One of the major downsides of cryptocurrencies is their risk of losses. This becomes even more significant if the crypto platform holding your tokens suffers a service disruption due to varying reasons, such as a liquidity crisis.
2022 will go down in history as one of the worst years for the crypto market. It bore witness to some high-profile collapses in the industry, the likes of crypto lending platforms Voyager and Celsius, token project Terra/Luna, and trading platform FTX.
The wave of insolvencies even affected crypto mining firms, with prominent Nasdaq-listed bitcoin mining company Core Scientific declaring bankruptcy and filing for Chapter 11 protection.
So, how does it affect investors? That is what we will be exploring in this article.
1. Customers will be unable to withdraw their crypto
Crypto investors trust centralized exchanges with their crypto for convenience. Platforms like FTX and Voyager were widely popular among novice investors for that very reason. However, if an unforeseen event cripples the exchange, the chances of you being able to withdraw your funds might be zero.
The insolvencies of Voyager and Celsius alone lead to investors suffering over $2 billion in losses.
When Voyager filed for bankruptcy in July, the company promised that customers would get back all their US dollar deposits but not their crypto holdings. The platform declared in its bankruptcy proceedings that it held $1.3 billion worth of customers’ crypto assets.
Similarly, Celsius filed for bankruptcy in the same month after pausing all withdrawals, swaps, and transfers among customer accounts. The company declared in its filing that it owes roughly $1.2 billion to creditors including investors and customers.
With customers not able to withdraw their crypto from these platforms, they were left with no choice but to look towards taking legal action but that is where the next problem set itself up.
2. Cryptocurrencies are not insured by the FDIC
When a bank in the United States fails, the Federal Deposit Insurance Corporation (FDIC) steps in to insure the depositors. This was recently observed in the case of Signature Bank and Silicon Valley Bank, which collapsed in April 2023. During that time, the FDIC guaranteed up to $250,000 in deposits for their customers.
However, when it comes to crypto assets, they are not protected by the FDIC. What you need to know here is that whenever cryptocurrency exchange goes out of business, no government agency will step in to make them whole like they do for banks.
The FDIC now requires its member banks and financial institutions that engage in any sort of cryptocurrency-related activity to disclose it to the agency for supervisory feedback.
Stablecoins, which are crypto tokens pegged to the value of a central bank-issued fiat currency, also fall outside the FDIC’s bracket for coverage. This was apparent when algorithmic stablecoin TerraUSD collapsed back in March 2022, as those currency pegs weren’t viable.
How to recover your funds from a disrupted cryptocurrency platform?
User accounts on centralized crypto platforms are created by following know-your-customer (KYC) requirements, which include submitting your legitimate information like government IDs for account verification.
Therefore, when the centralized exchange files for bankruptcy they are supposed to have your contact information and an account of what they owe you. In that case, you are also supposed to hear from them with information on how you may be able to recover the funds and the amount you will be eligible for.
Most firms employ their procedures to distribute the funds to customers. This requires you to fill up forms, confirm your payment information, and keep up with any other paperwork that may be necessary to get back your cash or crypto.
However, there is also the possibility of investors not getting back their money or crypto in the event their trusted crypto custodian declares bankruptcy. In most cases, you will be returned at least a portion of your original investment with the platform.
Bankruptcy of any financial institution can be stressful to investors, and in the case of crypto service providers like exchanges, this can become even more difficult. Crypto service providers are not offered the same privileges as banks and therefore have no way of guaranteeing customers their deposits in the event of a financial crisis.
In most cases, customers won’t be able to withdraw their assets or cannot claim their losses with insurers. But there is no reason to panic as the best way to move forward in that case is to let the bankruptcy procedure determine the result.
If you happen to find yourself amid a crypto exchange that is battling bankruptcy, it is recommended that you keep a close tab on your mailbox for information on how to file a claim to get back as much of your crypto as possible.