While Terra’s collapse threatened some of the crypto ecosystem, exchange platform Coinbase announced that it would be possible to account for the loss of crypto held in customers’ names in the event of bankruptcy. At the same time, ECB President Christine Lagarde told German television that she was concerned about people “who do not understand the risks, who will lose everything and who will be terribly disappointed, therefore it must be regulated”†
In this context of uncertainty, investors are seeking both a trust framework from crypto exchange platforms and legal answers from the authorities. Decryption of risks in case of bankruptcy of exchange platforms or security vulnerabilities for investors in virtual currency.
Cryptocurrency: Which Regulatory Framework in France?
In France, activities related to services in the cryptocurrency sector are regulated by the AMF (Autorité des Marchés Financiers). In particular, the AMF grants its PSAN approval for Digital Asset Service Providers to trading platforms. This authorization allows the different platforms to carry out their activities, in particular with regard to “the custody of crypto-assets or access to crypto-assets (for example via private encryption keys)”, the purchase and sale of cryptocurrencies, etc. It could also be portfolio management, advising clients on crypto assets, or even “secured or unsecured investment of crypto assets”†
To date, more and more exchange platforms have the PSAN such as Litebit, Coinhouse, Bitpanda and Binance for example. The list of granted PSAN approvals is available on the AMF website. This regulation introduced in 2019 by the PACTE law aims to establish a trust framework, but the AMF reminds us that we need to monitor “the measures that the platform has taken to protect its own equipment, as it too can become the victim of malicious actions”†
In addition, the service provider for financial products derived from cryptocurrencies must have PSI approval for Investment Services Provider. We must remember that in the context of derivatives, the investor is in no way the holder of the cryptocurrencies. Likewise, ETFs that reproduce the movements of cryptocurrencies also require the approval of the AMF. It is therefore now possible to trade cryptocurrencies from traditional brokers through derivatives and the risk of bankruptcy is subject to the same legal restrictions as stocks. For example, it is possible to trade cryptocurrencies through Futures contracts listed on the Chicago Mercantile Exchange, which clearly defines the terms of the contract and the risks are known to the investor. In this sense, the issue of the risk of losing its portfolio in cryptocurrencies is rather relative to the issuer of the derivative product and the regulation of transactions.
Buying cryptos live through exchange platforms therefore does not have the same legal guarantees as trading cryptos with derivatives through traditional stock brokers.
Are crypto exchanges safe?
Renowned exchange platform Coinbase, which has a balance sheet of nearly $20 billion, recently questioned the security of guarantees to customers in an SEC document. This challenge in the event of Coinbase insolvency comes as Coinbase has fallen by more than 75% since the beginning of 2022. Earnings for the first quarter of 2022 are down more than 26% year-over-year to $1.16 billion. The company, which has been listed on the Nasdaq since 2021, said in its report filed with the SEC that the platform’s cryptocurrencies “may be treated as assets subject to bankruptcy proceedings and customers may be treated as general unsecured creditors. This could lead to customers finding our custody services more risky and less attractive”† In other words, the risk of bankruptcy would provide no security for customers.
Quick, the Coinbase CEO Brian Armstrong responded to the networks by specifying that there was “no risk of bankruptcy” adding that: “This disclosure makes sense to the extent that this legal protection has not been specifically court-tested for crypto assets, and it is possible, though unlikely, that a court could rule to treat customer assets as part of the business in bankruptcy proceedings… even if it harms customers”† This therefore raises the question of the solvency of all other cryptocurrency exchange platforms in the event of bankruptcy.
As Martin Finnegan, COO of the British law firm Punter Southall Law, reminds us, most trading venues specify in their terms the presence of risks of loss. The conditions state that: “you accept that all your money could be lost and not only can you not do anything about it, but we (the platform) are not liable under any circumstances”†
Nevertheless, some platforms, such as Binance, would have chosen to secure some of the dollar deposits with the FDIC (federal deposit insurance company). In France, it seems that no deposit guarantee has been taken out by the platforms with the Guarantee Fund for Deposits and Resolutions (FGDR). The FGDR guarantees € 100,000 to savers in the event of bankruptcy of traditional banks. However, these cryptocurrency deposit guarantee measures would be essentially arbitrary and almost non-existent.
The Risks of Crypto Exchanges
This legal clarification from Coinbase reminds us that crypto exchange platforms are primarily there to provide a service of democratization and flexibility. However, security issues are cropping up again, be it the risk of hacking or the solvency of the platforms.
The first crypto players are still thinking of the bankruptcy of the Japanese exchange platform Mont Gox, which was active from 2009 to 2014. In 2014, the platform suffered a hack that caused more than 700,000 Bitcoins to disappear and the platform went bankrupt. Examples of theft are numerous in the financial sector. Recently, the perpetrators of the Bitfinex platform hack in 2016 were found worth 120,000 Bitcoins and the US justice confiscated the equivalent of more than 3 billion dollars in Bitcoin in 2022 after a long investigation.
From now on, the risks of losses evolve due to the democratization of the market. The risks of hacking are quite limited, but we are now seeing solvency risks appearing closer to the risks of bank run traditional 19th century finance. In this sense, certain regulatory measures have come to light since 2021, notably by the bank for international settlements related to, for example, stablecoins.
The different ways to secure your cryptocurrencies
As we have seen, the AMF communicates its whitelist in France of all players who benefit from PSAN approval. However, this is not enough to provide sufficient legal foundations to answer crypto platform customers’ questions in the event of bankruptcy. Coinbase recently asked this question regarding its exposure to the stock market and to investors. For the time being, it is likely that a bankruptcy of the stock exchange platforms will not give rise to additional guarantees from institutions or specific funds. In this sense, exchanges can expose their clients to the risk of losing their deposits in the event of insolvency.
Today, no serious bankruptcy has been recorded since the broad democratization of the market began in 2017. But the context of tensions in the cryptocurrency market raises many security questions. It is therefore always preferable to diversify crypto holding resources. Using a hard wallet such as Ledger, Trezor or Ngrave makes it possible to physically hold the keys that guarantee the ownership of virtual currencies. In addition, it is always possible to use online or mobile wallets such as Metamask.
What future guarantees for cryptos?
In any case, limiting the possession of cryptocurrencies to the possession of a digital key does not yet make it possible to decide on the conditions under which ownership is recognized. Recalling the practical precautions to optimize the security of its investments, the AMF legally regulates many services so far provided by trading venues.
In addition, this context of uncertainty about the security of the market was recently underlined by ECB President Christine Lagarde. The President of the ECB has not failed to specify that: “The day we have central bank digital currency, any digital euro, I will guarantee it. […] The central bank will therefore be behind this. I think it’s very different from all those things.”† This statement comes after both the collapse of Terra and the fall of Bitcoin, which cast doubt on the solvency of certain players in the system.
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