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What Happens If A Crypto Exchange Declares Bankruptcy?

In May 2022, the industry was set ablaze as Coinbase, one of the top cryptocurrency exchanges, released its first-quarter earnings report. Essentially, the crypto firm did not enjoy a successful start to the year, given that their revenue had fallen 27% from the previous year.

Perhaps more worrying was a clause in the customer disclosure statement that followed, which implied that its customer’s cryptocurrencies could be at risk if the exchange were to go bankrupt.

Not only did Coinbase’s statement spark mixed reactions in the cryptoverse, particularly on social media sites like Twitter, but it has also caught the attention of many customers who are find themselves more concerned than ever about the fate of their digital asset holdings across many exchanges.

The worries were exacerbated in July 2022, when prominent crypto platforms, Celsius and Voyager Digital made the spotlight after filing for bankruptcy protection, after both crypto firms had previously suspended numerous withdrawal operations on their platforms.

It was later reported that the firms had frozen client account, alleging that an influx of withdrawals had caused a liquidity crisis. Whether or not the justification was genuine, it became evident that a considerable portion of their clients’ assets were now locked within the platforms.

Perhaps the most intriguing aspect of this string of events is that, unlike typical CEX or DEX exchanges, which one would naturally consider extremely risky to utilize, both Celsius and Voyager operated similarly to traditional banks, albeit for crypto assets. Sadly, it was later revealed that they may have made high-risk investments as a means of generating unrealistically high yields, which eventually caught up to them.

According to a reliable source, Celsius was found to have either used users’ funds to lend deposits, or make risky gambles on so-called decentralized financial instruments in the hopes of generating high yield.

Voyager seemingly took a similar tact to Celsius, but took the treachery a notch further. In its case, Voyager became caught up in the collapse of high-profile crypto hedge fund Three Arrows Capital, which itself went bankrupt after defaulting on a $660 million loan from Voyager.

By now, many people are probably wondering what exactly happens to customers’ funds in such a scenario, or if they even stand a chance of ever withdrawing them from their respective accounts, which now lie frozen and inaccessible. This is something we will explain below, but for now, let’s explain how bankruptcy works in order to provide a clearer understanding of the finer details, and exactly what’s at stake.

Understanding Bankruptcy

Bankruptcy is a term commonly used in the traditional corporate world, and simply refers to a legal process by which corporate organizations that are unable to repay their creditors’ debts may seek relief from some, or all of their debts; often this is done by liquidating assets in order to pay their debts, or by agreeing upon a repayment plan.

Unfortunately, in most cases, the status often results in the death of the entity in question, implying that they may simply cease to exist, and that their customers may face a variety of consequences, including the loss of valuable assets within the company. Does this mean that customers bear the brunt of the losses? Well, not entirely. Here is what happens next.

“I need a second chance”

That’s how InCharge, a nonprofit organization offering confidential and professional credit counseling, describes bankruptcy “in a nutshell.” Why so? According to the debt solution firm, filing for bankruptcy is the last available option left to a corporate entity whose financial situation, for whatever reason, has gone south. To reach this point, a company must have completely drowned in debt, felt remorseful, learned its lesson, and decided to scream for help.

That said, Bankruptcy, as explained earlier requires a series of legal processes, one of which includes writing to a national court of bankruptcy, such as the U.S. Bankruptcy Court, and pleading to them to release you from your debt, and perhaps, let you restart your financial situation with a clean slate. While this may sound like a walk in the park and a quick way off the hook, it’s not all as easy as it sounds.

The honest truth is that there are at least six types of bankruptcy, and each of them come with their own unique terms and conditions. The formats of bankruptcy recognized by the U.S. bankruptcy court are: liquidation, personal reorganization, business reorganization, municipalities, farmers, and cross-border.

Generally speaking, business reorganization is the type of bankruptcy most commonly filed for among corporate organizations. In simplified terms, business reorganization is similar to personal reorganization, but with a notable exceptions. Therefore, in order to better understand the concept, let’s first consider how a personal reorganization bankruptcy works.

By filing a personal reorganization bankruptcy claim, the court permits an individual time in which to devise a plan that allows them to pay off “some” of the debt owed. To do this, the person’s remaining assets are liquidated, and what remains is channeled into paying back their existing debt in installments. Typically, the debt to be paid off over 3-5 years, as allowed by the court.

There are a few alterations to this for business reorganization. While the procedure is similar overall, the company or firm may also be permitted to keep its assets and continue operations, but on condition that it devises a plan to pay off some of its debt, or have it otherwise forgiven.

As one might expect, while some consumers may be patient enough to wait for a company to pay them what they are owed at a convenient time, or even to forgive the loan entirely, most people, or at least those who are heavily invested in the business, may grow impatient, and would most likely not accept releasing the debt.

It is also important to note that, while repaying their debt, a bankrupt company curates a priority list of those to be paid back, which essentially determines if and when a beneficiary will be repaid the debt owned by the company. Those still curious to learn about bankruptcy more in-depth can do so via this link.

Moving forward, let’s circle back to the main discussion, which is: what exactly happens to your crypto investment or savings if a crypto firm declares bankruptcy.

How Does a Bankrupt Crypto Firm Affect Investors?

The first thing to consider is that it is no secret that the cryptocurrency industry remains largely unregulated, which naturally implies that typical bankruptcy laws may not be applicable to crypto projects—including exchanges and any other blockchain protocols.

More specifically, Federal laws are not explicit about the protection that would be extended to consumers in the event that a crypto exchange files for bankruptcy, thereby making it a particularly dicey situation, as seen in the cases with Celsius and Voyager Digitals cited earlier. So what does that mean for investors?

1. Investor Funds Stays Frozen

As in the traditional corporate world, the first measure taken immediately after bankruptcy is consumer assets lose accessibility. From the point a crypto firm goes bankrupt, it will cease to operate as usual, meaning that customers lose the ability to choose if or when to carry out transactions, including, most notably, withdrawals.

In other words, depending on the type of bankruptcy filed by the crypto firm, customers may be unable to access their deposits for as long as the crypto firm is unable to pay them back. More so, in the eventuality that the company is in the position to make repayments, the bankruptcy filing will determine what portion of their customers’ crypto holding will be paid back.

This has been the case of Voyager Digitals, which, after filing for Chapter 11 bankruptcy protection (the same as business reorganization bankruptcy), the crypto firm informed customers that they should receive returns on their U.S. dollar deposits. With U.S. dollar deposits being the sole beneficiaries of the policy, there was no mention of the firm repaying any other forms of crypto assets; nor did it specify precisely what portion of their holdings would be refunded.

As for the portion to be repaid to the customer in a bankruptcy case, the court often rules that it be paid over a period of time, as approved by the court in question. At this point, customers will typically be notified about when they will be paid, as well as the pro-rata share of their deposit to be returned to them.

2. Cryptocurrency Deposits Are Mostly Uninsured

As previously stated, with the exception of Central Bank Digital Currencies (CBDCs), the vast majority of cryptocurrencies are unregulated, and are mostly not insured by any regulatory authority, such as the Federal Deposit Insurance Corp. (FDIC).

While the FDIC is responsible for insuring deposits made to U.S. banks and thrifts in the event of bank crises, their security provisions do not cover cryptocurrencies of any kind, including stablecoins, which are typically pegged to a national, government-backed fiat currency.

Generally speaking, most national banking insurance agencies, like the FDIC, require member banks and financial institutions that engage in cryptocurrency-related activities to report such activities for supervisory input, but does not necessarily provide any form of security. This wase made apparent during the TerraUSD stablecoin crash, which saw investors cumulatively lose almost $45 billion in just a matter of days.

Ultimately, the lack of deposit insurance across crypto firms and blockchain projects exposes customers to a significant level of risk that may result in the loss of money and other valuables.

3. What’s Left of a Bankrupt Crypto Firm Is Repaid in Priority Order

Another issue that customers may face in the event of a bankrupt crypto firm, is delays in the repayment of the pro rata share. Not only will customers be repaid a pro rata share at a later, typically unspecified date but they are also paid in the order of a priority list, as stipulated under Chapter 11 bankruptcy proceedings.

Naturally, there are rules in place that determine who should be paid first when a company undergoes liquidation, and there are typically two main categories that claimants are divided into during an insolvency process—secured creditors and unsecured creditors. While secured creditors are a category of lenders directly tied to an asset or investment that holds a “lien“ against a debtor’s property, they are usually the first group to be paid back by a bankrupt firm.

Unsecured creditors, on the other hand, are secondary in terms of recovering their assets from a bankrupt firm. Unlike in the case of secured creditors, unsecured creditors do not hold any lien against a debtor’s property, making them less “valuable” to a bankrupt firm at the time of liquidation.

Ultimately, the determination of who will be paid first during liquidation is dependent upon the model adopted by the crypto firm in question. For instance, if a crypto lending project goes bankrupt, it is highly likely that liquidity providers will be the first to receive reparations, followed by collateralized lenders, and so on.

The Best Practice to Stay Afloat During Bankruptcy

Although not all crypto projects mandate their users to meet Know Your Customer (KYC) criteria when registering on their platforms, it is often critical to do so in order to stay afloat in the eventuality of bankruptcy. By providing legitimate information, a customer’s interest are effectively preserved.

For example, in the event of a bankruptcy, the ailing crypto firm would communicate with customers to inform them of the situation, and provide the necessary information or procedures that will allow them to recover their assets. Since most organizations will utilize their own procedure to distribute funds to clients, you don’t want to be left out because you failed to meet the initial KYC criteria.

On the Flipside

Multiple filings may ensue from customers regardless of the provisions made by a bankrupt crypto firm under the Chapter 11 bankruptcy proceedings.

Why You Should Care

Unlike traditional financial institutions, which deal in tangible assets such as real estate, crypto firms have little to no substantial assets to fall back on in the event of liquidation. As a result, it is critical to exercise extreme caution while investing in any crypto platform, particularly with regards to long term aspirations.

Learn more on Celsius’ bankruptcy filing:
Celsius Network Files for Bankruptcy Protection, Leading to a 50% Loss for CEL

Read more about the ripple effect of the Celsius bankruptcy filing:
Crypto Exchange Nuri Files for Insolvency in Germany, Celsius Bankruptcy to Blame

Text source: DailyCoin.com

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