What happens to tokens if wallet providers or crypto custodians go bankrupt?

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What happens if a wallet provider files for bankruptcy? What rights and risks do I have as a private person? Are the tokens gone when in doubt? Our guest authors clarify the most important questions.

The Covid-19 pandemic has rocked the global economy. The fintech industry has also felt this. For example, the fintech Monedo, formerly Kreditech, was finally brought to its knees after having circumnavigated many crises and filed for bankruptcy.

It stands to reason that token service providers will also have to deal with bankruptcies in the future. But what does it mean when wallet providers or other crypto custodians go bankrupt? What rights and risks do private token owners have?

Token: Easy to use, but not without risk

Tokens have experienced a real boom in recent years. They are integrated into a clearly defined ecosystem. This means that they are built on a specific blockchain, within which they have a specific function depending on the type of token. Since the function of the token is linked to its ecosystem and the specific blockchain, tokens outside of this are mostly useless.

There are different forms of tokens that have different functions and thus also harbor different opportunities and risks. This is especially true when they come into the context of bankruptcy.

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Basically, the market distinguishes between three types of tokens, whereby the terms are currently not standardized by law: the currency tokens, the utility tokens and the security tokens. Currency tokens serve as a means of payment. Utility tokens act as digital vouchers that guarantee access to a platform and its services. The term utility token has so far been used to cover tokens that are not subject to any financial market regulation. Therefore, unlike security tokens, they must not have any financial stimuli such as a distribution of returns. Security tokens, on the other hand, are tokenized assets. They are capital investments similar to securities (such as stocks or bonds). Due to their token structure, they have the advantage over traditional capital investments that the token issuers do not certify the placing of tokens on the market. This means that they can act much more flexibly – especially without intermediaries. At the same time, however, this creates a risk that is not harmless for the token owner. Because most blockchains also rely on anonymity, it is often difficult to prove in a legal dispute that you have ever owned the token – from a legal point of view, it is not even possible to own a token, i.e. hold a real one in your hands.

Little legal security in an emergency

Compared to the legal security of stocks or other traditional capital investments, tokens do accordingly poorly. If I buy a share, I receive (co-) ownership of a certificate (even if this is usually with a central securities depository). This, along with the custodian records, if applicable, attests that I am the legal owner. However, blockchains and their ecosystems have not yet been under state supervision and in fact cannot be experienced. Our legal system does not grant the entry on the blockchain any protection of good faith. I don’t get a certificate for a token that I can use to identify myself as the owner. I usually only receive two digital keys: one public and one private.

The private key is particularly relevant because it replaces ownership of the token. However, ownership is defined here by the fact that a token holder has sole access to his token through his private key. If I want to prove in a legal dispute that I am the owner of the token, I would have to share my private key. Then I would no longer have sole access to the token and, according to the blockchain logic, would no longer be the (sole) owner. It becomes clear: Not only the missing legal framework is a risk factor in legal disputes, but also the blockchain logic itself.

Bankruptcies at wallet providers – the legal worst case scenario?

The situation becomes even more tricky when token owners keep their tokens and keys in so-called wallets. Wallet providers are digital service providers who store the keys of token holders and through which transactions are made. However, if the wallet operator becomes insolvent, this can lead to major problems for the token holder. This is especially true if the token holder has not noted his key anywhere else, but only saved it in the wallet.

The rights that the token holder has in the event of such insolvency have so far been little discussed and, in particular, not expressly regulated. In the worst case, bankruptcy of the wallet operator ensures that values ​​are blocked or keys are lost and the token holder therefore loses access and – according to blockchain logic – his ownership of the token.

What can I do to protect my tokens as best as possible?

The legal situation around tokens and related bankruptcies is currently still quite vague. However, the state is aware of this and is addressing the challenges associated with blockchains. The Federal Ministry recently published a bill on the introduction of electronic securities. The aim of the draft is to create a secure legal framework for electronic (and also tokenized) securities. And the European Union has also presented a proposal for the regulation of tokens and token service providers (MiCA).

As long as this has not come into force, however, token holders must show their own initiative and get the clearest possible overview of whether and to what extent their own actions in connection with blockchains fall under the protection of already existing regulations.

When choosing the wallet provider, care should also be taken to choose reputable providers. However, this is not easy, especially if you want to protect yourself from bankruptcy. Because many providers are quite young companies that do not yet have a strong financial base and therefore carry a greater risk of bankruptcy. It would therefore be safer to manage the tokens on your own hard drive so that at least the valuable keys are not lost if the crypto custodian or wallet provider becomes insolvent. Alternatively, the keys can also be documented on paper in the same way and kept in a safe.

Even if we want a digital society, we must not forget that current legal regulations have so far only inadequately captured them. Dealing with tokens therefore remains risky until it is regulated by law.

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