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If cryptocurrency companies fail, customers may not get all of their money

June 9, 2020

A recent article by Leiden Law School scientists said investors could lose control of their stored coins if a cryptocurrency exchange or cryptocurrency management company went bankrupt. This happened with the collapse of the Mt. Gox exchange in Japan and more recently with the failure of the BitGrail exchange in Italy. It could happen again.

In fact, the document implies that even U.S. users who exchange Coinbase could have trouble claiming their cryptocurrencies in the event of bankruptcy – since Coinbase does not separate addresses in the blockchain. Therefore, the question remains open: “Is there a risk that you will lose your bitcoins” if a stock exchange or custodian bankrupt?

“”There is absolutely a risk“Edgar Sargent, a law firm partner, Susman Godfrey, who has been hired by CoinLab to sue Mt. Gox, told Cointelegraph. Results vary by jurisdiction and applicable law, but the default position is that it does.” a debt contractually agreed by the exchange and In the event of the company’s bankruptcy, a Bitcoin (BTC) investor must go online with other creditorsSargent said.

If cryptocurrency companies fail, customers may not get all of their moneyIf cryptocurrency companies fail, customers may not get all of their money

Evan Thomas, an attorney at Osler, Hoskin Harcourt LLP, told Cointelegraph: “In the case of Mt. Gox, the remaining bitcoins were treated as assets of Mt. Gox, not as assets of customers. Therefore, bitcoins could be used to pay off debts to other Mt. Gox creditors.However, Coinbase differs from Mt. Gox, presumably because it is at least a U.S. regulated company.

In addition, in the 2019 amended user agreement, Coinbase added rules that relate specifically to ownership of crypto assets deposited on the exchange: “Ownership of the digital currency remains with you at all times and is not transferred to a Coinbase Group company.However, this may not be enough to protect users, suggested the Leiden Law School document, which generally examines the legal risks of depositing cryptocurrencies with cryptocurrencies, such as cryptocurrency exchanges.

“Coinbase has full control over the private keys of the deposited bitcoins. It can effectively access cryptocurrency wallets and their funds.” Not only can this increase the risk of hacking or mismanagement, but it can also lead to disputes over the ownership of the crypto assets stored in Coinbase, as control over the private key (and thus the ability to have bitcoins) may indicate Coinbase is the owner of these bitcoins or ownership has been transferred to them. In the absence of proper separation, assigning cryptocurrencies to individual clients can be problematic. “

By comparison, Gemini, based in the United States, another cryptocurrency manager, guarantees that the crypto assets of its custody accounts will be separated from all other assets that Gemini owns. “”This separation [es decir, la de Gemini] In contrast to the Coinbase contract, which does not promise to separate the crypto assets from clients with separate addresses in the blockchain, but allows shared addresses in the blockchain“The document shows.

Cointelegraph asked Coinbase to comment on this story, but the company didn’t respond before the date of this release.

The number of bankruptcies

The bankruptcies of a cryptocurrency exchange are not particularly rare events. “”In recent years, exchanges such as Cryptopia (New Zealand), QuadrigaCX (Canada), BitGrail (Italy), Cointed GmbH (Austria) and many other exchanges worldwide have disappeared. These cases show that the classification of contract and property rights of crypto investors is problematic.“wrote the authors of the Leiden Law School.

Thomas agreed: “If an exchange / custodian goes bankrupt, customers who have cryptocurrencies with the exchange / custodian may not get anything.” In accordance with the terms and conditions between the user and the exchange and the applicable bankruptcy law, the cryptocurrencies managed at the exchange or the custodian can be considered part of the assets of the exchange or the insolvent custodian.

Using the Einstein exchange as an example, Thomas explained in more detail: “In other words, some of the cryptocurrencies can be liquidated to pay other debts to employees, lenders, tax authorities, etc., thereby reducing the remaining costs for customers.” . Peter Watts, a law professor at the University of Auckland and a lawyer, told Cointelegraph:

“If a cryptocurrency exchange goes bankrupt, investors could lose control of their currencies – or part of the aggregated currencies – unless the exchange jurisdiction recognizes the concept of the trust and the rules for trusts have been met . “

The Cryptopia case

Watts represented the account holders in the Cryptopia case. Cryptopia, a cryptocurrency exchange founded in New Zealand in 2014, was liquidated in May 2019 after suffering a serious hack and losing around $ 30 million in cryptocurrencies.

As in the case of Mt. Gox, the question arose: “Who owned the remaining cryptocurrencies under the control of Cryptopia, valued at around $ 111 million (New Zealand $ 170 million)?The matter was brought before the New Zealand High Court, a dispute in which Cryptopia’s creditors – 37 corporate creditors and 90 shareholders – faced around 800,000 account holders with positive currency balances.

The court ruled in April 2020 that the rest of the cryptocurrencies should be considered “property” of the investor and returned to the investor, for whose benefit it was held in “multiple trusts”.

As Watts Cointelegraph explained: “Cryptopia Ltd. hasn’t said anything about trust in his terms and conditions for most of his life. Fortunately, we were able to convince the Court that trust can, however, be derived from the entire context, including marketing documents and online instructions.“- although it would have been much easier if the terms and conditions had expressly recognized the relationship of trust. In February 2020, the Singapore Court of Appeal ruled in Quoine Pte Ltd against B2C2 Ltd in a similar case, such as adding Watts.

Thomas noted that the fact that cryptocurrencies are viewed as “property” rather than something else like a currency is okay, “but the most important issue is the legal relationship between customers, custodian / exchange and cryptocurrency”. . Does the custodian / exchange owner of the cryptocurrency have that customers have only a contractual right to receive delivery of a certain amount of that cryptocurrency? Does the custodian / exchange keep the cryptocurrency trustworthy for customers? Or are the customers the owners of the cryptocurrencies and the custodian is simply a custodian, like a warehouse, in which their customers’ goods are kept? “Depending on the response, customers’ ability to file for bankruptcy may vary.”

Related: The ball is in your field: cryptocurrency managers are waiting for regulators to act

There is no clear instruction here. “The rights of clients in bankruptcy proceedings ultimately depend on the applicable bankruptcy and property laws,” wrote the authors of the Leiden Law School, adding: “The determination of the applicable law is therefore critical, but the lack of harmonization makes it more harmonious It complicates rules of private international law that are appropriate for the peculiarities of cryptocurrencies and the relationships between customers and crypto custodians. “

The BitGrail case

Control over private keys is often an important determinant of cryptocurrency ownership, according to the document. Without them, a court may not be able to allow users to claim their Bitcoin or other cryptocurrencies in the event of bankruptcy. This happened in the case of BitGrail, an Italian cryptocurrency exchange that was declared bankrupt in January 2019.

“”The court found that the deposited cryptocurrencies went to the main address of the exchange (a single collection address), which was controlled by its founder“The document points out. It was impossible to determine which client the missing crypto assets belonged to, as stated in the document:

Due to the interchangeability within the bus address, the court decided: As soon as the users’ cryptocurrencies went to the main address of BitGrail, the coins […] They no longer had the characteristic elements associated with owning a single user, which led to an irregular deposit relationship. “

An Italian lawyer who wanted to remain anonymous has been working on behalf of account holders on BitGrail’s ongoing bankruptcy, confirming to Cointelegraph that cryptocurrency investors will be treated as unsecured creditors in this case “So you don’t get 100% of what you deposited – you could get 20% or even less“”

The court ruled that BitGrail act as a bank, the Italian lawyer said, so all BTC and other deposited cryptocurrencies would be considered property of the exchange. “”It wasn’t like other exchanges where your BTC could stay separate, like a piece of art where you get your BTC back in full. Everything was mixed and the bank has debts“The bank is required by law to repay an amount equal to the deposited BTC – not the same Bitcoin with the same addresses. The authors of the Leiden Law School stated:

“In the Mt. Gox and BitGrail cases, the courts rejected requests for recovery [es decir, devolver BTC en su totalidad al menos a algunos inversores], either because Bitcoin cannot be owned (Mt. Gox) or due to the mix of deposited crypto assets (BitGrail). According to other laws, the result can be different as long as the client of a cryptocurrency exchange can prove that the individualized bitcoins stored in a cryptocurrency were not issued or reused. “

Protect investors

How can you protect investors? In countries where trusts are recognized, creating a trust to help protect investors is fairly easy, Watts told Cointelegraph. “D.Unfortunately, many exchanges do not state in their terms and conditions that the exchange is a trustee for investors.Thomas added:

“Any customer who leaves their cryptocurrencies under the control of a stock exchange / custodian runs the risk of not fully recovering the cryptocurrencies if the exchange / custodian goes bankrupt. Customers must decide whether to take this risk.”

Stock exchanges and custodians would likely prefer to mix and reuse BTC, as a bank does when it lends its fiat deposits and makes profits, rather than storing them in a vault for years, Sargent said. However, if the custodians finally agree to keep the BTC addresses separate, Investors should probably not expect to earn interest on their domed bitcoin, and conversely, they could even charge a fee for the service.

A ban on lending cryptocurrencies for safekeeping?

The authors of the Leiden Law School concluded that shared custody can pose a higher risk to clients. If bitcoins are mixed, it suggests that the custodian or exchange It’s more like a bank that mixes deposits and may lend, rather than a warehouse or locker.

In practice, this means that if a stock exchange goes bankrupt, it becomes more difficult for a user to claim that the stock exchange has its “property”. The investor may have to wait with other unsecured creditors.

Investors must be informed in advance if a cryptocurrency exchange or custodian plans to use or transfer their bitcoins or other deposited cryptocurrencies., summarized the authors of the Leiden Law School. According to the document, for reasons of public order, regulators may find it sensible to “prohibit a crypto custodian from transferring, selling, mortgaging, or otherwise selling, selling, or encumbering crypto assets from customers, unless explicitly approved by a crypto investor “.

With or without specific regulation, such transfer or reuse of deposited cryptocurrencies is less likely if the cryptocurrency is stored in separate blockchain addresses instead of a single address or pooled addresses.