What Does It Mean for Investors When a Crypto Exchange Goes Bankrupt?

By Konstantin Boyko-Romanovsky, CEO and Founder, Allnodes

General consumers, investors, creditors, traders or bankers invest in digital transformation through blockchain development. Blockchain is a technology that can be the backbone of any system in every business sector imaginable, and many already are. However, how and where to invest depends on one’s personal preferences. This article compares the two types of most common crypto investing avenues, the centralized versus decentralized cryptocurrency exchanges, examines what happens if they fail and concludes with an outlook for the blockchain sector in 2023 and beyond.

Two Types of Crypto Investing Avenues

There are two types of exchanges for cryptocurrencies, centralized exchange CEX and decentralized exchange DEX. The main difference between the two is in the custody of traded assets. CEXs have custody of investors’ funds, while DEXs do not. From the moment an investor deposits funds into a custodial cryptocurrency exchange or CEX, they are, in a way, swapping the risk of losing their funds (if the CEX goes bankrupt) with ease of use and convenience offered by the CEX, such as liquidity and cheaper and faster trades. DEXs are slower, less intuitive and less convenient. There is no option to exchange fiat currency for crypto and vice versa on a DEX. However, investors keep their assets if DEX collapses. Neither of the exchanges is secure from collapsing or getting hacked.

What Happens if the Exchanges Fail?

Suppose a custodial cryptocurrency exchange or CEX (centralized exchange) goes bankrupt. Then no government agency will come to the rescue, and the investors’ funds on the exchange might be hard to recover. It is because the government does not insure crypto exchanges in the same way as banks. As a result, all crypto asset types, even those classified as Stablecoins, which are pegged to a national fiat currency like the dollar, are not protected and might not be recoverable.

Investors in cryptocurrencies might be able to recover some of their lost funds from Chapter 11 bankruptcy proceedings. However, they are the most affected by the insolvency of CEXs and are last in line to get paid. Therefore, it might be wise to keep a thorough paper trail on all forms of communication that will follow with the bankrupt entity or their representatives to ensure some form of compensation in the future.

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On the other hand, if a non-custodial DEX operating on a blockchain collapses, like Serum, a Solana-powered blockchain exchange, the user’s funds won’t be affected. Since the onus of crypto custody rests with the investor—the users of DEXs trade from their personal crypto wallets instead of the custodial gateways of CEXs.

One way for investors to ensure funds stay safe on the CEX is to invest in a premium hard wallet and move all idle cryptocurrencies into one’s own custody. Making this a habit and practicing vigilance is a good risk management strategy to get behind.

There are additional risk factors to consider when it comes to DEXs. Unlike in CEXs, where trading takes place on the CEX platform, in DEXs, the trades are executed via smart contracts. These are digital agreements or programs stored on a blockchain that facilitate transactions. Like most things, smart contracts aren’t bulletproof and can be hacked, leading to losses in cryptocurrencies and the reputation of blockchain protocols behind them. Other risks are associated with the speed of transactions, minimal support to investors, liquidity, limited options for advanced trading tools and potential lack of transparency of costs.

Investors in blockchain technologies should familiarize themselves with the inherent risks in cryptocurrency exchanges and select the option that works for them. These are the tools currently available, but both exchanges continually evolve to minimize risk and offer better service to investors.

Outlook for the Blockchain Sector in 2023 and Beyond

The crypto market in 2023 will most likely go through waves of additional turbulence, as is its nature. Blockchains that don’t repair and rebuild, those that don’t stabilize and strengthen their networks and utility will fade into the background or seize altogether. Therefore, it’s good to research every blockchain before investing in its crypto assets, ensuring that the technology is evolving and its network of developers and users is steadily growing.

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New investors looking to enter the crypto market may want to consider doing it sooner rather than later. The prices for digital assets are low at the moment, but things should start to pick up in the second half of 2023 and 2024 due to the Bitcoin halving event scheduled for next year.

Bitcoin halving happens every four years when a certain number of blocks is mined, and the reward for mining blocks gets reduced by half, as well as the rate at which Bitcoin is mined. Since Bitcoin is in limited supply, halving causes significant price appreciation. One can imagine what would happen to any commodity if we half its supply every once in a while. The prices will go up. Bitcoin is not the single driving force behind the value of digital currencies, but it is a significant contributor. The rest of the blockchain protocols will prevail because of their utility.

Both DEXs and CEXs have their own benefits and potential risks. The most important thing is for investors to do their own research before spending any money and to make a plan for a potential worst-case scenario. While we’ve seen a few exchange bankruptcies lately, crypto is still a powerful investment to mix into your overall portfolio for educated and savvy investors.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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