Bankruptcy filings by Celsius and Voyager have raised questions about what happens to investors’ crypto if a platform goes down.
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Traders hoping to recover their funds from failed cryptocurrency exchanges soon will likely be disappointed, legal experts tell CNBC.
Crypto trading and lending firms Celsius and Voyager Digital filed for bankruptcy this month, leaving users’ assets trapped in their platforms. Both companies froze customer accounts after an influx of withdrawals caused liquidity problems.
Celsius functioned much like a bank, accepting customer deposits and lending them or engaging in risky games with so-called decentralized financial products in order to generate high returns.
Voyager had a similar model. The company became embroiled in the collapse of high-profile crypto hedge fund Three Arrows Capital, which itself floundered after a $660 million loan from Voyager defaulted.
This interconnectedness has left the crypto market vulnerable to contagion, with large companies falling like dominoes as a plunge in token prices has removed excessive leverage in the system.
Is my crypto safe?
Cryptocurrencies are unregulated, meaning they don’t offer people the same protections that 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 experiences financial difficulties.
The Federal Deposit Insurance Corporation offers depositors up to $250,000 in protection if an insured lender defaults.
Similar systems exist in the United Kingdom and the European Union.
Without cryptoasset laws, there are no guarantees that investors will get their money back if an exchange freezes someone’s account — or, worse, collapses entirely.
“There is currently no such scheme” for crypto, said Daniel Besikof, a partner at Loeb & Loeb.
“It wouldn’t surprise me if one happens later,” he added. “This will reinforce calls for increased regulation.”
What happens if an exchange fails?
It’s not entirely clear at the moment. While there are examples of crypto firms filing for bankruptcy abroad – Mt. Gox in Japan, for example – such an event is unprecedented in the US
The creditors of Mt. Gox, which went offline in 2014, are still waiting to be repaid the multi-billion dollar cryptocurrency.
The problem with centralized crypto platforms is that they can mix different clients’ funds to make risky bets, according to Daniel Saval, an attorney at Kobre & Kim. Such commingling can result in a decision that the assets are owned by the exchange and not the users.
“Users may be surprised to learn that in a bankruptcy scenario, the cryptos and funds in their accounts may not be considered their own property,” says Saval.
“Exchanges often pool different clients’ cryptos and funds into the same storage bag or account.”
What happens to customers’ funds in bankruptcy cases depends heavily on the company’s user agreement and how it has used its assets, Besikof said.
Celsius’ terms of service state that any funds deposited with the company “may not be recoverable” in the event of bankruptcy. The company filed for Chapter 11 protection last week, exposing a $1.2 billion hole in its balance sheet and owing users around $4.7 billion.
Celsius claims to have $167 million in cash. But it still won’t let customers withdraw their funds and hasn’t offered any clarity on when it will reopen withdrawals.
According to Voyager, its customers’ dollars are held in an FDIC-insured account at the Metropolitan Commercial Bank in New York — but this claim has been disputed by legal experts and the bank itself. The FDIC only provides protection of funds in the event of a bank failure, not a crypto exchange.
For its part, Voyager says it is going through a “reconciliation and fraud prevention process” with its banking partner, after which users will regain access to their cash.
Voyager also presented a plan to refund users with crypto in their accounts, Voyager shares and the company’s token, and any debt recovered by Three Arrows Capital.
Both Celsius and Voyager hired the renowned law firm of Kirkland & Ellis to represent them in court.
“Investors holding crypto assets through Voyager Digital and now Celsius have found themselves in a difficult position with their accounts frozen, their lawsuits suspended and the value and timing of any recoveries unknown,” Besikof said.
“There is a lot of work for them in the bankruptcy court before these issues are resolved.”
Celsius and Voyager filed for Chapter 11, a form of bankruptcy protection that allows companies to restructure their debt. The aim is to ensure that there is still a profitable business at the end of the process.
There’s a high probability that Celsius and Voyager users will be treated as “unsecured creditors,” legal experts said, a categorization that puts them in the same box as a company’s suppliers and contractors.
That means they would likely be at the end of a long line of creditors lining up for a payout from the court case — behind banks, employees and tax authorities.
In a May filing, Coinbase said its users would be treated as “general unsecured creditors” in the event of bankruptcy.
“Generally speaking, most clients on cryptocurrency exchanges are unsecured creditors, so if an exchange goes down, the secured creditors are repaid first, along with legal fees,” said Dustin Palmer, chief executive of consulting firm Berkeley Research Group. “Customers are paid pro rata last. In a typical bankruptcy, that’s pennies on the dollar.”
“Customers will likely have to wait for the full bankruptcy process to complete before receiving compensation, and bankruptcy typically takes years,” Palmer added. “At Lehman, it took years. For example, some Mt. Gox customers have still not received any compensation.”
Saval added that recoveries from customers in bankruptcy proceedings “can be further diluted by other unsecured creditors such as vendors, landlords and litigants.”
How can I protect my crypto?
Investors may choose to move their cryptos from an exchange to so-called “self-custody” wallets instead.
Here someone is responsible for their own private key, a secret password required to access a crypto wallet.
However, such a move carries its own risks. If a crypto holder loses their private key, they may never be able to get their funds back.
There are countless examples of people who have lost hard drives or USB sticks containing millions worth of crypto assets.