The stock market is having a rough year so far, with the Nasdaq 100 technology index officially in a bear market, having declined 30% from its all-time high. Cryptocurrency markets have fared even worse, with the collective value of all tokens falling 58% since the November 2021 highs.
But, oddly enough, a drop in prices isn't the only risk facing crypto holders. In fact, a greater risk could lie within the brokerage platforms investors trust to hold their tokens, and it stems from the crypto markets' decentralized, unregulated nature that has made them so popular in the first place.
Here's why investors must pay close attention to the financial health of their crypto exchange of choice.
Minimal regulation equals maximum responsibility
Popular cryptocurrency exchange Coinbase (COIN -1.71%) just released its first-quarter 2022 earnings report, and there is an interesting (and scary) disclaimer buried on page 83 of its 10-Q regulatory filing. It begins by warning investors that the company is unable to obtain insurance to protect its customers' holdings:
"As of March 31, 2022, we held $256 billion in custodial fiat currencies and cryptocurrencies on behalf of customers. Supported crypto assets are not insured or guaranteed by any government or government agency."
It effectively means that in the event of a hack, loss, or other negative event at Coinbase, the company may not be able to recover the cryptocurrencies it holds on behalf of its clients. That leaves the customer at a complete loss and is something I've mentioned a few times when writing about Robinhood Markets (HOOD -1.55%), which has issued similar warnings.
But it gets worse. In the event Coinbase goes bankrupt, its clients' cryptocurrency assets may be recognized as the property of Coinbase:
"Moreover, because 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."
Unsecured creditors are treated as entities that have written loans to Coinbase without the benefit of security (assets) as protection. In the event of bankruptcy, an unsecured creditor effectively takes whatever is left (if anything) once secured creditors are repaid.
Therefore, customers are not only subject to external market and cybersecurity risks, but if Coinbase fails due to poor management or inability to generate a profit, they also stand to lose their holdings.
Is this any different from cash in a bank account or stock holdings?
Yes, significantly. Cash in U.S. banks has automatic protection under the Federal Deposit Insurance Corp. (FDIC), up to $250,000 per customer per bank. The FDIC is an independent government agency, and therefore, that money is effectively guaranteed by the U.S. federal government even if a financial institution enters bankruptcy.
Wealthier customers with more assets can seek further protection from tools like a MaxSafe account, which covers up to $3.75 million. The point is that alternative options are readily available, whereas it's near impossible to get the same coverage for cryptocurrencies.
As for stocks (shares in public companies), brokers are required to keep these client assets in separate accounts in accordance with strict regulations so that if they go bust, the assets can simply be transferred to another brokerage firm.
In the unlikely event of negligence or the misappropriation of client assets, the government's Securities Investor Protection Corporation (SIPC) covers up to $500,000 worth of securities per client. The client doesn't even need to be a U.S. citizen to recover funds from an SIPC-member firm.
Regulation might not be such a bad thing after all.
How to protect cryptocurrency holdings
Be vigilant and understand what happens when a cryptocurrency broker faces financial hardship. Coinbase only has $3.3 billion in long-term debt as part of its $14.4 billion in total liabilities, so the risk of wiping out $256 billion in client assets in bankruptcy is relatively low. But partial losses would be a reality, and in the event of a hack, a total loss is entirely plausible.
That's why storing crypto online with exchanges like Coinbase or Robinhood is one of the riskiest options.
A much safer way is to use cold storage. This involves buying a USB-like hardware device designed to take cryptocurrency holdings offline entirely, protecting them from potential hacks -- and, more importantly, taking them out of the hands of the exchange. Cold storage devices can cost a couple hundred dollars, and they're far less convenient when regularly buying and selling crypto tokens, but that's the price of top-tier security.
It's no secret some of the enthusiasm has evaporated from cryptocurrency markets. Coinbase, for example, experienced a 35% year-over-year decline in revenue during Q1 2022 and a blowout loss of $439 million. Its stock has also collapsed 86% from its all-time high.
Robinhood is in a similar position, consistently losing users and revenue, leading to a stock price collapse of 90% from its all-time high.
The long-term viability of these businesses might be something to consider when choosing to store valuable cryptocurrency holdings with them.