5 Ways to Reduce Risks for Customers in Case Bitcoin Exchange Fails
Amending laws to accommodate the nature of cryptoassets, tracing on-chain transactions, and prohibiting the re-use of deposited bitcoin (BTC) are some of the ways to reduce risks in case a custodian sinks, according to researchers from the Netherlands' Leiden University.
Their recent paper looks into depositing cryptoasset with crypto custodians like centralized exchanges, and specifically the legal risks when these custodians become insolvent. It provides certain recommendations on how regulation and practice can mitigate these risks.
The paper reminds that Bitcoin was created amidst frequent failures by intermediaries in the value transfers process, such as governments, banks, or brokers, as well as the high transaction costs that came with their involvement - to free the value transfers from their interference. However, "such disintermediation has not occurred and a large number of bitcoins and other cryptocurrencies are currently stored with crypto exchanges," the researchers said. This "creates significant risks related to the possible insolvency of crypto custodians," they added, giving as examples failed crypto exchanges Cryptopia, QuadrigaCX, BitGrail, and Cointed GmbH. "These cases demonstrate that the qualification of contractual and property law rights of crypto-investors is problematic."
To provide a way to mitigate the risks, the paper makes a few recommendations.
1. The amended version of the Hague Securities Convention should determine the applicable property law.
The paper explains that, when it comes to the customers' rights in insolvency proceedings, they depend on the applicable insolvency and property law - therefore, determining the applicable law is critical. But the problem is that traditional laws are not well-suited for the nature of crypto. The recommended approach would give priority to the law agreed by contract between a customer and a custodian, with applying the law of place in which the custodian is incorporated as the fallback option. "Both of these connecting factors are easily verifiable by the relevant parties involved, and thus should guarantee legal certainty and predictability."
2. Trace on-chain transactions for proof.
In the existing cases of failed exchanges, the courts refused customer’s revendication claims based on different bases, depending on the jurisdiction. Unlike cash on a bank account, though, the technical features of blockchain don't allow the commingling of BTC. The researchers argue that it's possible to trace each on-chain transaction, as well as the value assigned to it, and to show proof that the exact bitcoins that were deposited have not been spent and remain on the custodian's address.
3. Qualifying rights to BTC.
Per the paper, from the perspective of property law, rights to bitcoins can be qualified as:
- absolute rights;
- rights embodied in a documentary intangible (i.e. the physical carrier containing the wallet and keys).
When it comes to the rights on blockchain, the one who presents the keys first, regardless if they're the actual owner, is the one whose transfer will be accepted. "Whether a certain legal system allows for bitcoin rights to be made to bearer, depends on the law applicable to such rights."
4. Customers of crypto exchanges should be informed whether the crypto custodian uses or may use the deposited bitcoins.
Crypto custodians store cryptoasset for customers in a) a pooled (omnibus) blockchain address (e.g. Coinbase, Wirex, OKEx) or b) in the segregated blockchain addresses (e.g. Gemini). The first, however, poses a higher risks for customers, as it's highly likely that the deposited bitcoins originally allocated to one customer are being used for the benefit of another customer, for example, when they withdraw BTC from the exchange. "Such re-use will oftentimes bar a revendication claim in case of insolvency," warns the paper.
5. Consider prohibiting or limiting the re-use of the assets deposited.
This approach may be necessary in order to protect customers against the risk of crypto custodian insolvency, argues the paper. The risk that this suggested prohibition is violated can be reduced if the deposited bitcoins are stored in segregated blockchain addresses instead of pooled addresses.
Meanwhile, popular crypto researcher Hasu warned recently that the growing custodial banking layer creates an existential risk for Bitcoin.
Currently (12:13 PM UTC), BTC is trading at USD 10,129, having appreciated 6% in 24 hours and 14% in a week.
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