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In the wake of the ongoing FTX debacle, I wonder the following: How can a retail investor check whether a cryptocurrency exchange is safe to use, at least minimize the risk?

By safe, I mean no losing one's money due to issues with the exchange.

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    History suggests that "It's not safe to use" is the correct answer most of the time...
    – AakashM
    Nov 14, 2022 at 9:32
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    @AakashM I think you meant to write - all the time.
    – Faheem Mitha
    Nov 14, 2022 at 16:31
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    The only way to minimise the risk is to invest only small sums and keep the wallets on a personal disk. Use the exchange only to buy or sell, not as if it were a bank, there will never be enough oversight.
    – FluidCode
    Nov 14, 2022 at 16:33
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    @FluidCode The general advice for crypto, even when it first started, was that you should prepare to lose 100% of what you put in. If you can't afford do lose 100%, then lower the amount until you can.
    – Nelson
    Nov 15, 2022 at 4:00
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    @lvella I doubt that the proof of reserve will report whether that reserve is used also as a collateral for a loan. AFAIK that was what brought FTX down.
    – FluidCode
    Nov 15, 2022 at 16:33

7 Answers 7

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Given that most of practical regulation for crypto exchanges seems to be bankruptcy law (SCNR), it is probably safe to assume that no exchange is safe and transfer money only when you want to trade and pull out your tokens to a cold wallet as soon as the transaction got through.

However, there might be some exchanges that have spun off from stock exchanges and - even though formally not regulated as stock exchanges- should pose a much lower risk than an exchange funded by someone without experience in the field. BSDEX (as a spin-off of Börse Stuttgart) would be an example that comes to my mind, there is probably something similar in other countries.

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    The tokens themselves may also be unsafe, especially so-called "stablecoins." For example, TerraUSD infamously collapsed a few months ago, and there has been much speculation that Tether is basically a Ponzi scheme. If you want to avoid the wild market swings of "real" cryptocurrencies, it may be necessary to fully convert to fiat and hold it in physical cash or bank deposits.
    – Kevin
    Nov 15, 2022 at 0:23
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    @user253751: Tether openly admits that a significant portion of its reserves are not cash (or "cash equivalent"), and that some of its reserves are "Digital Tokens" (presumably meaning cryptocurrencies). That is wrong-way risk, because the value of those tokens is (probably) anticorrelated with the rate at which people want to redeem USDT for cash. That is to say, if there's a crypto-wide downturn, then the tokens will lose value at the same time as a bunch of people try to redeem their USDT.
    – Kevin
    Nov 15, 2022 at 4:36
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    @Kevin well then - claims to have 82% of the money accessible within 6 months or so. That's much better than any bank.
    – user253751
    Nov 15, 2022 at 5:05
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    @user253751: No, it isn't, for two reasons: 1. The bank doesn't "claim" anything. They have exactly what they are required to have, or else the regulators shut them down. I don't have to trust the bank's word. 2. My bank deposits are insured and I will be made whole if the bank goes bust.
    – Kevin
    Nov 15, 2022 at 5:41
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    @Kevin: Plus, thanks to points #1 and #2, plus a (typically) larger customer base, and the fact that the value of most currencies doesn't fluctuate wildly like cryptocurrencies do, there's far less need to be able to produce the entirety of their customer's balances on demand, because there are very few reasons why most/all of the customers would want their cash when the guarantees from #1 and #2 apply. Even when a large number of them do, the system has enough flexibility in overnight lending via central banks and selling off of liquid assets to satisfy anything shy of a full-on bank run.
    – ShadowRanger
    Nov 15, 2022 at 15:42
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How can a retail investor check whether a cryptocurrency exchange is safe to use, at least minimize the risk?

Generally, you would want to look for regulatory insurances/assurances. In the US, for example, that would be SIPC. If the exchange or brokerage is a member of SIPC, the SIPC would provide some assurances that your assets would be recovered in case of failure or fraud.

Even if the assurances don't explicitly include crypto assets (as is with SIPC), the fact that the brokerage is part of the scheme guarantees that they undergo certain audits and process reviews by the regulator to provide these assurances. Unless the brokerage is managing crypto in a completely separate way from everything else (which is unlikely and would probably be uncovered by these audits and flagged), you'll get some level of assurance through this regulator scrutiny.

Unfortunately most crypto brokerages and exchanges try to intentionally avoid regulatory oversight, and present it as a feature of their activity, not a bug that it is.

Without any third party providing the assurances - your recourse would be conducting your own due diligence and auditing of the brokerage. Infeasible task for an individual investor, obviously.

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    Note that SIPC specifically only protects cash and securities. Since cryptocurrencies are not securities (yet, it's complicated) only your fiat money is covered.
    – blues
    Nov 14, 2022 at 13:44
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    Can you provide a single example of a crypto exchange that is a member of the SICP? Or a general exchange that offers such warranties for crypto?
    – Mindwin Remember Monica
    Nov 14, 2022 at 15:23
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    @Mindwin robinhood is a broker that is a member of SIPC and offers cryptocurrency trading. They also make clear in their FAQ that SIPC offers no warranties for crypto assets.
    – blues
    Nov 14, 2022 at 16:04
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    @Mindwin no, I can't. Crypto providers explicitly advertise the lack of regulatory oversight as a feature and are trying to avoid it as much as possible. Not surprising given all the (allegedly) fraudulent behavior.
    – littleadv
    Nov 14, 2022 at 17:09
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    disclaimer, I work with banking compliance and auditing (SOX & Basel). There are few business more profitable than unregulated money trading though not for the customer.
    – Mindwin Remember Monica
    Nov 14, 2022 at 18:06
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How can a retail investor check whether a cryptocurrency exchange is safe to use

There's no really reliable way for ordinary retail investors to check that a cryptocurrency exchange won't fail sometime in the next year.

However investors are arguably different from traders.

There is no really good reason for an investor to ask a custodian to look after their cryptocurrency investment for them if it is a medium to long term investment that does not require active trading. Many cryptocurrencies can be held in a self-custodial (AKA "non-custodial") wallet that has no dependency on any exchange or similar business. Indeed one of the primary objectives of the creators of Bitcoin was to enable two parties to make payments to one another (and hold money) without the need for any trusted third parties.

What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

Bitcoin: A Peer-to-Peer Electronic Cash System, Satoshi Nakamoto, 2008. (The "Bitcoin whitepaper", my emphasis)

How can a retail investor [...] at least minimize the risk [of exchange failure]?

By holding investments in their own non-custodial wallet, based on software running entirely on their own computer hardware, independently of any exchange or other custodian.

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    +1 "By holding investments in their own non-custodial wallet, based on software running entirely on their own computer hardware, independently of any exchange or other custodian."
    – paulj
    Nov 15, 2022 at 18:27
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Unfortunately all exchanges are vulnerable to problems like FTX. However any custodial service is going to be a risk. The easiest way to mitigate this is to move the crypto you buy to a wallet you can control, then if that exchange goes bankrupt, your wallet is still safe. Trust no-one, least of all yourself and find a way to safeguard your wallet recovery phrases.

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One of the core tenets of crypto (yes, not the only one) is that there is no regulation and oversight. This is praised as a major advantage, as it allows people to trade them and pay with them, without ’evil’ banks, regulators, or governments having their fingers in it.
Unfortunately, that means that no regulators or governments watch for you over these exchanges, or even cover their losses, and they are only as good and stable as their leaders make them.

In other words, you can’t have your cake and eat it - you have to pick either ‘evil’ oversight or the wild wild west.

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Two options that, at the time of writing, have not yet been covered by the existing answers are:

Open Source Decentralised Exchanges

Shifting the vulnerability from trust in exchanges and regulation (enforcement), to trust in verifiable, yet possibly complicated, code.

Properly decentralised exchanges allow ordinary retail investors to verify how they work (albeit with the help/explanations of (audits of) cyber security specialists), and where the assets/tokents etc. are stored.

Such decentralised exchanges still allow for zero-day exploits (new bugs that nobody ever found/used/published before). Additionally, the mere fact that the code is open source, does not mean it has also been critically evaluated.

One advantage of such DEX's is that, if x% of the "regular users" evaluate (a segment of) the DEX critically, the overall trust in these DEX's increase (because the efforts add up in terms of "trust"). The same thing can not be said of centralised exchanges, because "regular users" have no direct means of verifying opague, centralised exchanges. In essence, they do not have certainty in determining whether the centralised exchanges hold the funds, and typically rely on someone telling them that it is "safe". This someone can be the centralised exchange itself, a regulator, or a third party. If a lot of people rely on those entities, the cumulative "trust" in such a centralised exchange still is as strong as its weakest link/can not be added up in terms of "trust".

Organised "Bank Runs"

How can a retail investor [...] at least minimize the risk [of exchange failure]?

Past performance does not provide guarantees for the future, however; if users consistently withdraw all their funds from the centralised exchange, the ones without sufficient liquidity will soon be found. One could argue regular users could have more confidence in an exchange that showed a liquidity level of 100% for 10 years without a single hiccup than one that has no such track record.

So to put it in context of the quoted question, if users collectively and consistently withdrawl all their funds on a specific time, (I expect) many more (de)centralised exchanges will fail initially. Over time though, the trusted/reliable exchanges should survive such procedures.

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The best way to check whether a cryptocurrency exchange is safe to use is to do your own research. Look for online reviews from other users, and try to find an exchange that has been in operation for a while and has a good reputation. You should also make sure that the exchange uses good security practices, such as keeping its user funds in cold storage.

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    Just as it is with medical procedures or vote counting - "doing your own research" is a code word to "believe to those whose lies you like". There's absolutely no possibility for any individual to "do their own research" in any meaningful way.
    – littleadv
    Nov 14, 2022 at 17:11
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    This works up until it doesn’t: FTX was well-liked until it suddenly wasn’t.
    – Tim
    Nov 14, 2022 at 21:21
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    No amount of research will reveal "incorrectly" setup liabilities. In a normal stock, people would've went to jail over what people did in these exchanges, and it wouldn't even be allowed to be listed.
    – Nelson
    Nov 15, 2022 at 4:05
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    The research up until last week would've said "FTX is well-regarded and considered reputable". Ooops.
    – ceejayoz
    Nov 17, 2022 at 14:17

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