Crypto Exchange Insolvency: Segregation Key to Protecting Holdings

Investors in cryptocurrency exchanges are often unaware of the risks involved when their chosen platform becomes insolvent. While some may assume that deposits are protected by deposit guarantees or investor compensation, this is not the case for crypto-assets.

In Germany, as per a consumer notice from BaFin on August 22, 2022, crypto-assets do not fall under the protection of the deposit guarantee, and investor compensation does not apply 'as a general rule'. This leaves investors with two possible outcomes: either their holdings are still legally attributed to them, or they fall into the estate, which could lead to a pro-rata dividend.

The distinction between these two outcomes hinges on whether a right of segregation exists, given the structure and actual performance of the contractual relationship between custodian and customer. This is governed by insolvency law, specifically Section 47 of the German Insolvency Code (InsO), which states that a person who can assert a right in rem or personal right to an object not belonging to the estate is not an insolvency creditor.

The right of segregation is contingent upon the actual separation of holdings. Crypto-assets held on trust may qualify for segregation if they sit in wallets kept apart from the custodian's own holdings, and the custodian honours the trust arrangement. However, where a provider mixes customer holdings with its own or deploys them for its own purposes, an individual holding can no longer be attributed to an individual customer.

The EU regulation on markets in crypto-assets (MiCAR) introduced duties around custody, including the requirement for providers to make adequate arrangements to safeguard client ownership rights and prevent the use of clients' assets. Article 70(1) MiCAR explicitly addresses insolvency cases and requires providers to protect customer holdings. Regulated exchanges must also separate holdings and ensure clear identification of means of access.