Cryptocurrency Custodial Arrangements: A Red Flag

Robert Hillman

Not Your Keys, Not Your Coins: Unpriced Credit Risk in Cryptocurrency, by Professor Adam J. Levitin, is a must read for anyone writing about or just interested in (or even trying to understand) the world of digital currency. The article is filled with important information and explanations about cryptocurrency, cryptocurrency exchanges, the language and meaning of investor agreements, and current and proposed regulation. The article nonetheless has a particular concern: It focuses on the risks investors face if a cryptocurrency exchange, which not only facilitates trades between sellers and buyers, but also serves as custodian for their cryptocurrency, becomes insolvent. Such an issue, the article points out, likely escapes many investors passively holding their cryptocurrencies in such a custodial account (hence the title’s reference to “unpriced credit risk”).¹ Although no U.S. exchange has yet filed for bankruptcy, the article posits its inevitability in part because of the likelihood of exchange hacking or poor exchange investment strategies. In fact, as I write this JOT, cryptocurrency values are plummeting, raising questions about their future.²

Although Not Your Keys discusses an assortment of exchange account arrangements, the article focuses on a particular common one: Cryptocurrency is held in a custodial account, but for various reasons well documented in the article, the exchange has exclusive access to the cryptocurrency and comingles the asset with other investors’ holdings.³ Further, the custodial account may “lull customers with misleading language about ‘ownership’ and ‘title.’”(P. 52.) In such instances, investors face an insolvency risk possibly unknown to them. The bankruptcy court may treat the co-mingled cryptocurrency as the property of the exchange, with investors holding only a general creditor contract right. This is crucial because in such circumstances, customers must compete with all unsecured creditors of the bankrupt exchange after secured creditors and others with priority rights have taken assets off the top.

Accordingly, a significant part of Not Your Keys investigates whether, under current law and in light of this arrangement, investors or the cryptocurrency exchange has a property interest in the custodial account. Of course, the language of the custodial agreement comes first in answering this question. “Not Your Keys” therefore sets forth examples of custodial contracts, which often contain contradictory language on the issue of ownership. For example, on the one hand, an agreement may provide that the exchange is only a custodian of the cryptocurrency and that the investor is the “owner” or has title, which indicates that the investor has a property right and priority in bankruptcy. On the other hand, the same agreement may provide that the exchange controls the “private key” that accesses the cryptocurrency and may authorize the exchange to “store its customers’ cryptocurrency * * * in unsegregated accounts for all purposes—controlled solely” by the exchange. (P. 17.) Such language suggests that the exchange is the owner of the cryptocurrency and the investor is a mere general creditor.

How should a bankruptcy court interpret an agreement with internal contradictions of this nature?  Court decisions interpreting similar contradictions in other contexts have largely ignored conclusory legal labels in the agreement if the evidence probative of the meaning and function of the agreement rebuts that language. Consider, for example, a “liquidated damages, not a penalty” term when the term is not a reasonable estimate of predicted or actual loss. Consider also, an agreement that states a conveyance is a lease and not a security interest when circumstances show otherwise.⁴

Because custodial account agreements contain contradictions, Not Your Keys looks beyond them for guidance on how to treat cryptocurrency located in an insolvent exchange. Guidance is limited, however. The article reveals that current legal strategies that regulate bank deposits and securities accounts at brokers have not been applied to cryptocurrency exchanges.⁵ Nor do various kinds of legal relationships, including express and constructive trusts, bailments, entrustments, and sales, shed sufficient light on whether customers have a property or contract interest in their cryptocurrency.⁶ But analyses of these constructs as applied to particular facts should alarm investors. For example, “[f]or retail investors, the trust beneficiary * * * is typically the exchange itself, rather than the exchange’s customer, an arrangement that means that the exchange holds the beneficial interest in the cryptocurrency and its customers are merely its unsecured creditors.” (P. 26.)

In fact, Not Your Keys emphasizes that “this lack of clarity about legal characterization of custodial arrangements is the key point.” (P. 22.) The article’s main function is thus to raise a red flag about a risk not well appreciated by investors. Readers who want to understand the intricacies of cryptocurrencies, their exchanges, and looming bankruptcy ramifications should read the article for a very helpful primer on these subjects.

1. “To be sure, some awareness of these risks exists within the cryptocurrency investor community. The mantra ‘not your keys, not your coins,’ appears frequently in online cryptocurrency forums. Yet this mantra is generally recited without analysis or understanding of particular nature of the underlying legal risks.” (P. 7.)
2. “Stock prices of crypto companies have cratered, retail traders are fleeing and industry executives are predicting a prolonged slump that could put more companies in jeopardy.” David Yaffe-Bellany & Eric Griffith, ‘The Music Has Stopped’: Crypto Firms Quake as Prices Fall, N.Y. Times, (June 15, 2022).
3. For example, Professor Levitin explains, that exchanges can “achieve transaction account savings through bundling and netting.” (P. 14.)
4. For one more example, labeling an item as a fixture will not succeed if the item does not satisfy the definition.
5. “The contrast between * * * uncertain and likely unfavorable treatment for cryptocurrency investors and the greater protections that exist for bank depositors and securities and commodities brokerage customers is striking.” (P. 64.)
6. The article also concludes that Article 8 of the Uniform Commercial Code does not apply. Rather dramatically (and with good reason), Levitin states that “[i]t is hard to overstate how uniquely problematic Article 8’s drafting is within the entirety of American Law.” (P. 36.)