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Cryptocurrency exchanges play a key role in the cryptocurrency ecosystem, serving not only as central marketplaces for buyers and sellers to trade but also as custodians for their customers ' cryptocurrency holdings. Exchanges, however, are thinly regulated for safety and soundness and face major insolvency risks from their own proprietary investments as well as hacking. This piece considers what would happen to customers' custodial holdings if a cryptocurrency exchange in the United States were to fail.
Any custodial relationship can potentially be characterized as a debtorcreditor relationship between the custodian and customer, rather than an entrustment or bailment ofproperty. U.S. law gives substantial protection to the custodial holdings of securities, commodities, or cash deposits by securities, commodities brokers, or banks. No such regime exists, however, for custodial holdings of cryptocurrencies. Instead, bankruptcy courts might well deem the custodial holdings to be property of the bankrupt exchange, rather than of its customers. If so, the exchange could use or sell the cryptocurrency, and the customers would merely be general unsecured creditors of the exchange, entitled only to a pro rata distribution of the exchange's residual assets after any secured or priority creditors had been repaid. And even if the holdings were ultimately deemedproperty of the customers, the customers would still experience extended disruption to their access to their holdings.
Cryptocurrencies are designed to address a problem of transactional credit risk-the possibility of "double-spending. " The lesson here is that credit risk can arise not just from active transacting in cryptocurrency but also from passive holding of cryptocurrency. Because this passive holding risk turns on technical details of bankruptcy and commercial law, it is unlikely to be understood, much less priced, by most market participants. The result is a moral hazard in which exchanges are incentivized to engage in even riskier behavior because they capture all of the rewards while the costs are externalized on their customers.
Introduction
It was hard to miss cryptocurrency exchanges at Superbowl LVI. The game was played in February 2022 at SoFi Stadium, named after cryptocurrency exchange SoFi Technologies, and the broadcast of the game featured ads from cryptocurrency exchanges Coinbase, eToro, FTX, and Crypto.com.1 Exchanges like these serve as the central marketplaces for cryptocurrency transactions, enabling buyers and sellers to...