Some investors and financial advisors were stunned in recent weeks when one of the oldest and most trusted providers of exchanges and custodians for digital assets announced that it may not be as safe as they once thought.
In addition to announcing a large profit loss, Coinbase warned its users last month that they would have no protection from liability in the event of bankruptcy, which could put nearly $256 billion in investor assets at risk.
"The crypto assets we hold in custody on behalf of our clients could be subject to bankruptcy proceedings," the company said in its first-quarter earnings report.
Advisors should understand that the announcement was much ado about nothing for many die-hard cryptocurrency investors. Most dedicated crypto enthusiasts hold their own assets and only temporarily invest tokens on an exchange like Coinbase. But many newcomers to digital assets prefer the relative ease of holding their tokens where they bought them, just as they would buy stocks and funds through an online broker.
Coinbase's announcement is a reminder that digital custodians are not comparable to brokers and banks in the traditional financial industry and cannot offer investors the same protections as incumbents - yet.
The issue of regulation
"I think that's largely because we don't yet have regulatory clarity around custody of digital assets," says Marcel Kasumovich, head of research at One River Asset Management, an institutional digital asset manager. "Regulators haven't taken the time to revise their rules yet because this asset class has gone from nothing to something relevant in a very short time."
A bank account is protected by the Federal Deposit Insurance Corp. for deposits in checking, savings and money market accounts and certain certificates of deposit worth up to $250,000. A traditional investment account is protected up to $500,000 by the Securities Investor Protection Corp. which covers stocks, Treasury bills, corporate bonds, certificates of deposit, exchange-traded funds, mutual funds and money market funds. To date, there is no analogous insurance for digital assets.
According to Kasumovich, it's even uncertain what exactly would happen to crypto assets if an exchange or custodian files for bankruptcy.
"We don't know for sure what happens to assets in custody because we don't have final guidance yet," he said. "Coinbase has done its duty by disclosing that there are no safeguards in place."
Coinbase has publicly stated that it is not at risk of filing for bankruptcy. However, in a scenario where a Coinbase-like company files for bankruptcy, a court will have to figure out which assets go to which creditors.
In some previous bankruptcy cases, assets that were clearly defined and allocated to people not associated with the bankrupt company could sometimes be protected from creditors, Kasumovich said.
"If I, as an individual, owned assets that were separate from that business and were known to be mine, especially if they were stored somewhere, such as in a cold-storage wallet with specific addresses on the blockchain that identified me as the owner of those assets, it would be really strange if those known assets were assigned to a creditor funding another line of business," he said. "In such a case, I would technically be assigning Coinbase or whoever to take care of my keys and all these other things, but when I log in, I would see my account and my place in the chain. You couldn't just say that because of a bankruptcy in a common core business, my assets now belong to Goldman Sachs or some other creditor."
While there is little previous case law to draw on, Kasumovich said a court would likely recognize that a person's crypto holdings, identifiable on the blockchain, are separate from those of the exchange or custodian.
"Ultimately, we will get clarity on how digital assets fit into the commercial code and what it means to be a custodial institution, both in the context of the Advisers Act, the custody rule and the Federal Reserve," he said. "All of these things are transitional. It adds to the uncertainty, but it's just a bridge to integrating digital into the financial regulatory mainstream.
In the meantime, advisors and investors should pay close attention to the specifics of custody - who is holding their assets and where exactly those assets are being held.
Under current laws, self-custody may be the safest way to hold digital assets, Kasumovich said. However, if investors want to keep their assets in an exchange or other type of digital custodian, they should look for services that operate in New York State or somewhere with similar regulatory standards, as those places offer the best protection in the event of bankruptcy. Investors should also look for custody providers that are independently capitalized.
"Self-custody is primarily a matter of convenience," he said. "I think we'll get clarity from regulators in the next six months on what self-custody actually means. On the regulatory side, things are going to happen. Not everything will be what people want, but it will be helpful to have clarity on the rules of engagement."