Not Your Keys, Not Your Coins: How to Stay Safe in ‘Wild West’ of Crypto

Satoshi Nakamoto’s invention of Bitcoin in 2009 opened the door to rethinking the way value can be transferred and stored. However, crypto markets have long been considered by most analysts and attorneys as the “Wild West” of the financial world. These sentiments seem to have been further confirmed with the recent Chapter 11 Bankruptcy filing of exchange FTX and the arrest of its co-founder, Sam Bankman-Fried (“SBF”). SBF allegedly did not merely fail to disclose FTX investments and political donations, but also worked closely with trading firm Alameda Research (also co-founded by SBF) to illegally move customer funds to leverage and internally trade those funds primarily for FTX and SBF’s benefit. Through FTX’s own token, FTT, SBF and his associates were allegedly able to create a Ponzi scheme that puts Bernie Madoff to shame. In short, at least $10 billion of customer funds have been lost through SBF’s illegal activities. How could this lack of oversight have occurred, and what can be done in the future to prevent another similar incident?

Regulations and Reporting Requirements

The Infrastructure and Investment Jobs Act (PL 117-58) (“the Act”) was signed into law by President Joe Biden on Nov. 15, 2021. Beginning in January 2023, the Act heightens the reporting requirements for cryptocurrency exchanges and related parties. Defined as “digital currency brokers,” crypto exchanges will be required to report yearly profits and losses of assets to the IRS via Form 1099-B, just like individuals. Looking forward to 2024 and onward, the IRS plans on introducing Form 1099-DA to replace the previous 1099-B and related 1099 Forms for individuals and for digital currency brokers. While a draft of Form 1099-DA has not yet been released to the public, it is foreseeable that digital assets, such as cryptocurrency and NFTs, are going to be tracked much more closely by the IRS and SEC moving forward. One particular struggle regulators have is keeping track of such digital assets. While blockchain technology provides an immutable ledger of transactions, the ability for entities and individuals to move cryptocurrency across anonymous wallets, blockchains and exchanges provides a serious challenge for the IRS and SEC. Without a form that more closely tracks cryptocurrency information, it becomes a herculean challenge to track capital gain, capital loss, gross proceeds and cost basis across the digital asset landscape. [1]

Crypto Assets in Bankruptcy

The treatment of crypto assets in bankruptcy is a new and emerging issue that will be the subject of litigation in the bankruptcy courts for years to come. Thus far, the only guidance we have is a Jan. 4, 2023 decision by Chief Judge Martin Glenn in the Celsius Network, LLC, et al. chapter 11 bankruptcy cases pending in the United States Bankruptcy Court for the Southern District of New York. While not binding in any of the other crypto asset bankruptcy cases pending (and those to come), Judge Glenn’s decision provides an in-depth analysis on the ownership of crypto assets held in yield-earning accounts (“Earn Program”) on Celsius’ cryptocurrency platform. In summary, Judge Glenn held that the Terms of Service for the Earn Program is a valid and enforceable contract between Celsius and Earn Program customers that deposited their own crypto assets into Celsius’ cryptocurrency platform, and that the Terms of Use “unambiguously transfer title and ownership of [the customers’ crypto assets] deposited into Earn Program from [Earn Program customers] to the Debtors.” Therefore, crypto assets deposited in these accounts are property of the bankruptcy estate and not property of the customers that transferred their crypto assets into Celsius’ cryptocurrency platform.

As a result, the crypto assets held by Celsius in the Earn Program can be sold by the bankruptcy estate in order to pay expenses associated with the bankruptcy case, with excess funds (if any) shared by all of Celsius’ creditors on a pro rata basis, and not returned to the customers that deposited their crypto assets, likely wiping out most of the value of each customer’s account.  To avoid such a catastrophe, cryptocurrency holders should strategically move their holdings off of exchanges and platforms to avoid getting caught up in a bankruptcy proceeding, discussed infra.

How to Stay Safe

So, what can one do to protect themselves from alleged crypto thieves, such as SBF? And what can one do as an individual to avoid trouble with regulators? The first thing a cryptocurrency holder can do to avoid having funds stolen is bringing their crypto offline. This means that the crypto will be moved into “cold storage”, so the holdings are completely disconnected from the internet. By moving one’s crypto off of an exchange, and the internet entirely, the crypto will be protected from hackers and other bad actors. While there are third party custodians who can move your crypto to cold storage, the saying “Not Your Keys, Not Your Coins” holds true. Placing one’s crypto on a hardware ledger, such as a Ledger Nano X or Nano S, provides protection against the possibility of a third party gaining unauthorized access or tampering with funds. [2]

Finally, to avoid trouble with regulators, it is vitally important to report cryptocurrency sales and exchanges via Form 1099-B. While many exchanges already provide and require Form 1099-B for continued trading, exchanges are not legally required to send Form 1099-B until tax year 2023. Regardless of whether one’s exchange provides Form 1099-B, it is required to be filed to report all sales or exchanges for tax purposes. Further, all sales/disposals should also be reported on Form 8949. Due to each individual sale or exchange being a tax realization event, it is recommended that a tax tracking tool, such as CoinLedger, is utilized. While cryptocurrency and other digital assets are indeed still considered the “Wild West” of the financial world, it is also clear that regulators, the industry, and individuals are coming together to mold the legalities behind the next phase of the internet, cryptocurrency.

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[1] Senators Toomey, Sinema, Lummis, Warner and Portman are currently working on a bi-partisan basis with the Department of Treasury to narrow the scope of the definition of “digital currency brokers.”  The Act’s original definition is considered overbroad by both sides of the aisle.  GAI22365 PL8 looks to eliminate validators, hardware/software ledger providers and other cryptocurrency services from brokerage treatment, provided that other entity activities do not meet the brokerage definition under Subparagraph (D) of IRC § 6045(c)(1), as added by § 80603(a)(3) of the Act.

[2] External hardware for cold storage allows the owner to protect their offline wallet through a customizable and unique, 24-word password. The only way for a third party to access this crypto would be if they know one’s 24-word password.