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What happens to my funds if the cryptocurrency exchange goes bankrupt?

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Bankruptcy filings from Celsius and Voyager have raised questions about what happens to investors’ cryptocurrencies when the platform goes down.

Rafael Enrique | sopa images | Light rocket | Getty Images

Traders hoping to get their funds back from failed cryptocurrency exchanges anytime soon are likely to be disappointed, legal experts say.

Cryptocurrency trading and lending companies Celsius and Voyager Digital filed for bankruptcy this month, leaving users’ assets trapped inside their platforms. Both firms froze client accounts after a flood of withdrawals led to liquidity problems.

Celsius acted much like a bank, accepting customer deposits and lending them out or making risky bets on so-called decentralized financial products for high returns.

Voyager had a similar model. The company was embroiled in the collapse of prominent crypto hedge fund Three Arrows Capital, which itself went bankrupt after defaulting on a $660 million loan from Voyager.

This interconnection has left the crypto market vulnerable to contagion as large firms fall like dominoes as the token price collapse has eliminated excessive leverage in the system.

Is my cryptocurrency safe?

Cryptocurrencies are not regulated, which means they don’t offer people the same protection they would get with 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 hardship.

Meanwhile, the Federal Deposit Insurance Corporation is offering bank depositors protection of up to $250,000 in the event of an insured lender’s bankruptcy.

Similar schemes operate in the UK and the European Union.

Without laws governing crypto assets, there is no guarantee that investors will be able to recover their funds if the exchange freezes someone’s account or, worse, completely collapses.

“There is no such scheme at the moment,” said Daniel Besikoff, partner at Loeb & Loeb.

“It wouldn’t surprise me if one of them happens in the future,” he added. “It will reinforce calls for increased regulation.”

What happens if the exchange fails?

It’s still not entirely clear. While there are examples of cryptocurrency firms going bankrupt abroad — like Mt. Gox in Japan — such an event is unprecedented in the US.

Lenders of Mt.Gox, which went out of business in 2014, are still waiting for billions of dollars of cryptocurrency to be repaid.

According to Daniel Saval, a lawyer at Kobre & Kim, the problem with centralized crypto platforms is that they can mix funds from different clients to place risky bets. Such confusion can lead to the decision that the assets are the property of the exchange and not of the users.

“Users may be surprised to learn that in the event of bankruptcy, the cryptocurrency and funds held in their accounts may not be considered their property,” says Saval.

“Exchanges often bundle cryptocurrencies and funds from different clients in the same wallet or account.”

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What happens to clients’ funds in bankruptcy cases will largely depend on the company’s user agreement and how it has used their assets, Besikoff said.

Celsius’s terms of use state that any funds deposited with the firm “cannot be returned” in the event of bankruptcy. The firm filed for Chapter 11 protection last week, finding a $1.2 billion hole in its balance sheet and owing about $4.7 billion to users.

Celsius claims he has $167 million in cash. But it still doesn’t allow customers to withdraw their funds and is unclear as to when it will open withdrawals again.

Voyager claims that its clients’ dollars are held in an FDIC-insured account at the Metropolitan Commercial Bank in New York, a claim that has been disputed by lawyers 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 on a “fraud reconciliation and prevention process” with its banking partner, after which users will be able to regain access to their money.

Voyager also laid out a plan to reimburse users for the cryptocurrency in their accounts, Voyager shares and the company’s own token, and any debt collected from Three Arrows Capital.

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

“Investors holding crypto assets through Voyager Digital, and now Celsius, are in a quandary: their accounts have been frozen, their lawsuits remain, and the cost and timing of a refund is unknown,” Besikof said.

“They have a lot of work to do in bankruptcy court before these issues are resolved.”

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

There is a strong possibility that users of Celsius and Voyager will be treated as “unsecured creditors,” lawyers say, putting them on par with the business’ suppliers and contractors.

This means they are likely to be at the end of a long line of creditors lining up for litigation payments – banks, employees and tax authorities.

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

“In general, the majority of clients on cryptocurrency exchanges are unsecured creditors, so when an exchange crashes, secured creditors are paid first, along with legal fees,” said Dustin Palmer, managing director of consulting firm Berkeley Research Group. “Customers will be paid last on a pro rata basis. In a typical bankruptcy, that’s pennies on the dollar.”

“Clients will likely have to wait until the full bankruptcy process is completed before they receive a reward, and bankruptcy usually lasts for years,” Palmer added. “Lehman took years. For example, some clients of Mt. Gox still hasn’t received any compensation.”

Saval added that indemnifying customers in bankruptcy proceedings “may be further diluted by other unsecured creditors such as sellers, landlords and litigants.”

How can I protect my cryptocurrency?

Instead, investors can move their cryptocurrency off the exchange to so-called self-custody wallets.

Here, someone is responsible for their own private key, the secret password needed to gain access to the crypto wallet.

However, such a move comes with its own risks. If the owner of a cryptocurrency loses his private key, he may never be able to recover his funds.

There have been countless examples of people losing hard drives or USB sticks containing millions of cryptocurrencies.

#funds #cryptocurrency #exchange #bankrupt

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