Bloomberg Law
Free Newsletter Sign Up
Login
BROWSE
Bloomberg Law
Welcome
Login
Advanced Search Go
Free Newsletter Sign Up

If a Crypto Exchange Goes Bankrupt, What Happens?: Explained (1)

May 19, 2022, 10:00 AMUpdated: May 19, 2022, 5:12 PM

Coinbase Global’s public pondering of what-if-bankruptcy scenarios underscored cryptocurrency market volatility and raised questions about what may happen to users’ assets on an exchange if it does go bankrupt.

The largest US crypto exchange said in a Securities and Exchange Commission filing last week that a bankruptcy court could consider customer assets Coinbase is the custodian of a bankruptcy estate’s property.

Coinbase CEO Brian Armstrong clarified that the company faces “no risk of bankruptcy.” The company has also said customer assets are safe and each account is segregated.

But the filing and the crypto market’s topsy-turvy week did little to allay concerns over how crypto assets would be treated in the event of an exchange’s bankruptcy.

The concerns partly stem from the fact cryptocurrency’s emergence has outpaced courts’ review and regulators’ oversight. Bankruptcy rules and regulations may not apply neatly in dealing with any cryptocurrency fallout.

Here are some questions to consider.

What do bankruptcy laws say about cryptocurrency?

Federal laws aren’t explicit on how consumers are protected if a crypto exchange files for Chapter 11 protection.

Cryptocurrency exchanges are different than traditional brokerage firms, which are members of the Securities Investor Protection Corp., or SIPC, a federally created nonprofit charged with overseeing the liquidation of brokerage firms.

Cryptocurrency isn’t subject to Federal Deposit Insurance Corporation or SIPC protections.

A federal law that created SIPC regulates brokers and dealers that are SIPC members. The law, called the Securities Investor Protection Act, or SIPA, lays out a recovery priority for customer assets and way to return them when covered firms are liquidated.

A brokerage firm, which generally is a custodian of customer assets, must follow certain SIPA protocols to protect those assets. In a bankruptcy liquidation, the SIPC asks the court to appoint a trustee to protect customers.

A trustee appointed by the SIPC has been recovering lost funds as part of Bernie Madoff’s historic Ponzi scheme.

In the Lehman Brothers bankruptcy, an SIPC-appointed trustee worked to transfer more than 110,000 former securities customers’ accounts— worth about $92 bllion—back to those customers to make them whole, according to the SIPC.

The SIPC also stepped in to protect securities customers in the bankruptcy of MF Global Inc.

Futures commissions merchants also are required to keep customer funds segregated, and those funds get priority status in the event of a bankruptcy. But crypto exchanges aren’t considered a futures merchant.

Can crypto customers get paid back if an exchange goes bankrupt?

An exchange going bankrupt would likely have to face Chapter 11 debtors’ rules on creditor recovery. Generally, secured creditors would be paid back first before others.

A crypto exchange is not likely to have investor protection measures in place for cryptocurrency, though it could carry insurance policies for certain covered incidents, such as cybersecurity incident. And unless user terms specified otherwise, an investor would likely be an unsecured creditor who may not be able to recover what they’re owed.

Courts haven’t closely considered how the assets of a crypto owners are treated when their exchange goes bankrupt in the US.

Crypto customers in such a situation could argue that an exchange held their funds in a constructive trust, which is a trust used to right a wrong. That could boost the customers’ priority in recovery, but it’s hardly a slam dunk.

VIDEO: Tax Your Crypto and NFTs? Yes, the IRS Wants Its Cut

What other issues could arise?

Whether crypto or other alternative assets are property of the debtor’s estate in a crypto exchange bankruptcy may turn, in part, on the terms and conditions of the agreement between the crypto customer and broker.

How the exchange commingles the underlying crypto assets, the crypto exchange’s ability to use the underlying customer’s specific assets, and state-specific trust law will also likely be factors in an exchange bankruptcy.

How smooth a bankruptcy would go may depend on how willing creditors are to take a loss in order to maintain faith in the overall crypto ecosystem.

Some non-customer creditors may want to maintain faith in the industry, and possibly be willing to refrain from treating customer accounts as exchange property.

Even if customers can quickly get their property back, there’s not a clear process for how to return their assets or funds quickly, rather than waiting through the full bankruptcy process that includes claims reconciliation.

Questions could arise in a crypto exchange bankruptcy over what date a token should be valued on.

Intercreditor fights could also break out between different token holders over how losses should be apportioned.

Sign up for The Brief, a daily afternoon newsletter showcasing Bloomberg Law’s top stories.

To Learn More:

—From Bloomberg News:

Coinbase Gives $256 Billion Reminder About Agonies of Bankruptcy

Coinbase Says No Bankruptcy Risk Amid Black Swan Event

(Updated with additional reporting )

To contact the reporter on this story: James Nani in New York at jnani@bloombergindustry.com

To contact the editors responsible for this story: Roger Yu at ryu@bloomberglaw.com; Keith Perine at kperine@bloomberglaw.com