What is a cryptocurrency exchange?
Many people who invest in digital assets use specialized exchanges to convert their assets from fiat currencies (like the US dollar) to cryptocurrencies (like Bitcoin), from one cryptocurrency to another (like from Bitcoin to Dogecoin), and from cryptocurrencies back to a fiat currency. Most exchanges are centralized companies that match digital asset buyers and sellers. They generally charge commissions or take fees for that service. Many exchanges also have bank like operations, taking customer deposits, lending them to undisclosed third parties, and profiting from the difference in interest they pay their depositors and charge their creditors. While exchanges present themselves as a safe and easy way to trade your assets, using them often comes with many serious risks, highlighted by the recent failures of Celsius, Voyager, FTX, and BlockFi. If you want to know more about the risks of investing in cryptocurrency, read Cryptocurrency! What is it? What are the Risks?
While many cryptocurrency investors know about the risks of investing in cryptocurrencies, very few understand the hidden, and sometimes catastrophic, risks of putting their cryptocurrencies on exchanges.
Is it safe to use a cryptocurrency exchange?
Using a cryptocurrency exchange to store or exchange your fiat and digital assets can be extremely risky. In some cases, users have discovered that their assets are gone completely or indefinitely locked up in bankruptcy proceedings. If you are considering using a cryptocurrency exchange, it is worth remembering the old crypto adage: “Not your keys, not your coins.” When you put your digital assets on an exchange, if the exchange doesn’t give you your own wallet, you are giving that exchange complete control over your assets. Because of the amount of currency in their custody, exchanges are often the targets of hackers. Hackers brought down Mt. Gox, then the world’s largest exchange, in 2014, stealing hundreds of millions of dollars in the process. More recently, Crypto.com admitted to a $35 million hack in January of 2022.
If the exchange is financially healthy and has proper controls in place, your risk may be lessened, but there is often no way for you to know how healthy, trustworthy, or secure an exchange is.
While cryptocurrency exchanges may act like brokers (facilitating cryptocurrency transactions for commissions) and bankers (taking cryptocurrency deposits and paying interest to depositors), the exchanges generally aren’t registered and regulated as such by any state or federal authorities. This means that consumers typically don’t have much access to information about how safe the exchanges are, and their assets are not protected by regulatory authorities.
For instance, banks in the United States are subject to strict regulations to make sure that depositor funds are safe. Banks are required to maintain a portion of their assets in a way that makes the assets easily accessible to depositors. If the bank runs out of assets, depositors are protected by FDIC insurance up to certain amounts.
Likewise, securities brokers are subject to what are called net capital requirements to help ensure that their customers are able to access their assets in the event the broker goes out of business. Brokerage customers are also protected by the SIPC, which helps to ensure an orderly distribution of assets back to customers and even insures customers’ accounts up to a certain limit in case the firm fails.
Moreover, certain exchanges do things with customer assets that are highly regulated in other industries. One example is known as rehypothecation, where your exchange will pledge your assets as collateral to another entity so that your exchange can attempt to profit from its own separate activities. If your exchange gets into trouble, you might lose your assets that you placed on the exchange, even though you had no way of knowing how your exchange was using your assets.
There are currently no specific governmental regulations or protections for customers of unregistered cryptocurrency exchanges. If an unregistered cryptocurrency exchange fails, you could lose up to the full value of all the digital assets that you deposited on the exchange.
Are there red flags to watch out for?
Yes. The following could be signs that a cryptocurrency exchange poses a significant amount of risk for a potential customer:
- The exchange is incorporated or located outside of the United States. This could make it very difficult for you or the appropriate authorities to investigate the exchange or initiate legal proceedings against it.
- The exchange is not registered as a securities broker, depository institution, or money transmitter. Note that registration alone isn’t a guarantee that the exchange is safe or stable. For instance, FTX is registered as a money transmitter. Visit the following resources to research registrations:
- FINRA BrokerCheck:to determine whether a particular firm is registered as a securities broker.
- Federal Financial Institutions Examination Council National Information Center: to determinewhether a particular exchange is registered as a depository institution.
- Only registered money transmitters are legally permitted to engage in the business of transferring money or any other currency in the United States. Visit Financial Crimes Enforcement Network to determine whether an exchange is registered as a money transmitter.
- The exchange doesn’t tell you what it does with your assets. There could be significant danger if the exchange is lending your deposits to high-risk entities. Risky lending contributed to the demise of FTX and Voyager. If the exchange is rehypothecating or commingling your assets, it could be very difficult or impossible for you to recover your funds if the exchange enters bankruptcy.
- The exchange has minimal presence online or on social media. This could be a sign that it was set up quickly by scammers. Likewise, it could be a red flag if the exchange’s website has typos or misspellings.
- Someone you don’t know approached you on social media about investing cryptocurrency with the firm. Often scammers will approach their intended victims on social media to pitch fraudulent cryptocurrency investment schemes.
- You cannot easily find the firm’s wallets on the blockchain. Solvent exchanges will sometimes disclose proof of their cryptocurrency reserves. If an exchange keeps their wallet addresses or reserves hidden, it could be a sign that the exchange is undercapitalized or illegitimate.
- The exchange has previously frozen or interrupted customer withdrawals. While a withdrawal freeze could be a technical issue, exchanges facing liquidity shortages (such as firms running out of the assets needed to honor customer withdrawals) will often suspend withdrawals. For example, reports surfaced of the cryptocurrency exchange Voyager suspending customer withdrawals roughly a week before it filed for bankruptcy. It was widely reported that FTX suspended customer withdrawals before it filed for bankruptcy.
- The exchange doesn’t have a customer service department, or it is difficult to get in touch with customer service.
What can I do?
Remember that when you deposit your assets into a cryptocurrency exchange, you are giving the exchange full custody and control of your hard-earned capital. An exchange run by bad actors or one under financial duress could simply refuse to return your assets, leaving you in a very difficult situation. If the exchange collapses, you risk losing everything. Even if the exchange is legitimate and goes into bankruptcy, you would most likely be an unsecured creditor and last in line to recover anything.
Given the volatility of cryptocurrency markets and the risk of using unregulated exchanges to participate in the markets, you should take the time to research your options before exposing your assets to even more risk.
Before you invest, visit the resources below to learn more about how you can protect yourself and what to do if you get scammed.
Contact the Attorney General's Office
If you have a general consumer complaint, you may file a complaint with the Attorney General’s Consumer Protection Unit:
Consumer Protection Division
P.O. Box 30213
Lansing, MI 48909
517-335-7599
Fax: 517-241-3771
Toll free: 877-765-8388
Online complaint form
