Your crypto may not be protected against bankruptcy — here are steps you can take to protect it (2024)

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• Several crypto platforms have filed for bankruptcy in 2022 and 2023.
• Crypto exchanges use assets to pay debts and legal fees, so customers are usually last in line to get paid.
• You can retain better control over your crypto through decentralized custody, decentralized wallets, or by opening non-custodial wallets in addition to your custodial wallet.

Cryptocurrencies are decentralized digital assets that — unlike traditional fiat transactions — remove the intermediary (e.g., banks or other financial institutions) when sent from one party to another.

And while you can keep your assets secure by setting up a crypto wallet through your exchange or using an external wallet in many cases, your cryptocurrencies may not be protected against events like bankruptcy.

What happens when a crypto exchange goes bankrupt?

In the event of bankruptcy, crypto customers with custodially held assets are typically last in line to receive payment. In other words, those who have their cryptocurrencies locked away in non-custodial or self-custodial wallets won't be affected since they own the private keys.

The story is different for those who use their exchange's custodial wallet.

"First, the assets held on the exchange will be sold to cover debts to creditors and legal fees," explains Nick Saponaro, founder and chief executive officer of crypto payment platform, Divi Labs. "Only then does the user get paid. That's if there's anything left."

How to protect your crypto when bankruptcy happens

If you're solely tied to a custodial wallet through your platform during the event of bankruptcy, you'll likely be at the mercy of the exchange as it settles its fees. However, there are generally three proactive strategies you can use to keep your assets safe from bankruptcy.

You can: set up a custodial wallet and simultaneously open other non-custodial crypto wallets (this allows you to transfer assets back and forth at your convenience); use decentralized custody, or store your crypto through decentralized, or DeFi, wallets.

Consider a custodial wallet

There are two key types of crypto wallets: custodial wallets and non-custodial wallets. Custodial wallets are typically online wallets that a third party manages and controls. Non-custodial wallets — which can either be connected to the internet or established through offline storage devices (e.g., a USB drive) — give you complete control over your private keys.

"Users have a choice. They can allow a third party to take custody of their funds or they can take control of their own funds through self-custody," Saponaro says. "Each route has its own set of benefits, caveats, and risks."

Custodial wallets can be a convenient and secure way to store your cryptocurrencies, but users who solely use these types of wallets may be in trouble if bankruptcy were to occur. You can set up multiple crypto wallets, so one solution would be to open non-custodial custodial wallets in addition to your exchange's custodial wallet.

That way, you can lower your risk by storing your crypto in multiple places. Plus, you can transfer crypto balances back and forth when you feel it's necessary.

If you're using an investment platform that doesn't provide its own custody options — or if you'd rather go the non-custodial route of setting up a wallet that gives you complete control over your private keys — you'll be better off finding an external wallet before buying crypto. But if you're dealing with an exchange that offers its own custodial crypto wallets, you won't have to worry about setting up the wallet before making a purchase (unless, of course, you want to utilize both custodial and non-custodial storage).

With either wallet option, you'll be responsible for both a public and private key. Your public key functions like a digital address that helps other users identify you when they want to send crypto to you. The private key, on the other hand, is used both for signing transactions and securing your assets.

Pros and cons of custodial wallets

As mentioned earlier, custodial wallets are managed by a third party (e.g., a crypto exchange). They typically offer easy storage access, but your control of the wallet is limited. There are several other pros and cons to consider.

If you're a beginner crypto user or prefer convenient storage options, custodial wallets are a great place to start. Since they're managed by third parties, you don't have to take on the responsibility of both selecting and constantly monitoring the crypto wallet.

Plus, if you ever lose the password to your wallet, you can usually reset it without trouble (if you lose the password to a non-custodial wallet, that could result in significant financial loss depending on how much crypto the wallet contains).

Several of the best crypto exchanges — including Coinbase, Binance, and Gemini — offer their own custodial wallets.

Alternatives to custodial wallets

If you don't want to go the custodial route, there are two other options you can use to secure your assets.

When it comes to cryptocurrencies and bankruptcy, Saponaro adds that custodial wallets aren't the issue and that they can be great avenues for the successful onboarding of beginners in a space that has traditionally required significant technical expertise.

The issue, he explains, "is the same as with all custodial finance. You gain access but invariably lose control."

Sapanaro highlighted two alternatives:

1. Decentralized custody

With this non-custodial option, you can either store your crypto assets through "hot wallets" or "cold wallets." Hot wallets are essentially online software, whereas cold wallets allow you to secure your assets through hardware and offline devices.

2. Decentralized wallets

According to Saponaro, these wallets are self-custodial and give the user control. "Decentralized wallets (sometimes called DeFi wallets), like DiviWallet, provide a similar service to custodial solutions but do not have access to the user's keys."

Some examples of non-custodial crypto wallets include MetaMask, Exodus, Trust Wallet, and Wasabi Wallet.

The bottom line about crypto exchange bankruptcy

Any cryptocurrencies you hold through an exchange or investment platform may not be protected in the event of bankruptcy. Those assets are first used to cover legal fees and creditor debts, delaying the timeframe within which the customer gets paid back (though payback isn't guaranteed).

There are various types of storage options — including decentralized custody and DeFi wallets — that you can use if you're looking for more control over your cryptocurrencies. And even if your exchange only offers a custodial wallet, you can transfer your assets to external wallets if you choose.

The best method for you ultimately depends on how much control you want over your assets.