What happens when your exchange rips you off?

This week’s post was inspired by “What happens when the bank robber is the bank,” an article posted by Chris Skinner last week. The post refers to the situation in Lebanon where people are robbing their banks to get their own money.

Let me start with a couple of stories.

EminiFX was an online investment platform promoted by its CEO, Eddy Alexandre, as a “double your money” crypto and foreign currency exchange that used proprietary technology. He promised at least 5% weekly earnings and explained that investors could take their profits and use the money to pay their house mortgage, car loan, and other bills or reinvest the profits to make even more money. The proprietary technology that guaranteed these returns was a smoke screen and Alexandre scammed hundreds of investors out of at least $59 million.

Greed makes people gullible and plugs into our most basic instinct, which is to get something for nothing. People naturally want to do the least amount of work for the most amount of money and will trust a “grifter” that looks the part and comes along with a get-quick-rich scheme.

A grifter is a “confidence man”, someone who tries to gain your trust only for their financial benefit and theirs alone. Anything and anyone can be a grifter trying to take your money —governments, organizations, companies, and people— that you put your trust in and take advantage of that trust to rip you off.

What happens when you can’t trust a company and the technology that holds you’re digital assets? Have you ever thought about that?

I don’t know if you heard of this story, but in April 2021 Thodex, one of Turkey’s largest crypto exchanges suddenly went offline. Its founder and CEO, Faruk Fatih Özer, disappeared leaving almost 400,000 customers in the dark and without access to their funds. Customers had deposited $2 billion in cryptocurrencies on the exchange. This past August he was found and arrested in Albania. Now he’s facing 40,000 years of jail time.

The truth is you don’t know whether to look left or right anymore.

People that are building these platforms, thieves hacking into these platforms, and everyone in between is trying to steal your money, one way or another.

Εxchanges are used by just about everyone who uses cryptocurrency. While it is possible to manage your keys and transactions, most non-custodial wallers are difficult and prone to human error. Even if you can manage your keys, 99% of everyone else will not be able to, which means that practically everyone has an account with one or more crypto exchanges.

Throughout the years, exchanges have had a shaky track record.

MtGox, the first big exchange, went bankrupt due to fraud. QuadrigaCX, Canada’s largest exchange, went bankrupt when its founder died and was the only one holding the keys to the hundreds of millions of dollars.

When crypto exchanges vanish or fail, either because their founders are scammers engaged in “rug pulls” or because they are incompetent and in over their heads, the result is always the same —users lose everything with little or no recourse.

When you deposit cryptocurrency with an exchange, it’s a sale rather than a deposit. You are a creditor, not a depositor and the exchange has ownership of your coins instead of you.

If the exchange collapses, like any other business, a bankruptcy estate is created and all the exchange’s assets, including your coins, become the property of the estate. The trustees who oversee a bankruptcy, prioritize the creditors (secured, unsecured) based on their liquidation preference and start to liquidate the assets to pay back the creditors. Venture capital funds, investors, and financial institutions are usually the secured creditors.

Who are the unsecured creditors? You and me and everyone else who deposited their crypto in the exchange.

I assume you can figure out the rest. Once the secured creditors get their money back, what’s left is paid to the unsecured creditors. What does that mean? It means that we are the last in line to get our money back and if the assets run out before our turn comes, we get nothing.

If we are lucky enough to get something, the assets will be frozen until the finalization process is completed. Now if the exchange operated in shady and opaque ways to avoid taxation and regulation, you’ll be waiting for years, many years.

The recent examples of the Voyager and Celsius bankruptcies, highlight these risks. To give you another example, it’s taken more than eight years for customers affected by the MTGox hack to make a claim —the deadline was September 15, 2202.

It gets even better.

When you get paid you’ll be paid at the dollar value of your crypto when the exchange collapsed. Even if your coins have gone up in value from the collapse until everything gets resolved, your pro-rated share will be based on the value of your coins at the time the exchange went bust.

For most of these services, the fine print in their terms states that they own the funds the customers deposited with them. When customers deposit their coins, they transferred the ownership of their coins to these services and the coins became the property of the exchange. When an exchange goes bust, the only thing you should expect is that the exchange will try to save their own skin with your money.

Using the term fraud is putting it lightly. To lure in customers, Celcius promised to pay up to 18% interest on “Earn” accounts, when customers deposited their crypto. Voyager took it a step further, giving customers the false impression (the tweet has been deleted, but you’ll find it on the Internet Archive) that their money was insured by the FDIC.

What a sweet deal. Give me your money and I promise to keep it safe and pay interest on it, but if anything goes wrong, I owe you nothing —not your capital or any interest. I don’t know about you but that sounds like a scam to me.

When you give someone your money and they agree to invest it to make more money and pay you interest, that’s an investment contract.

If you go to your bank and deposit $100, you expect to be able to withdraw your $100 at any point, right? You expect your bank to be managing that $100 responsibly. If you go to your bank and the bank says, ‘Sorry, we made some bad investment with your money and you now no longer have $100, you’d be pretty upset, right?

Even Coinbase the poster child for crypto, in an eerie case of foreshadowing for the crypto market, disclosed in its first quarter 10-Q filing with the SEC that crypto held for its customers potentially could become the property of a bankruptcy estate should the exchange file for bankruptcy.

Do you still want to put your money on an exchange or any other centralized platform?

On a micro level, the answer is obvious. Centralized exchanges should be regulated. Customer funds must be held separately and securely, with clear rules on risk exposure. It’s more complicated on the macro level. Banks have been demonized since the 2008 financial crisis, and Satoshi created Bitcoin to restore our financial independence and free us from the grip of banks and other financial institutions. However, we have recreated centralized platforms that are far riskier, ignoring the decentralized nature of cryptocurrencies.

Crypto self-custody is no longer a choice, it’s an imperative.

While self-custody comes with its own risks and users have lost their crypto because they lost their keys, the alternative is not an exchange. There are solutions that have shifted away from passwords, private keys, and seed phrases to technologies like social recovery and the use of biometrics to manage and recover crypto assets.

 

by Ilias Louis Hatzis is the founder and CEO of Kryptonio wallet.

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