Cryptocurrency exchanges can fail. Whether due to hundreds of millions of dollars of funds stolen leading to bankruptcy, breaches of institutions that use exchange custody, or pausing withdrawals while taking “steps to preserve and protect assets,” it’s a simple fact that holding bitcoin on an exchange means taking on a lot of risk. Events outside of your control can and do happen, and when they do, you don’t want to be left waiting to be made whole.
Counterparty risk and exchanges
Counterparty risk is the chance that another party in a contract could default on its obligations. In the case of exchange risk, you make an agreement with the exchange that they will hold some amount of bitcoin on your behalf and, in return, you get an IOU—a redeemable coupon for the same amount of bitcoin. If an exchange fails to allow you to withdraw the funds, you’re a victim of that counterparty failing to meet its obligations to you.
What causes exchanges to fail?
The history of bitcoin exchange failures is a storied one, but perhaps none are as notorious as the Mt.Gox exchange hack and ensuing insolvency. When the exchange filed for bankruptcy in February 2014, it said that it lost 850,000 BTC—almost half a billion dollars at the time. Almost a decade later, creditors are still waiting on billions of dollars in payouts.
While a hack where 850,000 bitcoin—4% of the total 21 million supply—goes missing may be an extreme case indeed, exchanges suffering massive bitcoin losses at the hands of remote attackers is not uncommon.
Every year sees dozens of security breaches and exit scams, and those are only the ones that become public. Even in 2022, custodians were victims of hacks that led to the loss of tens of millions of dollars of client funds. Through 2020-2021, a major exchange lost $280 million, another lost $200 million, and a newer exchange shut down entirely after losing over $70 million. Every year between the inception of bitcoin and today has been similar.
Failed business practices
Sometimes, exchanges don’t fail because of hacks or attackers, but rather failed policies and practices within. From simple failed business models to the extreme of minting worthless tokens and stealing user assets to fund risky leveraged trading strategies, sometimes collapses are simply the result of incompetence and/or malice of exchange operators.
Large, publicly-traded exchanges going bankrupt or becoming insolvent might seem like a stretch to some, but speculative bubbles in “cryptocurrency” can be particularly brutal sometimes. Another recent example was Celsius, a lending platform that offered a yield product where customers would deposit their bitcoin not fully knowing the risks the company was taking to provide that yield. That company paused all withdrawals from the platform “due to extreme market conditions,” and has left thousands of unsecured creditors in its wake.
What happens to my bitcoin?
What happens to your bitcoin in these scenarios will depend on the specific circumstances of the company’s failure. There are a wide variety of potential outcomes, ranging from complete, permanent loss of funds to more “minor” failure modes that may or may not find you covered by an insurance policy. Regardless, the best-case outcome is that you’ll be waiting a very long time to see your funds returned—and that’s if you see any reimbursement at all. Let’s take a closer look at some of the possible outcomes.
1. Your bitcoin is gone forever
The worst outcome and the easiest one to understand: Cryptocurrencies like bitcoin held by exchanges are generally not protected by nor subject to traditional financial regulations and consumer protections. Not all institutions are appropriately positioned to account for various risks. Whether due to a hack or reckless business practices, the exchange could become insolvent and incapable of making good on its commitments to you.
2. Partial reimbursement
If the worst-of-the-worst outcome doesn’t come for you, the next best scenario is that at some distant point in the future you’ll be able to recover a small fraction of the funds you lost. In bankruptcy proceedings, officials seize and liquidate the accounts of the exchange and ultimately decide how to reimburse unsecured creditors. Usually, these reimbursements are pennies on the dollar.
For example, in 2022, Coinbase updated a 10-Q filing with the U.S. Securities and Exchange Commission (SEC) as it relates to what could happen to your bitcoin in the event of a bankruptcy:
Moreover, 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.
Translation: Bankruptcy puts the decisions around an exchange’s assets in the hands of a court, and if you’re a creditor for a bitcoin IOU at Coinbase, there’s no guarantee that you’re going to be made whole. Even if you do receive something, you might be waiting a while.
More than half a decade later, the victims of the infamous Mt. Gox hacks are still inching their way toward reimbursements, but it’s still uncertain who, when, and how they’ll be reimbursed, and it’s still possible the answers will be “no one,” “never,” and “they won’t.”
3. Situations where you might be covered
Many large exchanges do carry some kind of insurance to cover their own custody of funds on your behalf, but this is notably not insurance that would list you as a beneficiary. It’s also insurance that typically only covers very specific edge cases where your funds would be returned.
In most cases, larger exchanges that suffer cybersecurity breaches or internal theft carry their own policy that would take time to pay out, and that exchange would then endeavor to make you whole. Like bankruptcy, that’s all the hope you would have in this situation: a pending IOU.
There are failure scenarios in which you might be covered. Some exchanges offer products, for example, that include insurance for theft from unauthorized access, which would theoretically pay out more quickly and reliably if a malicious actor managed to steal bitcoin from your account. Exchange U.S. dollar balances are also, sometimes, covered on a per-user basis for up to $250,000 through FDIC insurance (although note this does not apply to bitcoin balances).
Not your keys, not your bitcoin
If you don’t hold your bitcoin keys, you don’t hold your bitcoin. As we’ve covered here, the risk is usually higher than you think that your exchange bitcoin IOU will become worthless. Exchanges are just not a safe place to hold funds, and with bitcoin, there’s no need to trust them. Everyone can securely take self-custody by investing some time and money—and the returns are great.