Coinbase Global (COIN -2.88%) is a gateway to the cryptoeconomy. It provides a number of financial services to retail traders and institutional investors, but its platform is best known as a cryptocurrency exchange. Coinbase supports the buying and selling of 166 crypto assets, and it offers custodial wallet services, meaning investors can store those assets directly on the platform. That's certainly convenient, but is it safe? Investors should understand the risks associated with custodial wallets before making a decision, as a relevant disclosure Coinbase just added to its regulatory filings makes all too clear.
Investors could become unsecured creditors
On May 10, Coinbase filed its latest Form 10-Q with the U.S. Securities and Exchange Commission (SEC). In the section titled Risk Factors, the company disclosed the following information:
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.
What does that mean? In the event of a bankruptcy, investors could lose their crypto. Coinbase would liquidate any assets on its platform to repay its secured creditors. After that, if there was any money left, unsecured creditors (like you) would be next in line.
That disclosure underscores the problematic lack of regulation surrounding the crypto industry. If a traditional brokerage firm filed for bankruptcy, the company wouldn't be able to touch securities held on behalf of its customers. Your stocks' safety would be guaranteed. But the same protections have not yet been extended to investors on crypto trading platforms.
So here's the question: What are the odds of a bankruptcy?
Bankruptcy is unlikely, but possible
At the end of the first quarter, Coinbase had $6.1 billion in cash and equivalents on its balance sheet, compared to $3.4 billion in long-term debt. That puts the company in a fairly strong financial position, which makes bankruptcy unlikely. CEO Brian Armstrong recently expressed the same sentiment on Twitter, assuring investors that their funds were safe at Coinbase, and that there is "no risk of bankruptcy."
However, credit rating agency Moody's slapped Coinbase's debt with a junk bond rating, citing regulatory uncertainty and crypto market volatility. Specifically, Coinbase generates the vast majority of its revenue through transaction fees, which are assessed based on the value and quantity of the asset being bought or sold. That means a prolonged crypto market crash could hammer Coinbase's revenue and significantly boost its risk of bankruptcy.
Fortunately for investors worried by that possibility, there are alternatives to custodial wallets. For instance, self-custody software wallets like MetaMask or Coinbase Wallet give investors complete ownership of their crypto assets. However, self-custody wallets are typically secured with a 12-word recovery phrase. If you ever lost or forgot that phrase, your cryptocurrency would be effectively be gone.
Is your cryptocurrency safe on Coinbase?
Investors have no reason to panic. Yes, storing assets in a custodial wallet comes with some risk, but Coinbase has a fairly strong balance sheet and it has historically been quite profitable. Additionally, the company has invested heavily in cybersecurity, and it has never lost customer funds because of a breach. From that perspective, your cryptocurrency seems relatively safe on Coinbase.
However, every investor and every situation is different, so the right answer depends on the person. If your decision to store crypto on Coinbase keeps you awake at night, consider making a change.