Best Way to Explain What Happens When a Crypto Exchange Goes Bankrupt?
Since 2009, crypto such as Bitcoin and Ethereum have transformed the global financial industry by offering a decentralized alternative to established banking institutions. However, as witnessed in 2022, the cryptocurrency industry’s mostly unregulated nature exposes investors to fraud, frauds, and other financial disasters if they place their faith and cash in the hands of the wrong crypto exchange.
FTX, Voyager, Celsius, 3 Arrows Capital, BlockFi, and Genesis were among the centralized crypto custodians, hedge funds, and exchanges that went bankrupt in the last year due to poor decision-making or outright criminal behavior by their leaders, which included mortal financial sins like over-leveraging, high-risk investments, and misappropriation of users’ funds.
This cost their customers billions of dollars.
money, severely harmed the crypto industry’s mainstream reputation (again), and caused terrible contagion across the whole sector, affecting other projects and their investors world wild.
In 2023, these bankruptcies are giving crypto investors nightmares as they worry about the safety of the crypto assets, they’ve entrusted to their preferred crypto trading platform. Unfortunately, there is cause for alarm. This is why.
What Is the Definition of a Crypto Exchange Bankruptcy?
Whether a cryptocurrency trading platform declares bankruptcy for any reason, whether due to a hack, fraud, or plain incompetence, it means that it is unable to pay its bills or satisfy its financial responsibilities to its clients and creditors.
What occurs during a crypto exchange bankruptcy is determined by the jurisdiction in which it is located and the legislation of that jurisdiction.
For the sake of this article, we will focus on the United States, where an exchange will typically file for either bankruptcy protection, which reorganizes its assets, or bankruptcy protection, which liquidates its assets.
the United States Bankruptcy Code and also establishes a repayment schedule that will allow the firm to remain viable while it repays its obligations, while impacted investors can utilize it to try to reclaim some assets. There is a clear succession of who receives payment for the remaining assets.
The first payments are usually paid to secured creditors. After that, the leftover money are used to fulfill debts to unsecured creditors, such as the exchange’s clients, which means they are practically last in line to reclaim their assets and only receive a pro-rata part of what’s left.
Who Is Prioritized During a Crypto Bankruptcy?
In broad terms, due to the industry’s lack of clear overall crypto regulation, crypto business consumers have more limited rights with cryptocurrencies than they would with traditional financial assets. This is something to consider while investing in cryptocurrency.
Unfortunately, after a crypto exchange bankruptcy, the small investor frequently receives the short end of the stick, with secured creditors getting paid first. Secured creditors are typically large institutions such as banks or bondholders who are prioritized over unsecured creditors and investors. Retail cryptocurrency account holders are classified as unsecured investors and, as a result, must typically wait in line for repayments.
How To Recover Funds from a Bankrupt Crypto Exchange?
The custodial wallets and private keys that contain their users’ deposited digital assets are often owned and controlled by centralized crypto exchanges (CEXs). This implies that if they fail, the exchange, not the individual account holders, is regarded the legal owner of the contents of the custodial wallet in the eyes of the law.
These assets have now been transferred to the bankruptcy estate and will be liquidated by the trustee to pay off outstanding obligations. As a result, investors may only be entitled to a pro-rata share of the estate’s entire value, along with other unsecured creditors such as vendors, lessors, lawsuit claims, and clients of the exchange.
In broad terms, investors may be permitted to recover some or all of their assets by filing a claim with the bankruptcy court. However, depending on the jurisdiction and the terms of the exchange’s bankruptcy declaration, the intricacies of the recovery process can vary substantially.
Typically, cryptocurrency organizations have a method in place for delivering monies to customers, although it may take some time for investors to get their assets. It is critical to be patient and adhere to the firm’s process as precisely as possible. Find out what paperwork is required and send it as soon as possible.
A Step-by-Step Breakdown of Bankruptcy Process
Here is a general summary of the bankruptcy process. Please keep in mind that there are a few significant variations between them that are best described by a legal expert.
The bitcoin exchange declares bankruptcy and closes its doors.
The asset liquidation proceedings are then overseen by a trustee.
The trustee takes custody of the assets of the exchange and determines their remaining value.
The trustee communicates with creditors and investors about expected returns throughout the bankruptcy process.
The order of payment for remaining assets is creditors first, secured investors second, and unsecured investors last.
Depending on the bankruptcy filing, investors may file claims for the return of their assets.
When all debts and after the payments are settled, the trustee distributes the leftover assets to investors in proportion to their investment.
Is your government protecting your crypto investments?
Unfortunately, contrary to popular belief, investments in cryptocurrencies are not generally protected by the government in the same way that traditional bank deposits are, and crypto investors may be forced to wait for the legal process to conclude in order to recover only a portion of their assets (in most cases).
The regulation of bitcoin exchanges differs greatly between countries. Exchanges are subject to specialized exchange rules or regulatory frameworks in certain jurisdictions, while in others with less sophisticated financial systems, they operate with little or no oversight.
This should change in the coming years when new policies are established and enforced globally to avoid another FTX tragedy and to limit money laundering and terrorism funding are prohibited (see FATF Travel Rule).
FDIC Insurance for US Investors
Unlike traditional bank deposits, investments in cryptocurrencies are not insured by the Federal Deposit Insurance Corporation (FDIC) or other government-backed insurance programs in the United States. As a result, investors may not have the same legal safeguards or guarantees as they would with traditional financial assets.
The FDIC was created as a result of the 1933 Banking Act to aid in the restoration of faith in banks following the Great Depression. Its primary responsibilities include providing deposit insurance, supervising financial institutions to ensure their safety and security, and conducting receiverships, a court-appointed instrument used to help creditors recover money or assets owed to them.
The FDIC rules for banks and financial institutions engaging in crypto activity are in place to prevent bank collapses – with one major caveat:
Individual crypto investors are not protected.
Of all, even with traditional banks, no one is safe when you put your money in the hands of someone else, as evidenced by the current banking crisis, which brought down major TradFi institutions such as significant crypto-friendly banks Silvergate Bank, Silicon Valley Bank, and Signature Bank.
Because traditional banking investors’ funds are only FDIC-insured up to $250,000, and many banks were carrying unrealized losses on their books as a result of the Fed’s interest rate hikes, the US Government had to step in and backstop retail investor deposits to prevent depositors’ fear from spreading further. In order to avoid a catastrophic bank run and the implosion of the banking industry, the government also established a preferential lending and funding scheme for banks.to escape a catastrophic bank run and banking system catastrophe that may have extended globally.
During a Crypto Exchange Bankruptcy, How Is Crypto Classified?
Because bitcoin is not specifically listed in the US Bankruptcy Code, courts struggle with how to categorize it as an asset in bankruptcy cases, and even federal US regulators disagree on the matter.
Should the affected cryptocurrency be classified as a currency, similar to cash, a security, similar to corporate stock, or a commodity, similar to gold? The outcome may have a significant impact on how much creditors are paid.
If it is categorized as a commodity, the trustee in charge of the bankruptcy can collect the value of the cryptocurrency at the moment it was transferred, plus any gain in value since then. However, if it is treated as cash, the trustee can only recover the value of the crypto asset at the moment of transfer.
The CFTC is the Commodity Futures Trading Commission.
The Commodity Futures Trading Commission (CFTC) regards cryptocurrency as a commodity, however the Securities and Exchange Commission (SEC), led by notoriously anti-crypto chairman Gary Gensler, increasingly believes that all crypto assets, other than Bitcoin, are securities under the Howey Test. As a result, dozens of firms and projects have been targeted in litigation. Both federal regulators are currently battling for the authority to regulate bitcoin firms and assets.
If the SEC prevails, it may try to appoint a receiver to take over and oversee an exchange’s assets if it believes the exchange has violated federal securities laws.
So far, bankruptcy courts have not reached an agreement on how to handle bitcoin. The procedure is quite complicated and vulnerable to numerous different circumstances. Once regulatory certainty is obtained, it should make bankruptcy processes for crypto exchanges considerably easier.
4 Notable Crypto Bankruptcies in History
Several cryptocurrency exchanges and organizations have declared bankruptcy owing to financial issues over the years, bringing thousands of investors heartache and empty wallets. The following are some of the most significant cryptocurrency bankruptcies:
November 2022, FTX
July 2022, Three Arrows Capital
June 2022, degrees Celsius
February 2020, FCoin
Bankruptcy of FTX
Due to liquidity challenges and financial difficulties created by founder Sam Bankman-Fried and colleagues’ criminal activity, FTX filed for bankruptcy in November 2022, with debts of approximately $11.6 billion against $4.8 billion in remaining assets on its balance sheet. While attempting to repay these massive obligations, the bankruptcy process was initiated.
Celsius Insolvency
Celsius, a centralized loan and borrowing platform, declared bankruptcy in June 2022 as well. During the May 2022 cryptocurrency market meltdown, the company apparently sustained large losses, resulting in a liquidity issue. As a result of being unable to meet the demands of its lenders and investors, Celsius filed for Chapter 11 bankruptcy protection in order to restructure its operations and repay its creditors. Many questions remain about its actions.
During the May 2022 cryptocurrency market meltdown, the company apparently sustained large losses, resulting in a liquidity issue. As a result of being unable to meet the demands of its lenders and investors, Celsius filed for Chapter 11 bankruptcy protection in order to restructure its operations and repay its creditors. Many doubts remain about its inventor, Alex Mashinsky, who is now being sued by the New York Attorney General (NYAG).
FCoin (2020) declares bankruptcy
FCoin, a Chinese exchange, declared bankruptcy in February 2020 after being unable to return its consumers’ assets totaling more than $130 million. FCoin blamed its demise on a series of technological issues and system breakdowns, which resulted in millions of bogus transactions and considerable losses for the company.
Bankruptcy of Cryptopia (2019)
After a strange attack resulted in the loss of $16 million in bitcoin, this prominent New Zealand-based cryptocurrency exchange for smallcap altcoins filed for bankruptcy in May 2019. After failing to retrieve the stolen customer monies, the company chose to sell its customer assets and distribute the remaining funds to its creditors. Creditors received a share of their damages after the liquidation procedure was finished in 2020.
How Can You Protect Your Crypto Assets from Bankruptcy?
Interestingly, cryptocurrencies were designed to shield you from bankruptcies (see the 2008 banking crisis), not to add you to their victim list.
Using a self-custody wallet that you control is one of the greatest ways to preserve your money, since it decreases the chance of losing your assets in the case of an exchange hack or insolvency. It is also known as a non-custodial, unhosted, or private crypto wallet because it allows you to generate your own hidden private keys and maintain complete control over your assets.
Non-custodial wallets are further classified as hot (software-based, such as MetaMask) or hardware wallets (also known as cold storage or cold wallets), which are dedicated physical wallets that keep your private key offline at all times, such as Ledger and Trezor.
But keep in mind that you
When you utilize a private wallet, you accept complete responsibility for your funds. You may lose everything if you lose your keys or recovery seed phrase, or if you mistakenly reveal them to the wrong third party.
The demise of FTX demonstrates that with crypto, anything is possible. Because no remedy is 100% perfect, it is best to hedge your bets and distribute your risk. Don’t put all of your eggs in one basket, and never put more money into any one of them than you can afford.
Consider distributing your cash across multiple exchanges and non-custodial wallets, and only utilize firms and products that you’ve thoroughly investigated to determine their dependability.
last Thought
Although investing in cryptocurrencies might result in life-changing wealth, it can also be a very painful experience if you don’t consider the hazards involved. By understanding the bankruptcy process and implementing the procedures outlined in this article to preserve your assets, you may reduce your risk and invest with a higher level of trust.
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