Are Crypto investors at risk of total wipeout from platform bankruptcy?

The U.S. Securities and Exchange Commission released guidance that cryptocurrency investors may be at risk of total and complete loss of their crypto assets in the event that the trading platform they use files for bankruptcy.  

Crypto platforms such as Coinbase, FTX, and Kraken have become the most common way for investors to access the frenzied cryptocurrency market, but in this potentially game-changing SEC guidance, investors are now being warned that if the company they use to buy and sell their crypto runs into financial trouble and files bankruptcy, the cryptocurrency in the investors’ accounts will becounted as liabilities (read: borrowed money) on the trading company’s balance sheet, rather than private assets of the investor. 

Translation: If your crypto trading firm goes broke, you could lose 100% of your crypto in the process. Ouch. 

As The Wall Street Journal reports, “The SEC’s new guidelines for crypto-trading platforms contrasts with the approach used by brokerages such as Charles Schwab Co. Inc. Those firms are allowed to leave the value of client assets off their own balance sheets because of legal precedent that has established that, in the event of bankruptcy, the assets belong to the clients. The law is less settled in the case of crypto, SEC officials say.” 

That's absolutely huge!

Can you imagine if during a bankruptcy of a traditional brokerage firm (remember Bear Stearns and Lehman Brothers?) if not just the equity owners and bondholders of the firm but the clients of the firm were completely wiped out? Think about a scenario where the proverbial Charles Schwab Co. went bankrupt and all the customers whose investment accounts, IRAs, 401k’s and the like lost all their money in bankruptcy court. That is the position that the SEC is saying crypto investors are in with their trading and custody platforms like Coinbase and the like.  

Every crypto investor should immediately be asking themselves right now: What is the credit rating of the cryptocurrency platform holding my account? Would I lend money to a company with that credit rating, especially considering they are paying you zero interest for that loan (which is how the SEC is telling crypto firms to list their investors’ accounts on the balance sheet)? Reviewing the few recent bond sales completed by crypto firms indicates they are rated in the non-investment grade or “junk” category. That should be sending up alarm bells everywhere in the cryptocurrency community. 

Despite technically being a millennial, I admit that I have been and continue to be quite skeptical of the cryptocurrency market. I believe that crypto will be here to stay, in some form or another, and there are potential benefits to the overall good of society with a decentralized currency, and further support that there are many benefits to the blockchain technology that underpins crypto, but the crypto craze that exists today is completely overdone in my opinion, and much, much more speculative than most people realize. 

The risk of total loss is very real, and the market in various cryptocurrencies is more fragile and could collapse much more rapidly than most crypto investors believe possible.

The risks do not only include those normal market forces that ebb and flow as the free market picks the inevitable winners and losers in the crowded field of cryptocurrencies, but as this SEC guidance highlights, the risks related to government regulations, counter-party risk between investors and platforms, and risks that we have yet to be made aware of as the crypto market evolves, are incredibly tangible. 

I am often asked about my opinion on cryptocurrency and whether investors should add crypto as an allocation percentage to their overall portfolio. My answer continues to be: tread lightly, do your homework and only invest what money you are comfortable kissing goodbye if you suffered a complete loss in your foray into the wild west of crypto.

If that sounds too risky, then you should probably stick to more developed asset classes, at least until such time as the cryptocurrency market become more developed, volatility subsides, risks are lowered and risk-reward targets are more readily calculable.   

The timeless advice from King Solomon rings true here, “The prudent sees danger and hides himself, but the simple go on and suffer for it.” (Proverbs 22:3)