Coinbase Customer's Crypto Could Be at Risk if It Goes Bankrupt

If you keep your crypto on a centralized crypto exchange, you could lose your assets.

It's been a crazy week for crypto investors. So much so that you may have missed a warning hidden in Coinbase's quarterly results. The popular cryptocurrency exchange said if it goes bankrupt, customers' crypto could be at risk.

Like many crypto platforms, Coinbase offers a custodial wallet service. This lets users leave their digital assets on the exchange rather than moving them to an external crypto wallet. However, according to the Coinbase filing, if the company goes bust those assets could be subject to bankruptcy proceedings.

"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," it said.

It would mean Coinbase customers had to get in line behind other creditors in order to recover their own cryptocurrency assets -- funds they'd deposited on the platform. In contrast, money deposited with a bank is protected by FDIC insurance for up to $250,000 per eligible account.

Custodial vs. non-custodial wallets

There's a lot of debate in the crypto world about custodial and non-custodial wallets. A custodial wallet means assets remain on a centralized platform. The investor does not control the private keys to their crypto -- like a bank account PIN. If the platform gets hacked or for some reason closes down operations in your country, your crypto could be at risk.

Moving your funds to a non-custodial wallet gives you total control over your assets. It means there's no risk of losing your funds in the event of a crypto platform hack or collapse. It would also mean your crypto didn't get tied up in a centralized crypto company's bankruptcy proceedings. Earlier this year, Kraken CEO Jesse Powell advised users to move their funds off centralized exchanges, but for different reasons. He was concerned that law enforcement officials could force crypto exchanges to freeze certain accounts. 

It's worth noting that Coinbase has its own non-custodial wallet called Coinbase Wallet which would not be impacted by any bankruptcy proceedings. There are several different types of non-custodial crypto wallets, each with their own pros and cons. Broadly speaking, they divide into hot wallets, which are connected to the internet, and cold wallets, which are kept offline. Cold wallets are more secure and often physical hardware devices that can be bought for as little as $50. Hot wallets are things like MetaMask that you install on your browser, or a mobile wallet that's installed on your cell phone. 

Nonetheless, some investors prefer custodial wallets because they don't want the responsibility of securing and managing their crypto. Becoming your own bank is not as simple as it may seem. When you move your digital assets to an external crypto wallet, there's no handy 'forgot password' button as there is on a centralized exchange. If you forget your master password or seed phrase, or lose access to your wallet in another way, you may not be able to get your crypto back. Indeed, billions of dollars worth of Bitcoin (BTC) are stuck in inaccessible crypto wallets.

Should Coinbase and other crypto exchange customers be worried?

Coinbase CEO Brian Armstrong reassured customers on Twitter that the company wasn't in any danger of going bankrupt and that their funds are safe. "We have no risk of bankruptcy," he said. "For our retail customers, we’re taking further steps to update our user terms such that we offer the same protections to those customers in a black swan event." 

Coinbase's quarterly results come the same week that Terra's decentralized finance ecosystem collapsed and Bitcoin hit a 16-month low. To be clear, Coinbase is a very different product from Terra. Unlike Terra, Coinbase is a centralized crypto exchange that's listed in the U.S. and regulated by the SEC. Nonetheless, Terra's collapse is a stark reminder that there's very little in the way of protection for cryptocurrency investors in the event of platform failure, and that even seemingly established players can fail.

Coinbase has to be transparent about these types of risks because it is required to do so by the SEC. Other platforms are not listed companies and don't have to come clean. If your crypto assets are in a custodial wallet with Coinbase or another crypto platform, it's worth researching what protections are in place for your funds. For example, some platforms have third-party insurance against hacking, but it isn't clear what would happen if the platform collapsed. Personally, I've already emailed the crypto exchange I use most to ask what would happen if it went bankrupt.

Bottom line

Ultimately, the best way to protect yourself would be to move funds into an external crypto wallet. However, this won't suit every investor. If you aren't confident of keeping your password and seed phrase safe, at least make sure you understand and trust the custodial services you're using.