Investing in Crypto While Avoiding Exchange Failures

Avoiding Crypto Pitfalls Series

For many of us, the appeal of cryptocurrencies (crypto) include being able to regain control of the keys to our own money and eliminating central parties. This is not without its trade-offs (I talk more about trade-offs here) — we regain control but we also take on the full responsibility of our own digital safe and key. Given that most transactions are irreversible and misplaced ‘keys’ remain lost forever, protecting your crypto is one of the most important things you need to learn to do.

In this article, I will dive into one of the most devastating pitfalls that you can fall into: crypto exchange failures. Let’s take a closer look at:

• The risks you take by leaving crypto on exchanges
• Useful tips you can do to avoid exchange failures and minimize your risks

Risky Business

There’s a common saying we have in the crypto space — ‘not your keys, not your Bitcoin’. Placing your assets on an exchange, whether crypto or dollars, exposes you to counterparty risk — you are trusting that another party will safeguard your assets for you and that you will get your assets back when you request them.

Globally, crypto users have experienced significant losses from exchanges failures, exchange hacks, or exchange owners or staff absconding with user funds. There have been a number of high profile exchange failures — from the collapse of Mt. Gox and the loss of ~850,000 bitcoins (Mt. Gox was largest exchange of its time, handling over 70% of all Bitcoin trading volume) to Canada’s own QuadrigaCX exchange collapse. Other exchanges like Cryptopia and BitFinex gave users haircuts off of their holdings to make up for losses due to hacks.

Personally, I experienced first-hand the impacts of an exchange failure. It was devastating to myself and 100,000 other users, some of whom lost their entire life savings!

The founder of QuadrigaCX, one of the largest Canadian exchanges, lost and/or embezzled $200+ million in customer funds. Gerald Cotten used users’ funds to purchase multiple real estate properties and other extravagant purchases and margin traded with client funds on other exchanges, accumulating millions in losses.

When I saw an opportunity to help the victims of this fraud, I applied because I believe in the long-term viability of crypto and the importance of supporting Canada’s crypto ecosystem and community. As a Supreme Court appointee, I represent all Affected Users of QuadrigaCX, and serve as an Inspector to its Bankruptcy. From this experience, I’ve developed good insights into what to watch out for. The QuadrigaCX exchange failure and its postmortem is a case study I like to use to help others understand how to better protect their funds.

Despite these risks, I’ve learned there are many steps you can take, and many crypto users, including myself, hold their crypto on exchanges for several reasons. The activities of buying, selling and exchanging crypto expose users to counterparty risk — even if for a short time. Some users prefer to place limit or stop-loss orders, which require holding the asset on the exchange until their order is executed. Many users may also choose to place their assets on an exchange during a hard fork to avoid the technical complexities of splitting their forked coins. Regardless of your reason, if you choose to keep your assets on an exchange, you need to be aware that the risk of losing your assets is very real and take steps to mitigate against losses.

Avoid Exchange Failures — Useful Tips

It’s not all doom and gloom— as a crypto user, there are several actions you can take to avoid exchange failures and minimize your risk of loss. Three key actions you can take are:

1. Use reputable exchanges

One of the most important things you can do to protect yourself from exchange failure and fraud is to pick a reputable exchange. The more established and reputable a company is, the less likely it will be that the exchange will go bankrupt or disappear overnight with its users funds.

Pick an exchange that:

• Has a long history
• Trades in large volumes
• Is located in a stable country and compliant with regulations
• Acts in good faith and cover clients in cases of crypto losses (eg, hacks, software glitches)
• Is run by a team with appropriate experience and the management team is disclosed and public.

2. Watch for warning signs

In picking an exchange, you need to do your due diligence. However, your job isn’t over after you’ve picked a reputable exchange; you need to remain vigilant and watch for warning signs, such as:

• Delays in taking money or crypto off of exchanges, or customers being unable to take any assets off of an exchange.
• Prices on the exchange get out of balance with the market. QCX arbitrage of double digits
• Communications — for example, look for excuses that continue to pile up or do not make sense or look at how they respond to bad events like cyber-attacks
• Warning posts on reddit or twitter of users experiencing problems, as well as bad reviews of exchanges.

A spotlight on QuadrigaCX:

Hindsight is 20/20 — looking back, there were several warning signs: users experienced delays of weeks to months in withdrawing their assets; the arbitrage between QuadrigaCX and the market rate reached double digits (likely because users could not withdraw cash, only crypto); and there were multiple posts on Reddit of users being unable to withdraw their cash (a few examples here and here). Its better to look at the positives in life — this exchange failure is now being used by crypto investors, regulators and other exchanges to identify and develop best practices.

3. Limit your exposure balances

No matter what, there will always be some level of risk when you place your crypto on any exchange. The best way to mitigate against this risk is to limit your exposure balances:

• Keep your assets spread out across a few reputable exchanges
• Do not use exchanges as your primary crypto storage — remember, not your keys, not your Bitcoin!

Is it worth it?

You may wonder, ‘this sounds like more trouble than its worth’, but to many of us, it’s worth the price of admission to be able to diversify into a new asset class (good resources here and here) and to gain full control of your own money. In future articles, I’ll cover tips on avoiding scams and SIM hacks and how to protect your crypto-assets.

Webinar: Avoiding Crypto Pitfalls

This information was based on a Webinar delivered by Pam Draper, CEO of Bitvo Cryptocurrency exchange and myself. You can re-watch our full webinar, covering exchange failures and other types of crypto pitfalls to avoid, here: https://metamesh.com/webinars