Non-Custodial Wallets v. Custodial Wallets: Considerations for Holding Digital Assets
Introduction: The FTX Collapse, Custodial Wallets, and Bankruptcy Concerns
The recent headlines regarding cryptocurrency exchange FTX’s collapse, and subsequent bankruptcy filing have put renewed focus on whether customers of a cryptocurrency exchange should hold digital assets through a custodial wallet. When a customer holds digital assets through a custodial wallet the service provider holds both the public key and the private key and effectively has control over the assets. The issue for cryptocurrency exchange customers is if a cryptocurrency exchange files for bankruptcy protection are the customers’ digital assets property of the exchange’s bankruptcy estate and available to be used to satisfy debts of other creditors? Bankruptcies involving cryptocurrency exchanges or cryptocurrency lending platforms is a developing area of the law and presents issues of first impression. Recent cryptocurrency bankruptcies include Voyager Digital LLC, Celsius Network LLC, and most recently FTX Trading Ltd. If customers of a cryptocurrency exchange or cryptocurrency lending platform hold their digital assets in a custodial wallet, rather than a non-custodial wallet (i.e., a private wallet), it may increase the risk that such assets are treated as corporate assets of the exchange or lending platform.
Risks of Holding Digital Assets in a Custodial Wallet
Unlike traditional banks, cryptocurrency holdings are not insured by the Federal Deposit Insurance Corporation (“FDIC”). Accordingly, even though an investor may hold cryptocurrency through a cryptocurrency exchange or a cryptocurrency lender that may function like a traditional bank (i.e., pays interest on cryptocurrency deposits) if the exchange or lender fails there is no protection for the investor customer. If the cryptocurrency exchange or cryptocurrency lender files for bankruptcy protection, it triggers the automatic stay of the Bankruptcy Code, which will prevent customers from immediately withdrawing or accessing their cryptocurrency. Additionally, in some cases cryptocurrency exchanges may freeze accounts or trading outside of the bankruptcy context, for instance, because of liquidity concerns as we saw with FTX before it filed for bankruptcy protection. If the cryptocurrency exchange has filed for bankruptcy protection, how the customer holds its assets (i.e., in a custodial wallet or non-custodial wallet) may determine whether the customer can access, trade, or withdraw the assets.
Property of the Bankruptcy Estate is Broadly Defined
The Bankruptcy Code broadly defines what constitutes property of the estate. Whether the contents of customer accounts or digital assets are property of the estate is a fact specific determination that takes into account various factors such as (i) intent of the parties, (ii) whether the customer’s assets are recorded on a separate ledger and are readily identifiable, and (iii) who has dominion and control over the assets. When a digital asset is held in a custodial wallet with the cryptocurrency exchange rather than in a non-custodial wallet where the customer has exclusive control over the asset, it shifts the factors towards the conclusion that the customer’s digital assets may be part of the broadly defined property of the bankruptcy estate.
For instance, if a digital asset is held in a custodial account with the cryptocurrency exchange, is a restriction on the customer’s ability to trade or withdraw it an indicia that the customer actually does not control the asset? Moreover, if the exchange commingles customer assets with other customer assets or operating funds, is it an indication that the customer relinquished some ownership or control over the digital assets such that they should be considered property of the estate to which the customer is a general unsecured creditor? If the digital asset is considered property of the estate, the automatic stay operates to prevent customers from accessing the cryptocurrency. Perhaps most importantly, customers who may have viewed their digital asset holdings as deposits with the exchange may be treated as general unsecured creditors of the bankruptcy estate and their claim is likely to be satisfied for pennies on the dollar with all other general unsecured creditors.
Non-Custodial Wallet Considerations
Holding digital assets through non-custodial wallets or private wallets may avoid the complicated legal issues described above. Additionally, it may protect exchange customers from the risk of loss in the event of a bankruptcy or liquidity crisis because the customer holds both the public key and the private key to his or her digital assets and, therefore, has complete dominion and control over their assets. In addition to maintaining control, holding digital assets through a non-custodial wallet or a private wallet has other important advantages including (i) avoiding trading restrictions or fund freezes, (ii) the user does not require an internet connection as it can be stored in a “cold wallet” (i.e., an offline storage device) (iii) the assets are less susceptible to hacking, (iv) it is generally fast to create new wallets, and (v) it enables dispersed holdings and risk as many exchanges permit customers to withdraw digital assets to non-custodial wallets.
There are also some disadvantages to holding digital assets in a non-custodial wallet or a private wallet. First, if a user loses private keys or recovery phrases it is impossible to recover the assets. This is a significant consideration and disadvantage over holding digital assets through custodial accounts where customers can reset their password to regain access to the assets. Second, it is less convenient than custodial services and places additional responsibility on the user. Finally, users need greater technical expertise to use some of the advanced features available for non-custodial wallets.
Non-custodial wallets or private wallets can either be “hot wallets” or “cold wallets”. Each contain one set of private keys. The difference is that a hot wallet is connected to the internet through online software while a cold wallet secures the digital assets through hardware and offline devices. In addition, there are joint custody or multi-sig wallets which are wallets that require multiple private keys to sign a transaction before execution. In this arrangement, custody and thus control of the assets is shared. As referenced above, another option is for customers of a cryptocurrency exchange to diversify the mediums through which they hold digital assets. For instance, if a customer prefers the convenience associated with a custodial wallet, they may consider holding some of their digital assets in the custodial wallet but moving others to one or more non-custodial wallets or private wallets to hedge against the risk of an exchange failure and asset loss.
The recent high-profile FTX cryptocurrency exchange failure and others should give cryptocurrency and digital asset investors pause about how they hold their digital assets. If digital assets are held through a custodial account with an exchange, there is a risk that the customer’s assets may become part of the exchange’s bankruptcy estate. Cryptocurrency and digital asset investors should consider holding their digital assets through one or more non-custodial wallets, or a combination of custodial and non-custodial wallets, to alleviate this risk. Each investor and cryptocurrency exchange customer should weigh the advantages and disadvantages of holding their digital assets in a custodial or non-custodial account against their personal risk tolerance. If the cryptocurrency exchange fails, their digital asset investment may become the bankruptcy estate’s property and the customers may become general unsecured creditors of the bankruptcy estate entitled to only their share of what remains.
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 In fact, in Coinbase Global Inc.’s May 2022 Form 10-Q report, the company warned customers that custodially held digital assets could be considered property of a bankruptcy estate if it were to file for bankruptcy protection.