The press has been buzzing about Coinbase’s most recent 10-Q disclosure in its May 10, 2022, filing with the Securities and Exchange Commission (SEC). In the filing, Coinbase indicated that a bankruptcy court might treat its customers as unsecured creditors if a Coinbase bankruptcy occurs. Coinbase most likely made the statement to comply with broad SEC rules regarding risk identification. The statement has triggered general concern about the security of cryptocurrency investments held by firms that look and act like brokerage firms but, in fact, operate without the regulation and legal structure that applies to brokerage companies that hold assets in trust.
Why Did Coinbase Issue the Disclosure?
The timing of and reason for the 10-Q disclosure is the first issue that raised questions, including about Coinbase, itself. Coinbase CEO Brian Armstrong assures the public that Coinbase is not at risk of bankruptcy.
So, why did Coinbase issue the disclosure? The simplest explanation is probably the best one – crypto assets held by Coinbase may not be segregated as held in trust and, therefore, may be subject to the claims of general creditors in a meltdown. The regulatory environment has not caught up with the business of crypto trading platforms.
What Did the Coinbase Disclosure Say?
The Coinbase 10-Q report outlined other potential risks (per SEC requirements) associated with its operations and cryptocurrency in general. Those risks included the following categories:
- Failure to safeguard and manage customer assets;
- Significant disruption in its technological and blockchain resources;
- Loss of a banking relationship;
- Interruption in third-party services; and
- Improper characterization of a cryptocurrency asset by Coinbase within a jurisdiction.
Why was the bankruptcy the stand-out risk factor? Probably because the market had not assimilated the issue. The market (meaning the collective minds of investors and analysts) was thinking of Coinbase as being like other financial institutions that hold customer assets in trust. If, however, customers’ assets are actually commingled with other customer assets and with Coinbase assets, creditors could argue that those customer assets should be available to the general unsecured creditors of Coinbase and that customers of Coinbase be considered part of the class of such general unsecured creditors. In that scenario, customers would have been better served if they had held their crypto assets in their own personal wallets.
Is Coinbase Secure?
Holding significant crypto positions in Coinbase appeals to investors who want the convenience of a brokerage firm. Coinbase offers enhanced levels of security from hackers and makes trading seamless. Prior to the “bankruptcy risk” gaining attention, the focus was on protection from hackers. The security of customer assets in bankruptcy, however, strikes us as a structural risk for trading platforms that should be addressed through federal legislation. In order to avoid this risk, investors that want to hold significant positions in crypto should consider using a cold storage provider or a cold storage device (if you are comfortable with technology). Another alternative is to use a standard stock trading platform or stock broker to invest in publicly traded crypto mining companies. The share prices of publicly-traded Bitcoin and Ethereum mining companies on NASDAQ correlate closely with the market price of those cryptocurrencies.