A Blog About Online Gaming and Entertainment Regulations
Is My Crypto Safe if My Exchange Declares Bankruptcy?
Celsius Network LLC, one of the largest cryptocurrency lenders in the industry, filed for bankruptcy protection on Wednesday, July 13th. The filing comes just a month after the company halted customer withdrawals, swaps, and transfers “to stabilize liquidity” on account of extreme market conditions caused by a dive in cryptocurrency prices. As such, many crypto-investors find themselves concerned about the safety of their digital assets and money. Celsius’s predicament illustrates the problems posed by the lack of legal protections for retail customers in the cryptocurrency industry, which lacks safeguard measures for investors and consumers comparable to those in place for regulated banks and brokerages. The insolvency of crypto exchanges or wallets likely will lead to larger investor losses than the insolvency of more traditional investment vehicles.
Celsius uses the cryptocurrency deposited by retail customers into its platform to invest in the wholesale cryptocurrency market. Such investments vary from decentralized finance, which are websites that offer traditional financial services such as loans and insurance by means of decentralized blockchain protocols, to “staking” the invested cryptocurrencies, wherein Celsius provides liquidity to markets and is offered a return for not being able to access it for a predetermined period of time.  This latter method means that Celsius would be unable to retrieve its assets easily, if at all, to pay back customers in the event of a mass-customer withdrawal until the staking period expires.
Celsius rose to prominence in the industry under the premise that the company provides “fair and transparent services that have been abandoned by banks – fair interest, low rates for loans, and lightning quick transactions.”  Celsius CEO Alex Mashinsky has repeatedly marketed its services as less risky than banks with higher returns for customers.  That proposition was always dubious. The Wall Street Journal reported at the end of June that the firm was overleveraged. The company’s assets-to-equity ratio, which regulators use as an indicator of risk, was 19:1, while the median assets-to-equity ratio for all the North American banks in the S&P 1500 Composite index was about 9:1.  Further compounding the risk, Celsius allegedly sold under-collateralized loans and rehypothecated the posted collateral. While banks tend to require loans be over-collateralized, in which the collateral is worth more than the loan, documents show that Celsius required its business borrowers to post only an average of about 50% collateral on $2.7 billion worth of loans.  As a result of these practices, it is highly unlikely that Celsius customers will recover their investments in full.
With the crash in multiple cryptocurrencies, multiple holes have sprung in Celsius’s business model. After the company’s crypto investments fell flat it found itself unable to meet customer withdrawal requests. Where a traditional bank might have similar assets-to-equity ratios, the assets are generally more stable than cryptocurrency and the banks have access to central-bank loans. Crypto companies tend to invest in inherently risky investments and have few regulatory safeguards.
Cryptocurrency is not insured or guaranteed by Federal Deposit Insurance Corporation (“FDIC”) or Securities Investor Protection Corporation (“SIPC”). So, if an exchange goes bust, investors’ remedies are limited to the assets of the exchange or any available private insurance. As an exchange is only likely to go bust if the underlying assets rapidly depreciate, this can create a death spiral for a crypto-company and its investors. As investors seek to remove their assets from a struggling company (whether an exchange, wallet, or other crypto investment vehicle), the company will face increasing financial pressure that it may be unable to meet. Bankruptcy in these cases is likely.
And in bankruptcy, crypto-investors will typically find that they hold general unsecured claims. Unless their investment is held in a trust account, their only recourse will be from the general fund of the bankrupt company. There are many ways a crypto exchange can ameliorate this problem, but crypto investors should know that their investments are not necessarily safe from the financial insecurity of the platform upon which the investor is trading.