Bankruptcy reports from Celsius and Voyager have raised questions about what happens to investors’ crypto when a platform fails.
Rafael Henrique | Sweep pictures | Lightrocket | Getty pictures
Traders hoping to get their money back from failed cryptocurrency exchanges anytime soon are likely to end up disappointed, legal experts told CNBC.
Crypto-trading and lending companies Celsius and Voyager Digital filed for bankruptcy this month, leaving users’ assets trapped inside their platforms. Both companies froze customer accounts after an influx of withdrawals led to liquidity problems.
Celsius operated much like a bank, taking customer deposits and lending them or making risky gambles on so-called decentralized financial products in order to generate high returns.
Voyager had a similar model. The company was caught by the collapse of the high-profile crypto hedge fund Three Arrows Capital, which even went up after defaulting on a $ 660 million loan from Voyager.
Such an interconnection has made the crypto market vulnerable to infection, with large companies falling like dominoes as a drop in token prices has wiped out excessive influence in the system.
Is my crypto security?
Cryptocurrencies are not regulated, which means that they do not offer people the same protection they would get with money held in a bank or shares in a brokerage firm.
For example, the US Securities Investor Protection Corporation insures traders up to $ 500,000 in cash and securities if a member broker gets into financial trouble.
The Federal Deposit Insurance Corporation, meanwhile, offers bank depositors protection of up to $ 250,000 if an insured lender fails.
There are similar schemes in place in the UK and the EU.
Without laws governing cryptocurrencies, there is no guarantee that investors will be able to get their money back if a stock exchange were to freeze someone’s account – or, worse, completely collapse.
“There is no such scheme at this time” for crypto, said Daniel Besikof, partner at Loeb & Loeb.
“It would not surprise me if something happens afterwards,” he added. “This will increase the demand for improved regulation.”
What happens if an exchange fails?
At present, it is still not entirely clear. Although there are examples of crypto companies that have filed for bankruptcy abroad – Mt. Gox in Japan, for example – is one such event unique in the United States
The creditors of Mt. Gox, which went offline in 2014, is still waiting to be repaid billions of dollars in cryptocurrencies.
The problem with centralized crypto platforms is that they can mix different clients’ funds together to make risky bets, according to Daniel Saval, a lawyer at Kobre & Kim. Such mixing can lead to the assets being the property of the stock exchange, not users.
“Users may be surprised to hear that in a bankruptcy scenario, cryptocurrencies and funds held in their accounts cannot be considered their own property,” says Saval.
“Switches will often collect different customers’ crypto and funds in the same storage wallet or account.”
What happens to customers’ funds in bankruptcy cases will depend a lot on the company’s user agreement and how it used their assets, Besikof said.
Celsius claims to have $ 167 million in cash. But it still does not allow customers to withdraw their money, and has not clarified when it will reopen withdrawals.
Voyager says that customers’ dollars are kept in an FDIC-insured account with the Metropolitan Commercial Bank in New York – but this claim was disputed by legal experts and the bank itself. The FDIC only offers protection of funds in the event of a bank’s failure, not a crypto exchange.
Voyager, for its part, says it is working through a “reconciliation and fraud prevention process” with its banking partner, after which users will be able to regain access to their cash.
Voyager also made a plan to repay users with crypto on the accounts, Voyager shares and the company’s own token, as well as any debt recovered from Three Arrows Capital.
Both Celsius and Voyager hired Kirkland & Ellis, the prestigious law firm, to represent them in court.
“Investors who have cryptocurrencies through Voyager Digital and now Celsius have been placed in a difficult position, with their accounts frozen, their lawsuits standing and the value and timing of any recoveries unknown,” Besikof said.
“There is a lot of work for them to do in bankruptcy law before these issues will be resolved.”
Celsius and Voyager applied for what is known as Chapter 11, a form of bankruptcy protection that allows companies to restructure their debt. The goal is to ensure that there is still a viable business at the end of the process.
There is a high probability that Celsius and Voyager’s users will be treated as “unsecured creditors,” said legal experts, a categorization that puts them in the same bucket as a corporate supplier and contractor.
This means that they will probably be at the back of a long queue of creditors queuing for a payment from the court proceedings – behind banks, employees and the tax authorities.
In a regulatory filing in May, Coinbase said users would be treated as “general unsecured creditors” in the event of bankruptcy.
“In general, most clients in cryptocurrency exchanges are unsecured creditors, so when a stock market collapses, secured creditors are repaid first, along with legal fees,” said Dustin Palmer, CEO of consulting firm Berkeley Research Group. “Customers will be paid last on a pro rata basis. In a typical bankruptcy, these are pennies in dollars.”
“Customers will probably have to wait until the entire bankruptcy process is completed before they receive compensation, and bankruptcy usually lasts for several years,” Palmer added. “Lehman took years. Some Mt. Gox customers, for example, have still not received any compensation.”
Saval added customer recovery in bankruptcy proceedings “may be further diluted by other unsecured creditors such as suppliers, landlords and litigation.”
How can I protect my crypto?
Investors can choose to move their cryptocurrencies from a stock exchange to so-called “self-storage” wallets instead.
This is where someone is responsible for their own private key, a secret password required to access a crypto wallet.
However, such a move comes with its own risks. If a crypto holder loses their private key, they may never be able to get their money back.
There have been countless examples of people who have lost hard drives or USB sticks that contain a lot of crypto worth millions.