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.
Cryptocurrencies like Bitcoin and Ethereum have revolutionized the global financial world, providing a decentralized alternative to traditional banking systems since 2009. However, as was seen across 2022, the largely unregulated nature of the cryptocurrency industry makes investors vulnerable to fraud, scams and other financial crises if they put their trust and funds in the hands of the wrong crypto exchange.
In the last year alone, several centralized crypto custodians, hedge funds and exchanges such as FTX, Voyager, Celsius, 3 Arrows Capital, BlockFi and Genesis went under during a cascade of bankruptcies due to poor decision-making or outright criminal behavior by their leaders, which included mortal financial sins such as over-leveraging, high-risk investments and misappropriation of users' funds.
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.
For this article, we’ll look at the United States, where an exchange will normally file for either Chapter 11 bankruptcy protection, which reorganizes its assets, or Chapter 7, which liquidates its assets.
Chapter-11 vs Chapter-7 Bankruptcy Protection (US)
Chapter 11 forms part of the US Bankruptcy Code and also establishes a repayment schedule that will allow the company to stay viable while it pays off its debts, while affected investors can use it to try and claim back some assets. There is a clear chain of who gets paid for the remaining assets.
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.
Unfortunately, the small investor usually gets the short end of the stick during a crypto exchange bankruptcy, with secured creditors repaid first. Secured creditors are usually big institutions such as banks or bondholders who receive a higher priority than unsecured creditors and investors. Retail cryptocurrency account holders are considered unsecured investors, and therefore, in most cases, have to wait at the back of the line when it comes to repayments.
How To Recover Funds From a Bankrupt Crypto Exchange?
Centralized crypto exchanges (CEXs) typically own and control the custodial wallets and private keys that hold their users' deposited digital assets. This means that if they end up going belly-up, in the eyes of the law, the exchange, and not the individual account holders, is considered the legal owner of the contents of the custodial wallet.
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.
This is something that should change in the next couple of years, as new regulations are being developed and implemented globally to avoid another FTX disaster and curb money laundering and terrorism funding (see the FATF Travel Rule).
FDIC Protection for US Investors
In the United States, investments in cryptocurrencies are not protected by the Federal Deposit Insurance Corporation (FDIC) or other government-backed insurance programs, unlike traditional bank deposits. This means that investors may not have the same legal protections or guarantees as they would with traditional financial assets.
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.
Of course, even with traditional banks, no one is safe when you trust your money with someone else, as we saw with the recent banking crisis that took down big TradFi institutions like key crypto-friendly banks Silvergate Bank, Silicon Valley Bank and Signature Bank.
As traditional banking investors' funds are only FDIC-insured for the first $250,000, and numerous banks were holding unrealized losses on their books due to the Fed's interest rate hikes, the U.S. Government had to step in and backstop retail investor deposits to prevent further spreading of depositers' fear. The government also created a favorable lending and funding program for banks in order to avert a catastrophic bank run and implosion of the banking industry that could’ve spread worldwide.
How Is Crypto Classified During a Crypto Exchange Bankruptcy?
Courts struggle with how to classify cryptocurrency as an asset in bankruptcy cases because it's not explicitly mentioned in the US Bankruptcy Code, and even federal US regulators can't concur on the subject.
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.
The Commodity Futures Trading Commission (CFTC) views cryptocurrency as a commodity while the Securities and Exchange Commission (SEC), under its notoriously anti-crypto chairman Gary Gensler, increasingly feels that all crypto assets - other than Bitcoin - are securities under the Howey Test. This has resulted in dozens of firms and projects being targeted through litigation. Both federal regulators are now fighting over the power to regulate cryptocurrency firms and assets.
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
Celsius, a centralized lending and borrowing platform, also filed for bankruptcy in June 2022. The company reportedly suffered significant losses during the May 2022 cryptocurrency market crash, leading to a liquidity crisis. As a result, Celsius was unable to meet the demands of its lenders and investors and filed for Chapter 11 bankruptcy protection to restructure its operations and repay its creditors. Many questions remain over the conduct of its founder Alex Mashinsky, who has now been sued by the New York Attorney General (NYAG).
FCoin (2020) Bankruptcy
FCoin, a Chinese exchange, announced its insolvency in February 2020 and filed for bankruptcy, unable to repay its users' assets, worth more than $130 million. FCoin attributed its failure to a series of technical glitches and system failures that resulted in millions of fake transactions and significant losses for the company.
Cryptopia (2019) Bankruptcy
This popular New Zealand-based cryptocurrency exchange for smallcap altcoins filed for bankruptcy in May 2019 after suffering a mysterious hack that resulted in the loss of $16 million worth of cryptocurrency. The company was unable to recover the stolen customer funds and decided to liquidate its customer assets and distribute the remaining funds to its creditors. The liquidation process was completed in 2020, with creditors receiving a portion of their losses.
Read more about the fall of Cryptopia!
Quadriga CX (2019) Bankruptcy
Quadriga was a Canadian cryptocurrency exchange that filed for bankruptcy in 2019 after its founder and CEO, Gerald Cotten, died unexpectedly. The company claimed to have lost access to its cryptocurrency reserves, worth approximately $190 million because they were held in cold wallets for which only Cotten knew the password. The case attracted widespread attention for the fraud it uncovered and raised big red flags about the need for better regulation in the cryptocurrency industry.
Mt.Gox (2014) Bankruptcy
The granddaddy of all crypto exchange hacks, Mt Gox, once the largest Bitcoin exchange in the world, filed for bankruptcy in 2014 after losing approximately 850,000 bitcoins worth over $450 million at the time in a security breach. The bankruptcy process for Mt Gox was complex and lengthy, with creditors having to wait several years before receiving any compensation. In 2018, the exchange's former CEO, Mark Karpeles, was found guilty of falsifying financial data but was acquitted of embezzlement charges.
Incredibly, a total of 200,000 BTC was found in an old wallet dating back to before June 2011, and put under the management of a trustee. Of these Bitcoins, a portion was sold in 2017 and 2018, causing markets to tank in fear, and currently about 142,000 remain. While some creditors have taken a discounted early payment, the remaining BTCs worth $3 billion are expected to be distributed this year once all claims have been posted by April 2023. The subsequent increase in value over the last nine years means that all affected investors should recoup most of their losses.
How To Protect Your Crypto Assets Against Bankruptcies?
Ironically, cryptocurrencies were created to protect you against bankruptcies (see the 2008 banking crisis), not join their lists of victims.
One of the best ways to protect your assets is to use a self-custody wallet that you control, which reduces the risk of losing your assets in the event of an exchange hack or bankruptcy. Also called a non-custodial, unhosted, or private crypto wallet, it lets you create your own secret private keys and stay in full control of your assets.
Non-custodial wallets can further be divided into hot wallets (software-based like MetaMask) or hardware wallets (also known as cold storage or cold wallets), which are dedicated physical wallets that keep your private key offline at all times, like Ledger and Trezor.
Remember though, you assume full responsibility for your assets when you use a private wallet. If you lose your keys or recovery seed phrase or accidentally expose them to the wrong third party, you may lose everything.
The demise of FTX shows us that anything is possible in crypto. No solution is 100% foolproof, therefore, it’s best to hedge your bets and spread your risk. Don’t put all your eggs in one basket, and never invest more than you can afford in any one of them.
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.
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