What happens to investors money when a cryptocurrency exchange goes bankrupt

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New Jersey-based Celsius Network is the latest to announce voluntary bankruptcy due to illiquidity in its balance sheet. Celsius has filed Chapter 11 cases which are said to provide the best opportunity to stabilize its business and consummate a comprehensive restructuring transaction that maximizes value for all stakeholders.

Last week, in its court filing for bankruptcy, the exchange said, “Celsius’ early success was not without its hiccups. The amount of digital assets on the Company’s platform grew faster than the Company was prepared to deploy. As a result, the Company made what, in hindsight, proved to be certain poor asset deployment decisions.”

Highlighting some negative factors for crypto exchanges, Celsius pointed out the implosion of Terra LUNA (“Luna”) and its TerraUSD (UST) stablecoin (“UST”) to be the cause – as it accelerated the onset of a “crypto winter” and an industry-wide sell-off in 2022.

Notably, as of July 13, 2022, Celsius’ liabilities are around $5.5 billion, and assets are valued at around $4.31 billion. Thereby, the company has a deficit of $1.19 billion on its balance sheet.

Another would be Voyager Digital  in a bankruptcy proceeding after suffering heavy losses in the collapse of 3AC and markets crash. Recently,  FTX has proposed to offer some liquidity to Voyager  customers amidst  proceedings. 

It’s not just the crypto market crash that has made crypto exchanges vulnerable. In fact, even investors can lead to a deep liquidity crunch for exchanges. At least, in the case of CoinFlex, it was only one investor that pushed the exchange to halt its trading.

On July 9, CoinFlex explained they halted their withdrawals after a big investor failed to pay $47 million in margin calls. CoinFlex plans to recover $84 million through legal proceedings against this individual. Further, the exchange is planning to create some temporary liquidity for its depositors soon. Meanwhile, in the long term, it is also in talks to form a joint venture with a large US-based exchange/ATS platform.

Asia’s leading crypto exchange, Zipmex has joined the bandwagon to disable trading until further notice. Although, the exchange has enabled withdrawals on investors’ trade wallet. Other crypto exchanges like Binance, Voyager CoinFlex, Celsius, Vauld, and Skybridge Capital are some of the platforms that have halted their withdrawals since June.

These struggles of crypto exchanges are alarming for investors as it is likely to impact their hard-earned money. When investors invest in crypto markets or any other capital market instruments, everyone wants to gain a substantial return on their investment. But what if, your money also gets entangled in the bankruptcy of your crypto trading platform. This is sadly true! 

Vinit Khandare, CEO and Founder, MyFundBazaar said, constrained market liquidity can spark a meltdown in stock prices that sets off a new financial crisis, surviving the liquidity crunch involves – increasing cash allocations, avoiding unduly positions being warning of an overall crowding risk and to develop an extensive strategy to exploit the negative impacts of liquidity.

In May this year, the US-based largest crypto exchange Coinbase in its Securities and Exchange Commission (SEC) filing, explained that “supported crypto assets are not insured or guaranteed by any government or government agency.”

Coinbase in the filing said, any failure by the crypto platform or their partners to maintain the necessary controls or to manage customer crypto assets and funds appropriately and in compliance with applicable regulatory requirements could result in reputational harm, litigation, regulatory enforcement actions, significant financial losses, lead customers to discontinue or reduce their use of the products and result in significant penalties and fines and additional restrictions, which could adversely impact their business, operating results, and financial condition.

Thereby, Coinbase had said, 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.

Simply put, if a crypto exchange goes for bankruptcy then chances are your crypto assets will also be pushed in the proceeding.

Abhijit Shukla, CEO and Director, Tarality said, “With no laws governing crypto-assets, there is a zero guarantee that investors would be able to recoup their funds if an exchange were to freeze an account – or, worse yet, completely collapse. In a bankruptcy scenario, the crypto and funds held in their accounts may not be considered their own property, often pooling different customers’ crypto and funds together in the same storage wallet or account.”

Further, the MyFundBazaar CEO highlighted that in the event of a bankruptcy, crypto customers with custodial held assets are typically last in line to receive payment – those who have their cryptocurrencies locked away in self-custodial wallets won’t be affected since they own the private keys.

“Owing to market bull runs and downturns, using either non-directional or probability-based trading methods, investors may be able to protect their assets from potential losses and may be able to profit from rising volatility scenarios,” Khandare said.

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