Crypto Exchanges and the Risk of Custody

Why keeping crypto on an exchange means trusting a company with your money, what went wrong at Mt. Gox and FTX, and the choice between custodial and self-held wallets.

Most people buy and sell cryptocurrency through exchanges: companies that match buyers and sellers and often hold customers’ crypto for them. This is called custody. It reintroduces the very trust in a middleman that blockchains were meant to avoid.

Private keys

Cryptocurrency is controlled by private keys, secret codes that authorise transactions. A popular saying in crypto is “not your keys, not your coins”: if a company holds the private keys, customers depend on that company’s honesty and security.

Custodial versus self-custody

Custodial wallets: an exchange holds the keys. This is convenient, and the exchange can help if you forget your password, but you rely on its security and solvency.
Self-custody: you hold your own keys, in a software or hardware wallet. You control your crypto directly, but if you lose your keys, the crypto is lost forever, with no one to recover it.

Mt. Gox

Mt. Gox, based in Japan, once handled a large share of global Bitcoin trading. In 2014, it collapsed after announcing that around 850,000 bitcoins had been lost, largely through theft over several years. Customers waited around a decade for partial repayments.

FTX

FTX, founded by Sam Bankman-Fried, became one of the largest crypto exchanges. In November 2022, it collapsed within days after reports revealed it had moved customer funds to its affiliated trading firm, Alameda Research. Around 8 billion dollars of customer money was missing. Bankman-Fried was convicted of fraud in 2023 and sentenced to 25 years in prison.

Lessons and regulation

Segregation of funds: customer assets should be kept separate from the company’s own.
Proof of reserves: some exchanges publish evidence of holdings.
Regulation: many countries have tightened rules for crypto exchanges, including licensing, audits and anti-money laundering checks. India requires crypto platforms to register with its Financial Intelligence Unit.

The lost hard drive

Some early Bitcoin owners lost their private keys when they threw away old hard drives or forgot passwords. Their bitcoins remain on the blockchain but can never be moved. Self-custody gives full control, but also full responsibility.

Thinking crypto on an exchange is as safe as money in a bank

Crypto held on exchanges usually lacks deposit insurance, and exchanges have collapsed or been hacked. Customers can lose their holdings if an exchange fails or misuses funds.

Key takeaways

Exchanges often hold customers' crypto, reintroducing trust in a middleman.
Custodial wallets are convenient; self-custody gives control but risks permanent loss of keys.
Mt. Gox collapsed in 2014, and FTX in 2022 after misusing customer funds.
Regulators now require segregation of funds, audits and registration of exchanges.