It is risky to store bitcoins with an exchange, says a recent academic paper from the Leiden Law School (Leiden University). In the event of a bankruptcy or other problem, it is not always clear which law applies. Users are usually short-lived and often appear to be little more than one of the many creditors.
From their own experience, bitcoiners regularly warn about the dangers of exchanges, but these risks are now also mentioned in an academic publication entitled “The Failed Hopes of Disintermediation: Crypto-custodian Insolvency, Legal Risks and How to Avoid Them”.
Exchanges & intermediaries
Many bitcoiners use intermediaries such as exchanges. They do this, for example, to be able to trade, but sometimes also because they find it easy to leave the security of the bitcoins to others. For the users it feels like just a place where they keep ‘their’ bitcoins, but legally it is not always clear whether ‘their’ bitcoins are still there at all Mrbitcoinexchange will tell you more about it., the paper shows.
“Thus, through crypto-custody, a crypto-investor gives up his direct rights to the blockchain, but gains the comfort of being able to (indirectly) dispose of those rights even when he loses his private key. From the crypto-investor’s perspective , the user agreement or crypto-custody contract with his crypto-custodian has therefore become the gateway to his rights relating to ‘his’ bitcoin. “
With bitcoin exchanges, it is not the case that you transfer the management of your private keys to the exchange, but instead you send the bitcoins from your bitcoin address to a bitcoin address of the exchange. As soon as they arrive there, the exchange owns them and the user receives a credit in return.
Exactly what that means and which law applies depends on local legislation. This differs per country and not every country has specific legislation for digital currency. Exchanges are often located in faraway places, which can be an additional hurdle in case of problems.
Separated or in one pile
The paper points out that an exchange’s way of working is important if something goes wrong. Are customer funds mixed together or kept separate?
Although it makes little difference legally, the researchers say, the chance that ‘your’ bitcoins are still there is greatest when an exchange uses separate bitcoin addresses where incoming transactions (UTXOs) remain unaffected.
However, most exchanges do not guarantee, according to the paper, that they will leave incoming transactions (UTXOs) unaffected. They often only guarantee the total value of all bitcoins from all customers. As a result, they are contractually free to send incoming transactions (UTXOs) from one customer to another.
“However, most crypto-custodians do not commit not to spend any specific unspent transaction output received from its customers. Instead, the crypto-custodian only commits to maintain the total value of all coins or unspent transaction outputs received from its customers and, once the customer in question requests a transfer of bitcoins, the crypto-custodian has contracted to be at liberty to use transactions outputs resulting from one or more other customers as input for that transfer. “
Bitcoins that one deposits are then, for example, paid out to another user who makes a withdrawal. The exchange keeps the balance behind the scenes. In such cases it is very difficult to claim ownership of specific bitcoins. What remains is a much weaker contractual claim.
This was the case, for example, with the well-known hack on MtGox, a bitcoin exchange where some 850,000 BTC of customer funds were stolen in 2014, resulting in bankruptcy. According to the judge, the remaining bitcoins were owned by the exchange and could therefore be used to pay off various debts. Exchange users could join the other creditors in line. A similar situation occurred with the more recent hack on the Italian Bitgrail.