Fear, uncertainty and doubt: Global regulatory challenges of crypto insolvencies

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Since the invention of Bitcoin in 2008, a crypto market has emerged. It is currently valued at less than $1 trillion due to the recent decline in cryptocurrency market capitalization, down from $3 trillion a year ago (Figure 1). This precipitous decline has amplified financial risks during a time of historically elevated debt and fragile growth around the world.

Cryptocurrencies, and in particular Bitcoin, initially gained popularity for promising anonymity, permissionless payments, and an alternative to cross-border remittances. However, the rapid growth of crypto exchanges and companies that did not practice proof of reserves, lack of self-custody, and the high volatility of crypto assets have substantially increased the risk of insolvencies in the industry. Combining this with the current environment of rising interest rates has led to some of the biggest recent global bankruptcies, such as Celsius Network, which reportedly owes its users around $4.7 billion, and the recent FTX Group, which might impact up to a million customers and that led to the arrest and extradition to the US of the FTX founder. FTX Group’s bankruptcy includes approximately 130 affiliated companies and could trigger contagion in the overall crypto ecosystem. The most recent bankruptcy filing of the lending unit of the crypto firm Genesis on January 20, 2023, serves as an example of the potential contagion effect in the industry. Genesis shares the same parent company as Grayscale, which manages the Grayscale Bitcoin Trust with over $14 billion in assets.

This cascade of crypto-related insolvencies revealed a series of regulatory challenges that policymakers should consider when implementing reforms in the areas of cryptocurrencies and insolvencies.  Below are some critical challenges that regulators might want to assess.

Figure 1. Total Cryptocurrency Market Cap: November 2021 – January 2023.
Total Cryptocurrency Market Cap: November 2021 ? January 2023
Source: coinmarketcap.com, available at https://coinmarketcap.com/charts.

Legal qualification of a crypto asset can be complicated. Cryptocurrency at its core is cryptographic code, which raises the question of how to legally classify these assets. Is it property, security, currency, or something else? There is no universal consensus on this issue and depending on the jurisdiction and the agreement between the parties, specific classification of this asset might impact the ability to get a freezing injunction against an insolvent company. Classification could raise other insolvency-related questions, such as the ability for a company to use a particular asset as a collateral to obtain rescue financing. Also, individual cryptocurrencies might be classified differently, leading to questions about regulatory jurisdiction, as was pointed out, for example, by the chairman of the US Securities and Exchange Commission, which may differentiate Bitcoin from other cryptos.

Asset-tracing and recovery can be a significant challenge. With anonymity as one of the distinct features of crypto assets, they might not be easily identifiable, and tracing such assets requires special skills and engagement of blockchain analytics companies. An even bigger challenge might be when companies’ assets are stored on private addresses, known in the industry as cold wallets, as opposed to exchange-controlled accounts, or hot wallets. Cold wallets provide the highest decentralized level of security to the cryptocurrency user. They are practically impossible to break without a private key that is usually only known to the owner. This feature of anonymity can potentially provide a value proposition of securing personal funds, especially for the most vulnerable. However, funds on a cold wallet can be a crucial challenge in insolvency proceedings if there is a need to secure the company’s assets. Even if a wallet’s geographic location is identified and it can be physically seized, it would be extremely hard, if not impossible, to recover the funds from such a wallet without the owner’s cooperation. For example, this happened in Quadriga’s insolvency case and the related death of the exchange’s CEO, Gerald Cotton, who owned the cold wallet with the assumed company’s funds, which therefore vanished. The potential solution, in this case, might be a transparent corporate governance regulation where a CEO or company’s officer of a crypto company doesn’t have exclusive access to the company’s crypto funds. For this purpose, using a digital wallet that operates with multi-signature address and requires more than one private key to authorize a transaction could be an option, or using a service of a trusted crypto custodian or some other alternatives that can ensure transparent and secure accessibility of a company’s funds.

Treatment of creditors poses a separate risk, and depending on the nature of a company, it can influence many individual retail investors and have a more significant systemic effect on an economy. In this respect, the crypto industry is characterized by the lack of any safety nets, such as investor protection funds, that are common in many securities markets.  Take the case of Celsius Network, mentioned earlier. According to Celsius’ terms of service, the treatment of customers’ digital assets in the event of an insolvency proceeding is “unsettled” and “not guaranteed” and may result in clients being classified as an unsecured creditor “and/or the total loss” of the assets. Respective agreements between the parties should also be appropriately interpreted within the insolvency frameworks of specific jurisdictions. In the recent development of the ongoing Celsius insolvency case, a US bankruptcy judge ruled that the deposits in the yield-bearing Earn accounts belong to Celsius, not individual account holders. As with many other crypto-related issues, lack of clarity on this matter, can create procedural challenges and might require appropriate regulatory intervention.

Distribution to creditors can be especially uncertain. Volatility is a central characterization of cryptocurrencies, a trade-off for its decentralization.  As the most used cryptocurrency, Bitcoin can be incredibly volatile. Between April 2022 and January 2023, Bitcoin’s value more than halved, from just over $45,000 to below $20,000. But three years ago, Bitcoin was half the current price and traded at levels below $10,000. Such recurring and unpredictable ‘booms and busts’ in the crypto industry can be a challenge in insolvency proceedings at the stage of paying proceeds to creditors, if the distribution was to be made in the legal currency of the country, as many insolvency laws currently require, instead of distributing the crypto assets themselves. From the moment of determining the payment amount and actual distribution to the creditor, the cryptocurrency can move substantially. 

Added to the complexity of the distribution to creditors is the practical challenge of delivering the funds to multiple creditors, possibly residing in different jurisdictions. For example, Celsius reportedly served 40,000 members from over 150 countries. Distributing funds as part of an insolvency process can also be costly, particularly when cross-border bank transfers are necessary. To overcome this challenge, it may be worthwhile to consider distributing the assets in cryptocurrency. This is because, as the Bitcoin community often says, “1 BTC = 1 BTC”, meaning that the value of one Bitcoin is the same, regardless of where it is held in the world.

Despite the current decline in the cryptocurrency market, Bitcoin and other digital assets are likely here to stay for the foreseeable future. While cryptocurrencies have brought certain innovations, they have also introduced new risks, which have created FUD (Fear, Uncertainty and Doubt) for financial supervisors and regulators in different areas, including insolvency.  A practical, comprehensive, and transparent regulatory framework that addresses some critical challenges that have appeared from recent crypto-related insolvencies could help to reduce some of these risks.


Harish Natarajan

Lead Financial Sector Specialist

Andrés F. Martínez

Senior Financial Sector Specialist

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