The fallout from FTX has had an extraordinary impact on the crypto space. For the past several weeks, rumors and accusations about commingling of funds, safety of customer assets, allegations of fraud and contagion effects have dominated headlines, as well as sending the prices of most major coins tumbling. While FTX clients are left wondering if they will ever see their assets again, other crypto investors may be wondering if their coins are actually safe.

A Question of Custody

When an investor buys cryptocurrency today in the United States, they have two main choices to store their assets — to self-custody the crypto, which is referred to as a hard or cold wallet, or to keep the assets on an exchange*, also referred to as a hot wallet.

Self-Custody: If an investor chooses to self-custody their coins, they are typically held in physical storage devices, such as flash drives or hard disk drives that store private keys, tokens, or cryptocurrencies. By securing coins on a private wallet, the crypto is effectively taken out of circulation as they are held under password-protected encryption.

However, the reverse effect of having crypto kept safely away is the lack of instant liquidity. In times of high volatility, investors would need immediate access to their crypto. When timing is an issue those few minutes connecting and uploading your cold wallet could cost money.

There is also the risk of the device or password to the device being lost or stolen. The amount investors have lost due to misplaced passwords or lost/disposed hard drives varies, with some accounts placing it at nearly 10% of the bitcoin “mined to date.”

Exchange: As broker-dealers are not yet allowed to custody crypto for retail clients, coins cannot be held in an investor’s existing brokerage account. They can, however, remain at the exchange where the coins were purchased, i.e., Coinbase, Binance, or Crypto.com.

Hot wallets have a number of benefits, including ease of use. If you purchase your coins on an exchange, keeping them on that exchange is simple — after executing the trade, the exchange holds the funds. And hot wallets provide the benefit of transaction ease — you can easily transfer your coins in and out, liquidate, or purchase additional coins. Crypto exchanges also provide up-to-date valuations on holdings.

Institutional investors do have another option. The Office of the Comptroller (OCC) — the bank regulator in the United States — granted banks the authority to custody crypto back in 2020, under former President Trump appointee Brian Brooks. However, acting Comptroller Michael J. Hsu has been more cautious in his approach. In November 2021, the OCC stated that banks needed “adequate controls in place,” before engaging in crypto activities.

Despite this, BNYMellon, the oldest bank in the United States, became the first to offer custody services of bitcoin and ether to institutional clients, alongside their traditional investments. And other major institutional firms are also considering offering crypto custody services to their institutional clients, including Nasdaq, which recently applied to the New York Department of Financial Services to offer crypto custody.

Impact of the Crypto Winter and FTX

The risks of holding your crypto on exchanges have never been more obvious than in the past few months. Recent volatility has seen assets leaving exchanges at a rapid clip. Even prior to the FTX meltdown over 34,000 bitcoin moved off exchanges on September 30, 2022, according to analysis firm Santiment.

The below chart shows the amount of money that has been leaving centralized exchanges, while funds into decentralized exchanges, is growing, as the threats of cyber attacks or exchanges failing loom.

Frozen Assets: The collapse of FTX prompted a historic withdrawal of coins off exchanges. According to Glassnode, 72,900 bitcoin left exchanges during the week of November 7, 2022, and withdrawals were not limited to bitcoin, as ethereum saw similar, significant movements.

Representatives of FTX have indicated that large amounts of cryptoassets had been stolen from the exchange. Combined with the company’s Chapter 11 bankruptcy filing and reports of hacking make it unlikely that investor assets will be fully recovered.

Cyber Attacks: Beginning with the infamous Mt. Gox attack in 2014, billions of dollars have been hacked from major exchanges. While crypto transactions on the blockchain are pseudo-anonymous, they are also irreversible; crypto also lacks a centralized authority. In 2021, there were over 20 hacks where victims lost at least $10 million in securities, according to a report by Chainalysis, and earlier this year, Crypto.com was hit by hackers for $30 million of stolen bitcoin and ether.

Other Options

Crypto Wallets are web-based applications that allow investors to store, send and receive virtual currencies. While ease of use is a benefit with a mobile wallet, the risk of cybercrime and the loss of key information may still be an issue. Many crypto exchanges, such as Coinbase, have also started offering custodial wallets as an option for their customers.

A decentralized exchange, or DEX, offers protection against the viability of the exchange where coins are held. These decentralized exchanges allow investors to conduct their trades, and are ultimately responsible for their trades, settlements and safe-keeping of coins or tokens. Users can trade tokens directly with each other using blockchain-based smart contracts instead of passing funds through an intermediary or central authority.

Tax Implications of Moving to a Private Wallet

If an investor moves assets off exchange, it generally does not create a taxable event. Jack R. Brister, EA, MBA, TEP, Managing Member and Founder of International Wealth Tax Advisers, said, “Moving coins between wallets is not a taxable event — whether it is to a private wallet or to another exchange.” However, Mr. Brister advises that if the platform an investor is moving assets to does not take a particular instrument (i.e. an account holding XRP and the exchange will only hold bitcoin), and an investor needs to sell assets to then reinvest into that platform, that would constitute a taxable event.

Looking Ahead: More Regulation or Self-Custody?

The crypto space saw increased acceptance in 2022, prompting global governments to look closer at regulations—given the failure of FTX, the question of custody will be further highlighted. While private unregistered funds targeting accredited investors and qualified purchasers are able to access custody services at certain banks, as of yet, retail investors do not have that option. However, Fidelity Investments is getting ready to launch a retail crypto trading platform and has opened up a wait list for retail investors.

Ultimately, where an investor puts their crypto depends on where they deem most appropriate — potentially storing a certain amount with an exchange frequently used, storing currency that is considered a long-term allocation on a hardware wallet and then using a mobile or desktop wallet for more speculative purchases. Investors typically have multiple accounts for their traditional finance investments, why shouldn’t it be the same for crypto investments?

* U.S. citizens should check if the particular exchange they are viewing is available in their residing state.

This content is for educational purposes only. It does not constitute trading advice. Past performance does not indicate future results. Do not invest more than you can afford to lose. The author of this article may hold assets mentioned in this article.

If you found this content engaging, and have an interest in commissioning content of your own, check out Quantum Economics’ Analysis on Demand service.