Harvey Dent's Wisdom

December 16, 2022

There has been a lot of talk about people losing money in crypto lately. I don’t enjoy watching people lose money. Unfortunately, many cryptocurrencies were scams from the beginning. Much of what we’re seeing is nature running its course. When people invest in scams, they lose their money. Only a matter of time. That is how it is supposed to work.

But there is another reason people are losing money many are unaware of. The fraudulence of particular cryptocurrency coins writ large has disguised it. People see someone has lost their money buying cryptocurrencies and they think, “well that is what happens when you invest in scams.” They are not wrong. But they overlook another reason people have money at risk. One much more pernicious. 

There are many, probably millions, of people who have bought cryptocurrencies who risk losing all of their investment even if the value of their cryptocurrency appreciates. This sequence would be a real bummer:

  • Invest in an asset*
  • Watch it appreciate in value
  • ???
  • Lose everything

What happened in step 3? That takes us back to boring issues of custody and insurance. Subjects whose importance we undervalue because we take them for granted. Do so at your own peril.

When people buy cryptocurrencies, they often do so on an exchange. That is, a centralized platform that matches buyers and sellers. If I want to buy $100 of Bitcoin, and someone else wants sell $100 of Bitcoin, the online exchange will match us together to complete the transaction. The exchange takes a fee (they can be rather high). But the exchange nonetheless provides a valuable function. Imagine wanting to buy $100 of a cryptocurrency and not having an exchange over which to do so. How would you do that? It is not so easy. Say you somehow found someone that wanted to sell $100 of the cryptocurrency you wished to buy. How would you complete that transaction? It could get complicated. That is why exchanges are important. You can place buy or sell orders with a few taps on your smartphone. Easy. 

You’ve probably heard of a few cryptocurrency exchanges. Coinbase is the biggest and is a publicly traded company. FTX has been in the news recently. Kraken and Gemini are other examples. Say you choose to use Coinbase. You download the Coinbase app and open an account. Then you connect your bank account and send some funds to your Coinbase account. Once the dollars are in your Coinbase account you begin purchasing cryptocurrencies. The market value of your crypto portfolio is updated in real time on Coinbase. Any time you wish to see how much crypto you have, you simply open the app. It feels quite a bit like checking your bank account balance by opening your banking app.


Well that is one of the reasons. But perhaps not the most important. The most important reason it is different is that in many cases the exchange now owns your cryptocurrency, and you have no insurance. Read that again. Slowly.

In May of 2022, Coinbase (giant, publicly traded crypto exchange) filed their 10Q. A 10Q is a document the Securities and Exchange Commission mandates publicly traded companies file every quarter. It contains all sorts of financial information the people generally consider credible as (a) it is an official form mandated by the government and (b) the agency doing the mandating is the SEC and no company wants to be on their bad side. Buried in Coinbase’s 142-page 10Q is a rather striking sentence. It reads:

“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.”[i]

That is a lot of legalese, and it’s buried on page 83. Not many people read 10Q filings. Probably something to do with the 142 pages of legal jargon. But this is a very important sentence. In layman’s terms, Coinbase is saying something like our customers have all this money sitting on our exchange invested in Bitcoin and Ethereum and other cryptocurrencies. If we happen to go bankrupt and need to pay back our creditors we could just, uhh… use our customers’ money they have sitting over here.


People have misconceptions about money. And banks. Those misconceptions bleed into cryptocurrency exchanges. We all have bank accounts. If you are like me, you imagine your bank has a special little lockbox or something with your name on it filled with US dollars. An amount that corresponds to the balance on your banking app. That is not how it works. You probably know that but still subconsciously think that way. The truth is when you keep money at a bank you are simply a creditor of that bank. The bank takes your money and does all sorts of things with it (namely lend it to others at a higher rate of interest than they pay you). They have a ledger that says they owe you x amount of money whenever you ask for it back. No special lockbox in a vault stuffed with cash. Just a line item on a spreadsheet.

Well, the same is true for a cryptocurrency exchange. Sure, when you open your app it appears you have x dollars in your wallet (the crypto version of an account) at the exchange. And in an important sense you do, so long as the exchange is solvent. But really you are simply a creditor of the exchange. Just as you are at your bank. This becomes a rather large problem for you if the exchange becomes insolvent. Your deposits at the bank are insured by the FDIC. If the bank files for bankruptcy, you will get your deposits back, up to certain limits. If the exchange files for bankruptcy, you are a general unsecured creditor without any insurance. Another way to say this is there are a lot of people this bankrupt company owes money, andyou must go to the back of the line and don’t expect much because the line is very long. In a bankruptcy, general unsecured creditors are the last in line to get paid. They recoup pennies on the dollar in the best-case scenario. The process often takes years.

These are the sort of details no one worries about when everyone is making money. In 2020 and 2021, everyone in crypto was making money. It was wild. Coinbase IPO’d in 2021 at $381/share.[ii] It was the seventh largest new U.S. listing of all time.[iii] Now the tables have turned. The bubble has burst. Crypto companies are filing for bankruptcy left and right. Celsius, Voyager, FTX, BlockFi… all printing money in 2021 and bankrupt in 2022. Coinbase bonds were trading at 92 cents on the dollar at the beginning of the year. As of December 13th they’re trading at 52 cents on the dollar.[iv] I am not saying Coinbase is going to go bankrupt. I have no idea. That is not the point of this post. The point is that sentence in their 10Q about “custodially held crypto assets may be considered to be the property of a bankruptcy estate” and “customers could be treated as our general unsecured creditors” seems more relevant these days.

I’ve written this post because (a) crypto companies are filing for bankruptcy left and right, (b) a lot of people have money on crypto exchanges and (c) they may lose all their cryptocurrency if the exchange becomes insolvent regardless of the market value of the cryptocurrency they “own.” This is a problem too many people remain unaware of. There is a solution, namely moving your cryptocurrency off an exchange onto a “hardware wallet.” It is essentially a fancy flash drive. You may have heard crypto people refer to it as “cold storage.” It is a form of self-custody. The equivalent of taking your money out of a bank and putting it under a mattress. Stuffing your mattress with cash is foolish when there is no apparent risk of insolvency, and your deposits are insured. It is wise when your custodian may have solvency concerns, and you have no insurance. Which is the precise situation for those who own cryptocurrency left on an exchange.

A final note on this situation. It is ironic the cryptocurrency ecosystem began as a decentralized solution to the purported problems of centralization. The first cryptocurrency was Bitcoin, founded out of displeasure regarding the bailouts of the big banks following the Great Recession of 2009. Bitcoin was decentralized for years. It still is, in its purest form. But the cryptocurrency ecosystem developed around Bitcoin made everything… centralized. Now cryptocurrency writ large has all the problems of centralization (large companies making bad decisions and going bankrupt) with none of the benefits (insurance & bailouts) for the consumer.

Harvey Dent said you either die a hero or live long enough to see yourself become the villain.

It seems crypto lived too long.

Sean Cawley, CFP®

*I suppose one would call all these cryptocurrency coins “assets,” although that really stretches the meaning of the word.

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