You have probably heard the news by now. The FTX exchange, once the darling of professional crypto traders, has fallen.
It's what everyone talks about these days—on crypto twitter, blockchain blogs, in the New York Times, and even on Capitol Hill in the United States.
And while the community digests the sober reality and what it means for the industry at large, a lot of individuals who saved their money on the platform are left licking their wounds.
How can the industry prevent a situation like FTX's crash from happening again? That's the 8 billion-dollar question. While regulators and industry players figure this out, mere investors are wondering how to protect themselves against possible platform failure.
If FTX's fall from grace has made one thing clear, it is that no platform is too big to fail. Things happen fast in the world of crypto and investors who haven't taken protective measures can lose all their money.
But how can investors protect themselves in this volatile and largely unregulated market? Here are three avenues to consider.
An exchange feels like a natural place to leave the crypto you buy. You can easily access, transfer, sell or use it for a variety of ways depending on the platform. For active traders especially, storing crypto on an exchange often feels like a no-brainer.
The problem with this is that the keys to exchange-stored crypto are kept by the exchange rather than the individual investors. You are using a wallet provided by the exchange and don't have access to the private keys. You are trusting the platform to keep your funds safe and secure just like you would a traditional bank to safeguard your deposit.
This type of wallet is a custodial wallet. The platform is the custodian who controls wallet access and they can withdraw that service at any time. You're just trusting that they won't. As the example of FTX has shown, this isn't always a wise choice. If a platform runs into liquidity issues, gets hacked or becomes suspicious about your activity, it can freeze your account.
The obvious counter to this is to store your funds in a wallet you control. You can move your crypto to an exchange for trading purposes and transfer it out to a non custodial wallet when you're done. You control the private keys to this type of wallet. Only you have access to the crypto in it and your funds cannot be seized by regulators or frozen by an exchange.
Using a non custodial wallet is the best protection you can have against platform failure. You can use either a cold wallet, which stores your crypto offline, or a hot wallet, which requires Internet access. The cold wallet is more secure but the hot wallet is easier and faster to operate.
That said, exchange wallets have some operational advantages over non custodial wallets. Here are some drawbacks of self-controlled wallets:
Exchange wallets are mostly plug-and-play while non custodial wallets require a setup process.
Non custodial wallets are harder to operate and require some technical knowledge.
The private keys to a crypto wallet can't be recovered once lost. But for an exchange wallet, you can simply contact customer support if you lose your account password.
Self-Custodial wallets are less suitable for active trading.
Old and new investors must consider whether the advantages of exchange wallets are bigger than the potential risks. Following the recent spate of crashes and collapses, trust in crypto custodians is at an all-time low. Not every crypto exchange will be truthful about what they're doing with customer funds. Fortunately, investors have the option to embrace decentralized wallets and skip exchanges altogether.
Most investors that lost money to the FTX collapse cannot substantiate their claims in court. So if the company decides not to compensate them, there's little they can do. This is because they kept no records of their activity on the platform.
A crypto platform that files for bankruptcy is unlikely to share your records with you just because you asked politely. Take matters in your own hand and keep a detailed, regularly-updated record of every substantial transaction you do on an exchange. Most platforms let you download a yearly, monthly, weekly or daily activity report.
Doing this has two benefits for the investor. If you live in a jurisdiction that taxes crypto transactions, you'll be able to make an accurate tax filing, if your crypto platform doesn't handle it. Secondly, should the platform go under, the records will serve as evidence of your holdings if there's a chance of getting some of your money back.
Weeks after the FTX scandal, a picture of mismanagement, recklessness and internal system failure is beginning to emerge. By all accounts, FTX founder, Sam Bankman-Fried, is a very charismatic fellow. But leadership nous, not charisma, was what FTX needed, and it had none of it.
Most major crypto platforms are helmed by people like Bankman-Fried with lots of charisma. As a result, investors tend to trust them and their platforms with their money. Also, because of the opaque ways most crypto exchanges operate, internal dodgy dealings usually go unreported to the public.
This does not mean all crypto exchanges cannot be trusted. It does mean that investors should carry out serious due diligence when deciding which platform to trade or save on. Here are some tips to help with making a balanced decision:
Some platforms save the dollar value of customer deposits in FDIC-insured bank accounts, thus protecting the insured funds against unforeseen losses.
The fallout from FTX's demise has led some cryptocurrency exchanges to release audited proofs of reserves. Others who haven't done so yet have promised to publicly release theirs in the near future. These documents help to assure investors of the platform's solvency and compliance with good business practices. Investors can also use the new reserve tracker tool from CoinMarketCap to get useful insights on platform reserves.
Some cryptocurrency platforms have also taken the initiative to secure licenses from the official financial regulators in their jurisdictions. This brings them in line with standard financial services companies in terms of operational and security compliance.
Until the regulators rein in the crypto industry, the task of protecting your crypto asset squarely lies with you. Make sure to diligently follow the tips in this article so as not to be caught unprepared.