Discover how to protect your crypto and recognize the early signs of a potential exchange collapse in this essential guide.
The downfall in November 2022 of the FTX crypto exchange is a stark reminder of the risks inherent in this high-stakes financial sector.
The rapid fall, sparked by revelations of questionable financial health, left investors scrambling, underscoring the necessity for robust contingency planning.
Understanding the impacts of such a collapse, recognizing the warning signs, and knowing how to prepare can be the difference between safeguarding your assets and financial ruin.
How does a crypto exchange collapse affect you?
A crypto exchange collapse can happen for various reasons, including security breaches, hacking incidents, insolvency, or fraud. The effects of such an occurrence include the following:
Money loss
Anyone with funds in a collapsed exchange faces the possibility of losing it. The exchange may freeze the funds, or the customer may no longer have access to them.
It is because when an exchange collapses, it means the company is bankrupt and can no longer operate. Additionally, the platforms may not have the necessary insurance to cover the losses or the funds may be tied up in legal proceedings.
Heightened regulatory scrutiny
Crypto exchange collapses do not go unnoticed, especially given the amount of money belonging to the public that often goes down with them.
They will quickly attract attention from regulators, leading to stricter measures being implemented to ostensibly stop similar incidents from happening in the future.
However, while well-meaning, many such measures can negatively impact crypto trading.
Market volatility
The crypto market is highly susceptible, so even the smallest things can trigger volatility. However, we can expect significant price shifts when something big happens, such as an exchange collapse.
Such fluctuations may affect current and potential investors, making it more challenging than ever for people to predict trends and make safe investment choices.
Understanding the signs of an impending collapse
Getting to know the signs that indicate a crypto exchange’s impending collapse is crucial for traders and investors to protect their hard-earned money.
While it is not an exact science, some signs are pretty obvious. Others require a more discerning eye and a sensitive finger on the pulse of the crypto industry.
It is the reason investors are often urged to constantly do research and stay up to date with the goings on in the sector.
Regardless of how attuned you may be to the industry, as long as you have funds in a crypto exchange, it is advisable always to stay alert to the following signs:
Top heads leaving the company
It may be just people leaving for greener pastures or deciding to take time away from the pressures of running a crypto exchange, but when key executives or leaders depart from the company suddenly, it could be a sign of brewing trouble.
These could include high-ranking officers like CEOs or CFOs, and their exit may indicate internal issues, mismanagement, or even fraudulent activities.
For instance, about one month before FTX’s troubles came to light, Sam Trabucco, co-CEO at sister company Alameda Research, abruptly left his position.
Trabucco claimed he wanted to “prioritize other things” and recover from the hectic schedule that came with running Alameda.
At the time, not too much was made of Trabucco’s decision, but the aftermath of his resignation should ensure that investors prod and probe every departure until they are satisfied it is a normal career or personal move.
Lack of liquidity
Anyone who’s ever tried trading crypto knows liquidity is essential. If an exchange has insufficient liquidity, it can result in late withdrawals and failed transactions.
Importantly, any crypto firm that has faced collapse, from Mt. Gox to FTX, has first had issues with honoring transactions, then resorted to halting withdrawals before finally filing for bankruptcy.
Suspicious account activity
Unusual account activity, such as unauthorized access or suspicious trading patterns, can suggest security breaches or internal misconduct within a crypto exchange. These signs should not be overlooked, as they can precede a collapse.
It’s essential for investors to monitor the movement of funds held by a crypto exchange. Large and irregular transfers from company wallets to external addresses without proper explanation or justification may indicate mismanagement or potentially fraudulent activities.
Unregulated exchange operators and lack of security measures
Regulation plays a vital role in ensuring the integrity and security of crypto exchanges. A crypto exchange operating in a heavily regulated jurisdiction should give users a measure of confidence in the business.
However, they should take more care when dealing with exchanges registered in countries with lax crypto laws.
Exchanges operating in unregulated environments may lack proper oversight, making them more susceptible to fraud, hacking, and potential collapse.
After the fall of FTX, The Bahamas, where the company was headquartered, was forced to defend its commitment to the rule of law around crypto, following suggestions that lax regulatory measures allowed the FTX debacle to happen.
How to prepare for crypto exchange collapsing
Once an investor knows the signs they need to look out for, the next step is to prepare themselves for any eventuality whilst protecting themselves as best as they can from the worst possible outcome of a crypto collapse.
Of course, these steps are not foolproof, and there are no guarantees they will protect funds from being lost in the event a crypto exchange collapses.
Evaluate the integrity and reliability of a crypto exchange
Anyone venturing into crypto needs to stay vigilant. It’s the most helpful trait an investor can have. It’s essential to evaluate your crypto exchanges regularly. One of the factors to consider when thinking about their stability is how well the exchange follows the rules set by the government.
Crypto exchanges that either bend, break, or ignore the law should be instantly avoided. It means investors must familiarize themselves with applicable crypto laws within their jurisdiction.
While crypto regulations may still be murky in many countries, one can use the services of dedicated crypto lawyers to help navigate their way around them. Crypto law is a practice that is fast-emerging globally.
Additionally, one can gauge the reputation and integrity of crypto exchanges by checking out reviews from other users on social platforms like X, Reddit, and Quora, or on review websites like Trustpilot.
Diversify investments and trading platforms
Don’t put all your eggs in one basket. This phrase holds in most situations, especially when selecting a crypto trading platform.
Traditional investors use diversification as one of their main risk management tools, creating a mix of investments within their portfolio to limit exposure to one asset.
Crypto exchange users can limit their exposure to a single platform by spreading their funds among several reputable exchanges. In that way, if something happens to one platform and it collapses, all your investments won’t go with it.
Personal security measures
Beyond diversification, individual security measures are critical in protecting digital assets from collapsed crypto exchanges.
The first rule of thumb in crypto is “not your keys, not your coins.” It means that the best place to keep your funds is somewhere you have complete control over them, and crypto exchanges are not the safest bet for that.
Investors can use reputable digital wallets or hardware storage to secure their holdings. These tools provide an additional layer of protection, ensuring that your assets are safe. More importantly, if an exchange collapses, your funds will not be anywhere near the disaster.
Research crypto exchange insurance policies
Unlike money invested in the traditional financial sector, funds on crypto exchanges have no baked-in protection to cover for theft or loss.
However, some exchanges claim to carry insurance that protects a portion of the crypto held in their custody against cybercrimes.
For instance, Binance has a program called Secure Asset Fund for Users (SAFU), which it established in 2018 to protect users in “extreme cases.”
Bittrex reportedly had a $300 million insurance plan from Lloyd’s of London that covered digital assets in its cold storage system. After filing for bankruptcy in May 2023, the exchange assured users their funds were safe and stated its intention to petition the bankruptcy court to briefly reopen customer accounts to return their crypto.
On its part, Gemini boasts a $200 million insurance plan from Nakamoto Ltd covering crypto in its hot wallets. Coinbase, too, has a reported $225 million facility from Aon covering up to 2% of the total amount of crypto in its hot wallets.
However, it is important to know that these insurance plans may not cover all types of losses or risks, and they may have different terms and conditions. Investors should, therefore, make sure to read the fine print and understand the limitations of each exchange’s policy before entrusting their funds to them.
Can you get your money back in case of a crypto exchange collapse?
When an exchange collapses, most customers are considered unsecured creditors, meaning they are paid back only after secured creditors. In such cases, customers can file a claim against the exchange.
Assuming that you’ve complied with the Know Your Customer (KYC) regulations and have set up your account using accurate information, the crypto company should have your contact details and a record of your owed amounts.
In the event of the firm’s insolvency, you should ideally receive prompt communication from them about reclaiming your assets.
Most exchanges have unique procedures to refund clients, which require them to fill out forms, confirm their address or payment details, and stay updated with any other essential paperwork to recover their cryptocurrency or cash.
Although there’s a possibility that crypto investors might not recover any funds post-bankruptcy, there’s also an opportunity that they might recuperate something—even if it’s just a fraction of their initial investment.
Investors can track their claims through the appointed trustee or liquidator. However, the timeframe for resolution can be lengthy, often taking several years, as seen in the Mt. Gox case, which has taken more than eight years to resolve.
In the case of FTX, the exchange claimed it was hacked to the tune of $415 million, which some legal experts think may diminish the chances of users getting back their funds.
According to documents filed in court, FTX owes at least 1 million creditors more than $3 billion, with another $102 million due to its customers. U.S. law gives courts the power to decide who among customers, investors, and creditors gets first priority when funds are being returned.
Per legal experts, if the court were to apply equitable principles in the return of FTX funds, then it would give creditors first priority, with investors considered second and customers last.
Even worse, new FTX CEO John Ray III previously said that the exchange’s books were not reliable. It means it may prove difficult to figure out whose crypto was stolen in the alleged hack, whose was used to prop up Alameda Research, and whose remained intact.
