Bankruptcy expert and Georgetown law professor Adam Levitin has just published a post on how customers would fare if a cryptocurrency exchange were to go bankrupt in the US. The short answer is badly. Cryptocurrency exchange members, often misled by the exchange itself, likely labor under the misapprehension that they still “own” the coins they’ve entrusted to the exchange. While possible legal arrangements vary, for the overwhelming majority of customers, that is almost certainly false.
I strongly encourage anyone dabbling in crypto or with friends and family doing so to read Levitin’s short and very readable piece.
The risk of exchange failure is real, and particularly so with cryptopcurrency exchanges. Brave New Coin listed 50 cryptocurrency exchanges that had gone bust in the past 11 years as of mid 2021 and warned:
Unfortunately crypto exchange failures or hacks often generate a perception that there was something wrong with the coins that got hacked. Typically, though, it is not a cryptocurrency that failed or a bitcoin failure, but instead it is basic mismanagement, outright founder criminality and/or mass government shutdown orders that are to blame.
According to Darwinist theory, failed crypto exchanges should result in the quality of the products and services of the exchanges that remain being higher than it would have been if these poorly managed exchanges had survived. As VC Marc Andresen said in a tweet soon after the now legendary MtGox failure: “MtGox had to die for Bitcoin to thrive. Its former role from early Bitcoin days has been supplanted by better, stronger entities.”
The theory goes that markets mature and get stronger through a process similar to natural selection, where bad or “unfit” services are bankrupted in one way or another, getting out of the way to make room for the good, or “fittest” services to thrive. If the theory is sound, then this long list of failed crypto exchanges should mean that the exchange sector is healthier than it has ever been – but the fact that so many exchanges continued to sink in 2020 along with all their depositor’s funds, is not reassuring.
Brave New Coin apparently missed a few rotten apples. CoinTelegraph found that 75 cryptocurrency exchanges had failed “so far” 2020….as of October 7.
Now to Levitin’s discussion of the consequences for hapless customers. Let’s start with the key point, when the exchange goes bust, your coins are almost certainly part of the bankruptcy estate, and you have to get in line with all the other creditors of the exchange to make your claim and eventually find out what if anything you get back. As Levitin elaborates:
First, the custodially held cryptocurrency is property of the bankruptcy estate—that’s the new legal entity that springs into existence upon the filing of the bankruptcy…
But wait, you bluster, the custodial agreement clearly says that I am the owner, that it’s my property, that I retain title to it. Yup, but that’s not how the law actually works. Just because they wrote that doesn’t mean it’s true.
For starters, the idea of “ownership” is a little more tricky. It’s not a binary concept in law. Legal thinking generally conceives of ownership as a bundle of sticks, and the sticks can be separated and doled out to different folks. For example, I might “own” an estate called Blackacre, but I can rent the back 40 to you, lease the westfold to your cousin, give you brother fishing rights in the stream, your sister an easement to cross the forest, and the bank a mortgage (that’s a contingent property interest). I still “own” Blackacre, but lots of other folks have property interests in it. Same story with crypto….
At the very least, the cryptocurrency exchange has a possessory interest in the cryptocoins. If that’s all there is, you might get your coins back, but it won’t be immediate or automatic, and you won’t be able to trade in the interim.
Things get much worse, however, if the exchange has any right to use the cryptocurrency—to rehypothecate it or to use its staking rights—that too is property of the estate. Not to pick on Coinbase, but under its staking arrangement it gets a 25% “commission” on any staking rewards and it indemnifies the customer for any slashing losses. The shared gains and internalized losses sure looks like an investment partnership there.
But even if the exchange can’t use your crypto in any way, things could still be bad. If the exchange can commingle customers’ coins and is not obligated to return a specific cryptocoin (e.g., #25601), but just a cryptocoin—and that’s typically how this works—then the entire cryptocurrency deposit, root and stem, is property of the estate.
The situation is no different than with your bank account—you have a general deposit—an unsecured claim for a dollar value, rather than a right to specific bills, as you would with a specific deposit in a safe deposit box. Put in fancier terms, if the obligation isn’t to return the same or altered/improved good, then it’s not a bailment, but a sale, which makes the crypto property of the debtor and the customer a creditor.coins and not others.)
Levitin goes on to explain that the cryptocurrency being part of the bankrupt estate means you as the customer are subject to the “bankruptcy stay”. All creditor claims, such as your “I want my money back!” are frozen until the court sorts things out. Creditors might petition the court to lift the stay but it would take time, cost money, and unless the exchange had only a custodial interest in the cyptocurrency, probably not work. Levitin also describes why the long list of exceptions to the automatic stay aren’t operative with cryptocurrencies.
Oh, and it gets worse:
Not only are the customers likely mere creditors, but they are also likely general unsecured creditors, which means they will have to wait at the back of the line for repayment with everyone else. They will share on a pro rata basis whatever assets are leftover (if any) after the secured creditors and the priority creditors (including the expenses of running the bankruptcy) get paid, and any payment might not be for quite a while. That’s not a happy to place to be. Recoveries could be pennies on the dollar…
What’s worse for the cryptocurrency exchange’s customers, is that their claims will be for the dollar value of the coins as of the date of the filing of the bankruptcy, so any future appreciation will go to the debtor and thus be available to first to repay higher priority creditors.
Even more fun, you might be subject to a clawback if you were a customer of the exchange and made an unusual-looking withdrawal before the collapse:
Once in bankruptcy, the cryptocurrency exchange can clawback certain pre-bankruptcy transfers, like redemptions by its customers as voidable preferences. If the transfers were made to unsecured creditors in the 90 days prior to bankruptcy, they are preferences. The only issue is whether an exception or defense applies. The only obvious exceptions would be the de minimis amount exception or the ordinary course exception, but the ordinary course exception requires that the withdrawal be made in the ordinary course of the customer’s business, not just the exchanges. Does the customer generally withdraw its funds? There’s some risk here.
In case you haven’t noticed, the idea that you as a cryptocurrency exchange customer are somehow safer in the Wild West of cryptobroland than in dealing with bank and securities firms is bunk.
And remember a key point from Levitin: the customer agreements can’t be relied upon to describe your rights or protections accurately. Caveat emptor.