Report: Bankruptcy Law Can Be Unclear When Crypto Custodians Go Belly Up

A paper recently published by the Law Faculty of the University of Oxford examines the legal risks of depositing cryptocurrency with custodians in the event of insolvency. The paper, featured in a June 1 blog-post by the faculty, also suggests ways that regulation and practice can help to mitigate this risk.

Disintermediation failed

Cryptocurrencies were initially created as a way to be free from the interference of governments, banks and other intermediaries. However, the reality is that a large proportion of Bitcoin (BTC) and other cryptocurrencies is currently held through custodians such as exchanges, rather than by investors themselves.

This creates significant risks related to the possible insolvency of these custodians, and the rights of customers with regard to their held assets in such an event. Exchange insolvencies are common, and it can take years before customers find out what will happen to their funds.

Determining jurisdiction

The paper states that customer rights ultimately depend on the applicable insolvency and property law. However a lack of international standards related to the legal status of cryptocurrency, along with the global nature of blockchain-based transactions, can make it hard to determine which laws apply.

Ideally, the paper suggests, priority would be given to the contractual law agreed between custodian and customer, with local law applying at the custodian’s place of corporation serving as a fallback. So a custodian’s terms and conditions should be essential reading before depositing or purchasing tokens.

Pooled funds or segregated addresses

Cryptocurrency custodians generally store customer assets in one of two ways: a pooled blockchain address, or segregated blockchain addresses. The former option presents a greater risk, as it makes it more likely that the individual tokens originally deposited by or allocated to a customer will be used for the benefit of another customer.

This can often be crucial in regaining assets in the case of insolvency. If individual assets can be proven to still reside at the blockchain address of the custodian, the customer has a far greater claim to those assets in most circumstances.

Again, information on how deposited tokens may be used should be clear from a custodian’s documentation.

Regulation on re-use could protect customers

The paper also suggests that regulation prohibiting or limiting the re-use of customer assets could further protect customers in insolvency situations. Again, holding funds in segregated addresses presents less risk that such regulation is violated.

Such regulations already exist for traditional investments held for customers by brokers or intermediary firms, which must:

“Make adequate arrangements so as to safeguard the ownership rights of clients, especially in the event of […] insolvency, and to prevent the use of a client’s financial instruments on own account except with the client’s express consent.”

Some custodians may already follow such recommendations. So ultimately, according to the paper, the safety of your tokens with an exchange or custodian depends largely on your due diligence in choosing which one to use.