Here's What Happens When You Use Crypto Platforms as if They're Traditional Banks

One of the great promises of Bitcoin (BTC) and cryptocurrency is that they might one day replace the traditional banking system. The thinking is that blockchain technology lets us cut the middleman out of many transactions. That could, for example, mean taking banks out of your day-to-day finances. Not only that, but Bitcoin also doesn't need the backing of a government or central bank to keep it secure. 

So far, crypto hasn't really lived up to that promise. It still might. It is early days and we don't know how this industry will develop. But if you're considering using a crypto platform instead of a bank and you plan on depositing large sums of money right now, bear in mind there are limited consumer protections in place.

Here are three things that happen when you use a crypto platform instead of a bank.

1. You aren't protected if your exchange fails

During the cryptocurrency frenzy of 2021, prices soared and millions of Americans flocked to the industry. Then prices fell dramatically. Many investors saw their portfolios decimated. And then FTX and other crypto platforms collapsed, taking people's money with them. 

One issue is that a lot of new crypto investors bought via centralized crypto exchanges and left their assets on the platform where they bought them. It's understandable, because these platforms have positioned themselves as similar to banks. The trouble is that by using centralized exchanges in this way, we're essentially substituting one middleman with regulations that have evolved over decades for another. The new one is much less regulated and much less transparent about what it's doing with your money.

We discovered the hard way that there's limited protection in place for customers if a crypto platform fails. FDIC insurance covers traditional bank accounts against bank failure. SIPC insurance protects brokerage accounts. Aside from some third-party insurance, there's very little in place to help if your crypto exchange goes bankrupt. Particularly if, as appears to be the case with FTX, the way it handled customer funds was at best chaotic and at worst fraudulent. 

2. You can perform a lot of traditional banking activities

Popular crypto exchanges offer a range of traditional banking services. For example, you can deposit money, including your paycheck. You can also make payments from the crypto platform or through a crypto credit card or crypto debit card, move money internationally, and earn interest on your funds. 

That said, a lot of the time, you'll need to convert your crypto into traditional money such as U.S. dollars when you, for example, use it to make a payment. This can have tax implications because converting your crypto into dollars to buy something means you're selling the crypto. If your crypto is worth more than you bought it for, this is a taxable event. 

Some crypto platforms also make it easy to borrow money without requiring a credit check. However, several crypto lending platforms collapsed in the wake of the FTX failure, leaving clients unable to access their funds. It's worth knowing the difference between centralized finance (CeFi) and decentralized finance (DeFi) and understanding the risks involved in both. 

3. You could be exposed to unscrupulous players

There are many different ways to invest in and use cryptocurrency. If you want to avoid centralized platforms, you could use only DeFi and conduct your transactions from a crypto wallet that you control. In this scenario, your funds won't be exposed if your crypto exchange fails. However, it's a very steep learning curve and you may not know who you're doing business with. 

Unlike many top cryptocurrency exchanges, which have introduced know your customer (KYC) and other anti-money laundering processes, many DeFi platforms are pseudonymous. Some see that as a good thing -- avoiding financial censorship is a core part of crypto's ethos. But if you're using DeFi for your everyday banking, you may unintentionally be interacting with criminals.

To be fair, money laundering exists in the non-crypto world as well. But one of the risks of becoming your own bank is that you need to think about compliance as well as security, and a host of other checks and balances. 

Bottom line

It's one thing to invest a small amount of your portfolio in cryptocurrency. It's quite another to deposit your monthly paycheck and put all your savings on a crypto platform. Broadly speaking, the system isn't ready to safely replace your bank.