always remember that your funds are technically not stored on the device. Your funds are stored in the blockchain, which is accessed using your device.

        As long as you’ve backed up your 24-word recovery seed correctly, you can simply purchase a new hardware wallet/device and input in your recovery seed, giving you back access to your funds.

        1. Yves Smith Post author

          Oh, come on, that is pure sophistry. Even I know that is bullshit.

          If you lose you device with no backup, you lose your key. My fact set was death/corruption of backup. Plenty of stories of people tossing devices with lots of valuable coins on them and suffering total losses.

          1. Some Guy in Shanghai

            Wallet files are stored on devices, but your wallet address exists irrespective of any single piece of hardware. With Bitcoin, at least, you can simply write down your private key and/or recovery phrase on a piece of paper and recover your address on a different piece of hardware. If it were as awful as you say, nobody would use a smartphone wallet app.

            Paper wallets are one of my favorite parts of crypto (though I remain skeptical about the actual social value of this technology)

            1. Yves Smith Post author

              No, there are multiple types of wallets and hosted wallets are the most popular. Do not Make Shit Up.

              Burying cash in a sturdy waterproof can in your backyard is way way way more secure than relying on passwords written on pieces of paper. I can’t believe adults are arguing this is a reasonable way to secure anything of real value.

      2. Jose Freitas

        This may be a completely stupid question (I don’t have crypto and don’t plan to for now), but is it possible to have a paper backup? The codes or whatever they are called. Does it work that way?

          1. Tom

            As long as you have the recovery phrase (which can and should be kept on paper) you can recover crypto after a device failure.

            1. Young

              Can a catastrophic event, like a global network outage that lasts days, collapse the entire infrastructure that holds the blockchain? If so, is recovery possible?

              1. Tom

                It would be recoverable once the network reconnected in that scenario. As long as every computer with a record of the blockchain data was not permanently lost it could be recovered.

  3. Mikerw0

    I am beginning to think, not fully formulated, that Crypto is analogous to the wonderful world of CDS. An interesting form of regulatory arbitrage. On the one hand, the argument is that Crypto is a “perfect” form of money, free and independent of governments (the CDS analogy is that these are derivative contracts and free from insurance regulation). Yet, when there is a problem these should have all the rights and protections of a tradable security (the CDS analogy being these are actually insurance products and should function as such when needed despite in many cases there isn’t an insurable interest).

    CDS got inflated into a big bubble that popped. Too many people were making too much money by skimming on the transactions to stop the party; e.g., rating agencies, KMV, big banks, etc. They became an asset class in their own right — for which nothing could go wrong.

    1. Phichibe

      I’ve the same sentiment wrt CDSs and Crypto. Were I a regulator I’d look into two things in particular: 1) the re-hypothication of crypto coins and 2) the mingling of crypto assets in the latest version of CDO Squared products a la the way Wall Street used CDSs in CDO^2 before the Global Financial Crisis. We know that crypto “investors” have been borrowing against their coins (hypothicating/mortgaging) to buy more coins. How much of the 50% collapse in crypto has been driven by margin calls? The question of title to coins in bankruptcy only raises the uncertainty, and as we all know Mr. Market doesn’t like uncertainty, especially when the manure hits the fan. Likewise, with CDO^2 as we saw during the GFC. Now imagine trying to sort out the value of the tranches of a CDO^2 when a significant amount of the underlying assets when these include illiquid crypto?

      I personally think crypto is the CDS of the next financial crisis. Go long cash.



  4. FreeMarketApologist

    As several other journalists & writers have said, crypto has been slowly re-inventing all the methods of creating, using, and storing cash and security products. In the examples given here, they’re clearly not up to speed on the methods of ownership and custody, and the set of protections that should be considered when holding assets for customers.

    There’s a well defined list of requirements in securities and banking regulation that brokers, banks, and other custodians have to follow if they’re holding customer property (e.g., segregation of funds, capital requirements, etc.) and the crypto world is learning just why those rules exist, and why customer agreements are worded the way they are. Since they chose not to build on established governance frameworks, and code is not actually law, there’s going to be a lot of money lost learning the lessons of previous generations.

    1. Tom

      I have a comment stuck in moderation on this, but there’s no reason for anyone other than an arb trader to use any centralized exchange outside the top 5. Or any exchange that isn’t licensed in New York, which has legal requirements for how and where assets are custodied and how they can be used. The New York regime obviously draws heavily on securities regulation precedent.

  5. someone

    I think its safe to say that majority of post-2019 crypto-investors are generally ill-informed on crypto PERIOD. They are the proverbial tourists in a foreign land; not the backpacking adventurer but the senior-citizen on a all inclusive bus-tour type.

    Their obliviousness to the risk and realities of exchange-based crypto is just par for the course.

  6. Matthew G. Saroff

    You know, this is almost word for word Alan Greenspan’s argument against regulation:

    According to Darwinist theory, failed crypto exchanges should result in the quality of the products and services of the exchanges that remain being higher than it would have been if these poorly managed exchanges had survived. As VC Marc Andresen said in a tweet soon after the now legendary MtGox failure: “MtGox had to die for Bitcoin to thrive. Its former role from early Bitcoin days has been supplanted by better, stronger entities.”

    That worked out so well in 2008.

  7. Susan the other

    Isn’t a crypto exchange bankruptcy the same as a busted counterfeit currency ponzi. Can’t think of an analogy of how to resolve a pile of non-assets. Shoveling out the crypt? This makes absolutely no sense to me whatsoever.

    1. Thomas P

      Just because a crypto exchange go bust doesn’t mean that the underlying crypto currencies do, anymore than a bankrupt US bank means the dollar is bust.

  8. Greg S

    Whenever you give your property to another party for safekeeping, there’s always a chance, however small, that you will not get it back as given. Corollary – know the party you are going to do business with. If a lot is at stake know them very well.

  9. Bill Carson

    Here’s my take on crypto and NFTs: The rich have *so* much money that they are investing in assets made out of thin air. And they want *you* to invest, my fellow 90%er, because they make money when there is increased demand and prices rise.

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