From disbelief to anger to bargaining, emotions run high when a crypto exchange goes bankrupt. But, what to expect and how can you prepare for such events? Let's find out.
This in turn cost their customers billions of dollars, severely damaged the mainstream reputation of the crypto industry (again), and created devastating contagion across the whole sector impacting other projects and their investors.
These bankruptcies are causing crypto investors sleepless nights in 2023 as they fret about the safety of the crypto assets they've entrusted to their chosen crypto trading platform. Unfortunately, there's good reason to be concerned. Here's why.
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What Is a Crypto Exchange Bankruptcy?
When a crypto trading platform goes bankrupt for whatever reason, whether it's due to a hack, fraud, or just plain stupidity, it means that it cannot pay its debts or meet its financial obligations toward its customers and creditors,
What happens during a crypto exchange bankruptcy depends on where it is located and the rules of that jurisdiction.
Chapter-11 vs Chapter-7 Bankruptcy Protection (US)
In general, the first payments are made to secured creditors. Once that’s done, the remaining funds go to repay debts to unsecured creditors like the exchange’s customers, meaning they are nearly last in line when it comes to recovering their assets and only receive a pro-rata share of what’s left.
Meanwhile, during a Chapter 7 bankruptcy, the company’s assets are liquidated with a repayment plan, and yet again, secured creditors are paid first ahead of unsecured creditors.
Who Is Prioritized During a Crypto Bankruptcy?
In general, it is safe to say that due to the lack of clear overall crypto regulation in the industry, crypto firm customers have more limited rights with cryptocurrencies than they would with traditional financial assets. This is something to keep in mind when you invest in crypto.
How To Recover Funds From a Bankrupt Crypto Exchange?
These assets now become the property of the bankruptcy estate, ready to get liquidated by the trustee to pay outstanding debts. As a result, investors may only be entitled to a pro-rata share of the estate's total value with other unsecured creditors, such as vendors, lessors, litigation claimants and the exchange's customers.
In general, investors may be able to file a claim with the bankruptcy court to recover some or all of their assets. However, the specifics of the recovery process can vary greatly depending on the jurisdiction and the conditions of the exchange's bankruptcy filing.
Crypto firms typically have a process for distributing funds to customers, but it may take some time for investors to receive their assets. It's important to be patient and follow the process outlined by the firm as closely as possible. Find out what the necessary paperwork is and submit these forms as soon as you can.
A Step-by-Step Breakdown of Chapter 7 or 11 Bankruptcy Process
Here is a general overview of the process flow of Chapter 11 or 7 bankruptcy. Please note there are a few notable differences between them that are best explained by a legal expert.
- The cryptocurrency exchange throws in the towel and files for bankruptcy protection.
- Next, a trustee is appointed to oversee the asset liquidation proceedings.
- The trustee takes possession of the exchange's assets and evaluates their remaining value.
- Throughout the bankruptcy process, the trustee maintains communication with creditors and investors regarding expected returns.
- The order of payment for remaining assets is to pay creditors first, followed by secured investors, and finally unsecured investors.
- Investors are allowed to submit claims for the return of their assets, depending on the bankruptcy filing.
- Once all debts and payments are settled, the trustee distributes the remaining assets to investors based on a pro-rata share of their investment.
Are Crypto Investments Protected by Your Government?
Bad news - no matter what you may have heard, investments in cryptocurrencies are generally not protected by a government in the same fashion as traditional bank deposits, and crypto investors may have no choice but to wait for the legal process to run its course in order to recover only some of their assets (in most cases).
The regulation of cryptocurrency exchanges varies vastly from country to country. In some jurisdictions, exchanges are subject to specific exchange controls or regulatory frameworks, while in others with less sophisticated financial systems, they operate with little or no oversight.
FDIC Protection for US Investors
The FDIC was established as a result of the 1933 Banking Act to help rebuild trust in banks following the Great Depression. Its main functions include providing deposit insurance coverage, overseeing financial institutions to ensure their safety and security, and handling receiverships, a court-appointed tool to help creditors recover money or assets that they are owed.
The FDIC mandates for banks and financial institutions engaging in crypto activities are in place to prevent bank failures - with a big BUT: they don’t protect individual crypto investors.
How Is Crypto Classified During a Crypto Exchange Bankruptcy?
Should the affected crypto be treated as a currency, like cash, or security, like company stock, or as a commodity, like gold? The result can have a big impact on how much creditors get paid.
If it's classified as a commodity, the trustee in charge of the bankruptcy can recover the cryptocurrency's value at the time it was transferred, plus any increase in value since then. But if it's treated like currency, the trustee can only recover the crypto asset's value at the time of the transfer.
If the SEC triumphs, it can theoretically complicate bankruptcy proceedings even further by trying to appoint a receiver who can take over and control an exchange's assets if it feels an exchange has violated federal securities laws.
So far, bankruptcy courts haven't come to a consensus on how to handle cryptocurrency. The process is incredibly complex and subject to various other variables. Once regulatory clarity is achieved, it should make crypto exchange bankruptcy proceedings much easier.
5 Notable Crypto Bankruptcies of All Time
Over the years, several crypto exchanges and firms have filed for bankruptcy due to financial difficulties, causing heartbreak and empty wallets for thousands of investors. Here are some of the most notable crypto bankruptcies:
- FTX, November 2022
- Three Arrows Capital, July 2022
- Celsius, June 2022
- FCoin, February 2020
- Cryptopia, May 2019
- Mt Gox, 2014
FTX Bankruptcy
FTX filed for bankruptcy in November 2022 due to liquidity issues and financial difficulties caused by founder Sam Bankman-Fried and colleagues’ criminal behavior, with debts of about $11.6 billion against $4.8 billion in remaining assets on its balance sheet. The bankruptcy process was started while trying to repay these enormous debts.
Celsius Bankruptcy
FCoin (2020) Bankruptcy
Cryptopia (2019) Bankruptcy
Read more about the fall of Cryptopia!
Quadriga CX (2019) Bankruptcy
Mt.Gox (2014) Bankruptcy
How To Protect Your Crypto Assets Against Bankruptcies?
Consider diversifying your funds across different exchanges and non-custodial wallets, and only use companies and products that you’ve personally thoroughly researched in order to assess their reliability.
Conclusion
While investing in cryptocurrency can lead to life-changing riches, it can also be a very painful experience if you don’t pay attention to the risks involved. By understanding the bankruptcy process and taking the right steps to protect your assets as explained in this article, you can minimize your risk and invest with greater confidence.
FAQ
What is a crypto exchange bankruptcy?
A crypto exchange bankruptcy occurs when a crypto trading platform cannot pay its debts or meet its financial obligations toward its customers and creditors.
What is the difference between Chapter 11 and Chapter 7 bankruptcy protection in the US?
Chapter 11 bankruptcy reorganizes a company's assets while allowing it to stay viable while paying off debts. On the other hand, Chapter 7 bankruptcy liquidates a company's assets with a repayment plan.
How can investors recover funds from a bankrupt crypto exchange?
Investors may be able to file a claim with the bankruptcy court and follow the process outlined by the firm. The specifics of the recovery process vary depending on the jurisdiction and the conditions of the exchange's bankruptcy filing.
How are crypto exchange deposits regulated?
Regulations for crypto exchanges vary from country to country, with some jurisdictions subjecting them to specific exchange controls or regulatory frameworks while others operate with little or no oversight.
Are crypto investments protected by the government?
Investments in cryptocurrencies are generally not protected by the government in the same way as traditional bank deposits.
What is the FDIC protection for US crypto investors?
The FDIC does not protect investments in cryptocurrencies or other government-backed insurance programs.
How is cryptocurrency classified during a crypto exchange bankruptcy?
Courts struggle to classify cryptocurrency as an asset in bankruptcy cases as it is not explicitly mentioned in the US Bankruptcy Code.
Who gets priority during a crypto exchange bankruptcy?
Secured creditors are typically paid first, followed by unsecured creditors and investors such as cryptocurrency account holders.
What are some big recent crypto bankruptcies?
Notable crypto bankruptcies include those of FTX, Voyager, Celsius, 3 Arrows Capital, BlockFi, and Genesis.
How can investors protect their crypto assets against bankruptcies?
Investors can protect their crypto assets by using hardware wallets to control their own crypto holdings, avoiding overexposure to a single exchange, and performing due diligence on the exchanges they use.