In recent years, many investors have made significant profits by utilising cutting-edge financial products such as cryptocurrency exchanges. Now that the markets are turning, many people wonder how they will be protected if cryptocurrency exchanges fail. We're about to find out the hard way as those cutting-edge financial platforms face bankruptcy court for the first time. Although many of these products have been on the market for a decade, bankruptcy filings are rare in a thriving market.

So, what does this mean for investors?

Bankruptcy in Crypto

Apart from the crypto lending platform Cred, which declared bankruptcy in 2020, the only other notable precedent for a crypto bankruptcy case is Tokyo-based Mt. Gox. The largest BitcoinBTC -4.4% exchange in 2010 collapsed in 2014; that was a Chapter 15 case (where representatives of a corporate bankruptcy proceeding outside the U.S. obtain access to U.S. courts).

After a crushing "crypto winter" over the last quarter of 2022, an avalanche of filings is on the way. The first was Canadian crypto broker and lender Voyager Digital, which was recently forced to file for Chapter 11 bankruptcy in New York after suspending account holders' ability to withdraw assets.

Voyager had lent $650 million in cryptocurrency to Three Arrows, another failed hedge fund. Voyager hired the prestigious firm, Kirkland & Ellis, to represent it in its forced bankruptcy filing. Voyager argued in papers filed with the bankruptcy court that it already had a preliminary restructuring plan. Account holders would be repaid in the form of crypto "coins" and "tokens," as well as proceeds from the litigation with Three Arrows and some equity in a future reorganised Voyager, according to the plan.

Then, a few days later, crypto lending platform Celsius, which bills itself as a "crypto bank" because it charges interest on crypto loans and allows crypto deposits to earn their interest, confirmed that it, too, had filed for Chapter 11 bankruptcy.

With more crypto firms becoming insolvent and declaring bankruptcy, it is becoming clear that many customers will suffer massive losses because their rights to their funds and assets are unclear. This ownership issue was highlighted in the Cred bankruptcy case, where customers lost ownership of their cryptocurrency after transferring it to Cred. Instead, the CreditEarn transactions were treated similarly to any other loan in a fiat currency.

In this case, the ownership issue is also a problem. For example, Celsius' terms of service make no guarantees that user deposits are protected in any way in the event of insolvency. The fine print of Celsius' terms of service makes it clear that depositors who use its "Earn" accounts, which pay up to 18% interest, grant the "crypto bank" ownership of their funds as a condition of use. As a result, in the event of bankruptcy, such account assets "may not be recoverable."

Similarly, while customers who open "Custody" accounts do not pay interest to retain ownership of their funds, Celsius does not explicitly guarantee that they will receive their money back in the event of bankruptcy. According to the terms of service, a bankruptcy proceeding could result in the "total loss of any Digital Assets."

Based on research, the Bitai Method site has mentioned that even if customers have the legal right to recover their money and assets, it is unlikely that they will receive anything for two reasons.

First, while Celsius claims in its bankruptcy petition that it is interested in restructuring rather than liquidating (meaning that if funds are available for distribution to unsecured creditors, customers may receive compensation), there is no guarantee that it will be successful. Second, once in bankruptcy, it is up to the bankruptcy process to determine: (i) creditor priority and (ii) asset valuation — two crucial tasks in the crypto world.

Do Investors Get Priority During Bankruptcy?

There is a transparent chain of who gets paid for the remaining assets during Chapter 11 bankruptcy proceedings. Investors may be satisfied even if a company owes $1 billion more than it has in assets.

The bankrupt company must produce a detailed schedule of assets and liabilities, as well as other financial statements and reports, under Chapter 11. During the bankruptcy process, the company, lawyers, and a bankruptcy judge collaborate to determine who receives what.

According to the legal code, the first payments are generally made to secured creditors. Once those obligations are met, funds are used to repay unsecured creditors. Investors are nearly last in line when it comes to recovering their assets.

When the pool of assets to be returned to individual investors is calculated, everyone is informed of their pro rata share. For example, if the company owes customers $100 million and has $90 million remaining after paying off debt, customers would receive approximately 90% of their deposits back.

Suppose you followed your customer (KYC) requirements and created your account with accurate information. In this case, the cryptocurrency company should have your contact information and an account of what you owe on file. If the company declares bankruptcy, you should hear from them as soon as possible about how to recover funds.

Most businesses will use their procedure to distribute funds to customers. While there is a possibility that cryptocurrency investors would then receive no money or cryptocurrency after bankruptcy, there is also the chance that they will receive something — even if it is only a portion of their initial investment.

Cryptocurrencies are a new asset with an uncertain track record. While values could rise significantly in the future, they could also fall to zero. It is up to each investor to determine whether cryptocurrencies are appropriate for their financial objectives and investment strategy. A bankruptcy at any financial institution with which you do business can be stressful, confusing, and expensive. Customer confusion and losses can be even worse in the cryptocurrency industry. However, rather than panicking, it is best to wait until the bankruptcy process is completed to determine precisely what you will receive.