Wed 07/27/2022 12:05 PM
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By now, consumers and crypto investors alike have already begun to grapple with newfound realities related to the cryptocurrency market as high-profile companies file for bankruptcy, hire advisors and weigh their futures. The blockchain technology aimed at solving the “double spend problem” and decentralizing currency has created new problems of its own.

While some have prematurely decried recent price plunges as the end of crypto, most agree that the market can outlast the downturn and spur of bankruptcy filings it has generated. However, crypto lending could look different in the future, as regulators look to put new guidelines in place and consumers themselves begin to understand their own standing, relationships and risks.

Substantial questions remain, though. The nature of restructuring companies with such ambiguous assets - and some aspects of crypto holdings may not be assets at all - as well as the nature of relationships between a crypto lender and investor are still dubious and in some cases have been misrepresented altogether.

The bankruptcy filings we have seen so far stay within the confines of the crypto-lender entities: companies that allow investors to lend their funds to other borrowers and earn a yield on the exchange or that offer crypto-backed loans. This differs from crypto exchanges, such as Coinbase, which act as a marketplace for the trading of various cryptocurrencies such as bitcoin, dogecoin and ethereum. A third type of crypto operation is crypto-mining operations, where new bitcoins are essentially created and verified.

The Voyager Digital and Celsius Networks filings have highlighted questions the market does not yet have answers to, including how these companies can be restructured (if they can), what customers are entitled to and how to treat the liabilities associated with leveraged crypto entities lending to one another. Celsius included a list of questions in its first day declaration outlining just how many crucial issues in the case will need decisions of first impression from the bankruptcy court.

At the same time, the recent bankruptcy filings have also brought to light broader questions around industry dynamics, the future of the market and the regulatory environment that may emerge. Below, we will explore the questions that exist both inside and out of the bankruptcies, how the market got to where it is, and where it is likely to go.

Setting the Stage: How Did Crypto Get to This Point?

Cryptocurrency and blockchain technologies go far beyond just bitcoin. The possibilities are seemingly endless, but the industry still tends to be viewed in a unary fashion, and the digital tokens that have long been the market’s focal point, the ones that were only meant to go up, up and away, have come crashing down, hard.

The volatility the industry is infamous for has reached new heights (or lows) as the price of bitcoin has dropped surreptitiously from $60,955.77 on Nov. 1, 2021, to $19,488 earlier this month.

There are a few reasons for this, says Jeff Dorman, chief investment officer at Arca, an asset management firm that invests in digital assets. One is that while crypto remains largely separate from centralized financial systems, it is not immune to the macro trends that sway markets insofar as many of its investors are exposed to other areas as well.

“Everyone who’s invested in digital assets is largely invested in other areas as well, and as we’re starting to see pain, you see universal selling everywhere,” Dorman said. “The first selloff was pretty innocent - it was in line with macro trade, the dollar rising, interest rates rising, the Fed fighting inflation, and everything from tech stocks to bonds to crypto has been way down.”

However, there are also some trends more specific to crypto, including highly leveraged capital structures and insufficient liquidity. While the over-leverage is by no means a story Wall Street hasn’t seen before, some crypto companies seem to be the latest victim in a long line of folly.

“The institutions that lever up to make pretty hefty bets, when those go against them, it leads to a cascading effect of leverage, and that's what we've seen for the last few months,” Dorman added. “So you have these lenders in the space who are borrowing short-term assets and lending out longer-term assets and getting liability asset mismatches.”

This is what resulted in Celsius and other companies being unable to satisfy requests to give money back to lenders and the subsequent liquidation of its collateral.

The industry is also a capital intensive one, said Michael Katzenstein, a senior managing director in the corporate finance and restructuring segment at FTI Consulting, and requires a certain degree of profitability in order to maintain its technology in respect of miners and others supporting cryptocurrency blockchain, which requires profitability in order to maintain the ecosystem. If there were to continue precipitous declines in the value of tokens, the entire system could be threatened.

“There are monumental amounts of capital attached to it and uncertainty as to the outcome. This is a big deal. It’s extremely interesting to insolvency practitioners, and it’s going to require a high degree of skill for there to be orderly and equitable resolution for creditors,” Katzenstein said.

Inside the Bankruptcies

Where Do Investors Stand? Whose Crypto Is It Anyway?

Recent events show that many customers did not understand in certain terms their transactional relationship between crypto lenders and themselves, and that uncertainty in and of itself creates certain risks. Adam Levitin, a Georgetown Law professor and principal at Gordian Crypto Advisors, discusses in his piece, “Not Your Keys, Not Your Coins: Unpriced Credit Risk in Cryptocurrency,” the possibility that customers may be deemed unsecured creditors in a chapter 11 case as well as the lack of protections for crypto custodial holdings.

“There’s a question mark about how customers will be treated in any cryptocurrency bankruptcy. The answer is going to depend on the specifics of the contractual relationship,” Levitin said in an interview.

As has already become clear in the Celsius and Voyager cases, different customers entered into different contractual agreements, with potentially drastic differences between - for example, a traditional depositor and one who agreed to allow the firm to use the assets in order to generate outsized interest payments. There are still questions about how the court will view these relationships, and that analysis will necessarily entail whether the crypto is viewed as property of the bankruptcy estate or property of the customers themselves.

Levitin stressed that the way a court views such questions will also likely vary between crypto companies - blanket answers across the industry are unlikely. In terms of disclosures to customers and the market, some companies tiptoed around the subject, making no representations about what may or may not happen in the event of a bankruptcy, Levitin added while noting others were more misleading, such as Voyager, who used language that suggested the holdings were FDIC insured against its own failure rather than the failure of Metropolitan Bank, where the cash holdings were held. (They are not.)

FDIC insurance protects funds held at a bank in the case of a bank’s insolvency, Bob Gayda, a partner at Seward & Kissel, said.

“It seems that Metropolitan has customer’s cash, and that will be returned on a dollar for dollar basis, which is the right result, once done with a fraud review,” Gayda said. “But I think any suggestion by Voyager that FDIC insurance would be implicated may be an example of some of the statements made in the public that do not necessarily meet reality.”

Avi Israeli, partner at Holwell Shuster & Goldberg, echoed the same sentiments, noting the risk involved in the possibility of being an unsecured creditor.

“There’s a real likelihood [customers] will face significant losses here because money in their accounts will be used to pay the debts of secured creditors who take priority,” he observed.

In most cases it seems that much of the misunderstanding also comes from inexperienced investors getting involved because of the puffery and the culture that encapsulated the market.

“Yeah, it’s a weird combination of cultish believers, fools and sharp players. And I think a lot of people don’t realize that they are the marks rather than the shark,” Levitin said.

Israeli said that in some cases, consumers viewed these companies as something akin to banks and therefore assumed their deposits bore the same protections.

“They were happy to earn interest at rates much better than they would otherwise get,” Israeli said. “The major difference is, their funds are not guaranteed in the event of insolvency.”

Timothy Spangler, a partner at Dechert LLC, believes that there was some undue faith in the platforms themselves. “There’s a belief that code is law, that my token is my token,” Spangler said. “But code is not law, code is code. Law is an additional set of rights and remedies and liabilities and obligations that parties can elect to enter into contractually or is applied due to the need to regulate financial services.”

Gayda agreed that for the most part, there was expectation of an entitlement to the return of their crypto assets, and it seems clear, at least in the case of Voyager, that that will not be the case.

“That could give rise to claims against management for misleading statements, lack of disclosure, things like that,” Gayda said.

Katzenstein, however, said it is not really a question of whether people should have known earlier, noting that the revelation came with the rapid decline in token values as an immense surprise across the industry. Until recently, it was a great investment category, he said, and retail investors often placed their tokens with crypto yield providers (lenders) on a short-term basis, which is frustrating for those whose funds are frozen until insolvency proceedings take their course.

“This is not a question of whether they should have known better or should have read the hypothecation agreements more carefully and understood perhaps that they were transferring title when they thought they were just lending their crypto for a month or two,” Katzenstein said.

Price Fluctuations and Continuing Risk

An added level of risk arises from the volatility in pricing throughout the bankruptcy proceedings. While the cryptocurrency could be returned to the customer, there is no way of knowing whether that is legally or practically feasible and where the value will stand at that point. Prices will continue to be at the mercy of the market, even when those whose funds are tied up and inaccessible.

“You’re illiquid until there’s a resolution of who owns the cryptocurrency,” Levitin said.

While it remains unclear in many cases whether the currency is owned by the estate or by the customer, Levitin says that even if it were determined that the customers owned that crypto, they would get that crypto back - but not its cash value prior to proceedings.

“And if the crypto has declined in value since the beginning of the case and has been locked up, because there’s been litigation over who owns the crypto, customers might prevail, but they’re gonna get back something that’s not worth much, and there’s a real risk,” he added.

The issue of how to calculate customer claims has already become a major issue for Voyager. In its offer to buy the majority of Voyager’s assets, FTX asserts that Voyager customers have a fixed U.S. dollar claim based on the value of the digital assets in their wallets as of the petition date. FTX essentially asserted that only its proposal could allow customers to quickly reinvest such funds in crypto and avoid missing out on a pricing upswing. Voyager rejected this premise - and FTX’s offer - maintaining that customers’ claims are not “capped” and noted the debtor has no plans to dollarize claims.

Is Restructuring Even Possible?

Liquidity is a major problem in crypto cases, Levitin said. A substantial part of a debtor’s assets will be various crypto holdings, and it will be difficult to receive DIP financing against such assets, he added.

“The question is, to what extent is this stuff encumbered,” Levitin said.

Additionally, crypto companies are likely to face a plan feasibility problem where feasibility is highly dependent upon cryptocurrency prices, Levitin said. Crypto prices are historically volatile and difficult to predict; where stocks and bonds have cash flows, digital tokens trade on little more than faith.

What’s more likely than a company reorganizing on a prayer that crypto prices rise to the point that mining remains profitable, Levitin said, is the companies simply liquidating in chapter 11.

“I don’t expect to see many cryptocurrency companies that go into bankruptcy be able to reorganize,” Levitin said. “Once they’re in bankruptcy, they’re looking at liquidating.”

Katzenstein echoed the difficulties of making mining profitable, noting the power, space and expertise required to maintain the technology and complex networks these platforms operate on. What is more, the declining value of coins creates an obvious pressure on mining.

Are the Customers the Asset?

In comparison to a bank restructuring, Levitin believes that none of the loyalty that comes from access to physical locations or particular offerings are likely to arise in a crypto case, meaning customers will not be “sticky.” And for that same reason, a white knight looking to salvage what’s left is equally unlikely.

However, Josh Sterling, partner at Jones Day and a former federal regulator, believes that one of the main assets a white knight could inherit is customer account relationships, which are typically one of the most valuable assets of any financial services business.

No Reorg to Be Had?

Another issue in restructuring these companies stems from the fact that there may not be a whole lot to reorganize. The crypto assets themselves, no matter who they belong to, fluctuate in value, and the technology platforms require financial backing to maintain.

But there are cases in which restructuring has no play at all. Some of these platforms are little more than a program, similar to C++ or Python, and in that case, who do you have a claim against?

“For some cases, it might not even be clear if you can sue anyone,” Spangler said. “I think as we move away from the corporate entities, and we start looking at the protocols and the digital assets that are, in essence, lines and lines of code, people are going to be scratching their head saying: ‘Well, you know, there might not be a remedy here,’ because you might not have a counterparty that can be identified as having a legal obligation that’s been breached.”

Dorman concurred, noting that in the case of Terra LUNA, a layer-one blockchain without ownership, meaning that it is not a business and therefore cannot run out of money.

“There’s no cost. There’s no revenue. It’s just a protocol, right?” Dorman said.

In the case of Terra LUNA, the platform and its community came up with and implemented a plan in a matter of weeks which included the launch of a new token distributed via a recovery waterfall to UST holders (worth nearly $20 billion at the peak) and LUNA token holders (worth nearly $40 billion at the peak), essentially handling its own out-of-court restructuring. Dorman goes into far more detail on this case in his own blog.

In Voyager’s case, Gayda observed that the company is essentially searching for a stalking horse bid. “They’re out there looking for prospective purchasers for the platform, or investors, financing for the platform, which might be able to lead to a more traditional restructuring if someone came in and bought it.”

Regardless, it is a tough position to be in, Gayda said, because, again - there are no hard assets, and the business is “such dire straits.”

A Look at the Industry

Widespread Failure or a Few Bad Apples?

Gayda said that the problems crypto is facing can, in some ways, be isolated to a few companies which have intertwined themselves, so to speak, rather than an industry wide systemic issue.

Some of these companies were lending to one another, including a $665 million loan Voyager made to Three Arrows Capital, which interwove their finances and subsequently caused Voyager to file for bankruptcy once Three Arrows defaulted on the loan.

It is possible that the business model at hand is posing more problems than the industry at large, Gayda observed.

“If you look at the business model, a crypto customer loans crypto to Celsius, and Celsius promises a pretty exorbitant interest rate, then turns around and runs that to third parties to generate whatever yield they need to generate to pay the interest rate,” Gayda said. “I think that dynamic may be at issue.”

Katzenstein said that some of these companies had taken on principal risk in order to finance their operations, and that risk was, in some cases, associated with opaque entities and other cryptocurrency lending practices.

“The failures of those counterparties could put those entities at risk,” Katzenstein said. “And there is no question that the amount of lending and investing back and forth is massive.”

Sterling said that the importance of the intermingling is illustrated in Coinbase’s disclosure that it had no financial exposure to the bankrupt crypto firms.

“[Coinbase’s] stock price went up after that announcement by about 14%, so that has seemed to be important information, and maybe that’s a little bit of market validation,” Sterling said.

While that is certainly a factor that led to the fallout, Sterling also noted that the public is currently trading cryptocurrencies far less than in the recent past and that transaction fees, which are an important revenue stream for many platforms, have fallen off dramatically.

“It is entirely possible that there are more fundamental factors underlying recent moves in the digital asset markets that go beyond bad loans made among a handful of companies,” Sterling added. “I think there's a lot of leverage involved in the crypto markets, which has led to a dramatic reduction in price as sources of leverage have withdrawn.”

Where We Go From Here: Regulation and Enforcement

The future of the market may not be hanging in the balance of the handful of ongoing bankruptcy proceedings, but the bankruptcies are likely to have an effect on how consumers and regulators alike view the industry. What does seem certain, at least, is that there will be regulatory changes, new guidelines and enforcement actions coming down the pike.

That being said, the nature of the industry, the nascent features of proposed regulations and the one-off facets of decisions being made in courtrooms has everyone from judges to disillusioned investors swimming in unprecedented waters.

“There are no fundamentals to any of this, right? It’s not like there’s some consumable good at the end, like speculating on wheat or orange juice futures or something. The only speculation in crypto is on future demand and there’s no basis for future demand other than expectations of future price rises,” Levitin said.

A lot of the loudness and the culture that surrounds crypto investing stems from the need to hype it in order to feed its growth because there is little other basis for it. And, eventually, the market will be tapped - all willing consumers will have bought in, the ceiling will have been reached and there will be no more rising.

“And once we hit that maximum investment, you won’t have that future expectation price rises. It starts collapsing. And then the spiral starts going the other way,” Levitin said.

Levitin said he expects a smaller market to rise from the ashes, less-levered companies with sufficient cash surviving and consumers pushing ahead, albeit with less tenacity and possibly more skepticism.

Up until now, the industry remained largely unregulated, with patchwork regulations being brought by various agencies in a piecemeal approach over the past few years. Levitin noted that one reason for this lack of action could be that each of the various financial regulatory bodies - the Securities and Exchange Commission, the Consumer Financial Protection Bureau and others - is subject to political influence, and there may be a fear that to regulate crypto would be to legitimize it. Now those agencies are realizing they may be outflanked following a bipartisan effort to regulate the industry comprehensively.

Levitin described in his paper a number of ways that the Consumer Financial Protection Bureau could use its authority to regulate the industry. Among these, he writes that it would be “squarely” within the CFPB’s “regulatory ambit” to require the providers of cryptocurrency wallets “to hold custodial funds in a bankruptcy remote arrangement (unless the consumer affirmatively opts-out), analogous to the SEC’s Customer Protection Rule” and to “have policies and procedures to protect customers rule, against liquidity disruptions in the event of a bankruptcy, effectively a sort of partial resolution plan or ‘living will.’”

For Spangler, the question really is: Why was more not done sooner by market participants to understand their legal situation and work with lawyers to improve it? For those who have watched the crypto market over the last decade, they have seen the intense volatility, the accelerated cycles and the pain of buying in at a peak. That being said, many questions remained unasked (and therefore unanswered) with little effort being made by customers to protect themselves from risk.

“Why wasn't more done earlier on to get the legal and contractual protection, to jump through the hoops the way other asset classes do?” Spangler said. “No matter how esoteric the assets are, there is a process for evaluating credit risk and protecting creditors rights. I think those that are in a distressed position now really need to ask themselves why wasn't more done earlier on to understand potential legal exposure?”

Regulations will often be difficult to prescribe, however, because crypto isn’t really any one thing. The blockchain could be used in a hundred different ways, and so to institute blanket regulation on a technology based one use case makes little sense, Spangler said.

“I think the better approach is the one embedded in the Biden Executive Order. I think it was really insightful to not pretend that there’s one answer here, that we need some sort of a lead regulator for crypto. We didn’t need a lead regulator for the World Wide Web,” Spangler said.

The executive order creates a national policy for digital assets intended to “support technological advancements and promote responsible development.” It also outlines a set of required reports coordinated between agencies and potentially creates a central bank digital currency, or CBDC.

Spangler said he anticipates incremental improvements across specific use cases. Attorneys in the government and private practice will be examining how existing laws - bankruptcy, financial regulatory, civil and criminal - map onto crypto.

Dorman has little misgivings on the fate of crypto. He stands firm that the recent fallout will be a blip on the market’s radar and that the technology will continue to grow and to work.

“Bitcoin is certainly a success story, going from nothing to a trillion dollar asset in 10 years with hundreds of millions of people who know about it,” Dorman said. “And Decentralised Finance (DeFi) is another success story - if you aggregated all of the money that’s deposited into these DeFi applications, it would be a top 25 US bank by assets.”

In terms of regulation, Dorman also believes that some existing laws will fit to govern certain entities. For instance, he says stable coins could be regulated with the money market, while Voyager and Celsius could be regulated using a bank framework. Other innovative areas get a little hairy, such as tokens with dual properties.

“I think it’s inevitable that this will be regulated, but it’s gonna take decades to get the whole space regulated,” Dorman said.

On Thursday, July 21, the SEC charged a former Coinbase product manager and two others with insider trading. The SEC’s complaint alleges that while employed at Coinbase, Ishan Wahi helped to coordinate the platform’s public listing announcements that included what crypto assets or tokens would be made available for trading, which Coinbase treated as confidential.

Sterling, who was formerly the director of CFTC’s Market Participants Division, said that this is likely a move by the SEC to try to establish that digital assets should be treated as securities, using its enforcement program to achieve a regulatory outcome, so-called regulation by enforcement. Essentially, if a judge rules that the cryptocurrencies involved are securities in this case, that decision will become a precedent that the SEC can use to bring other cases or to write rules that regulate digital asset companies as securities exchanges or broker-dealers. This could come before Congress acts by passing legislation settling the issues.

“If the SEC prevails, we may ultimately find ourselves with rules that are less fulsome and thoughtful than they should be, because they will come off the back of an enforcement action, rather than by Congress first having written a law that balances competing priorities and decides major issues before agencies like the SEC and CFTC create regulations. Hopefully we’ll get some legislation at some point,” Sterling said.

Sterling said he believes that major cryptocurrencies fall more along the lines of a commodity and that the CFTC would “naturally be a better regulator for digital assets, given its more evenhanded and apolitical approach to developing markets and asset classes.”

“It has a more flexible approach and has a history of regulating things that operate like commodities or goods in a market, and I think that tokens are generally more like goods than they are like securities,” Sterling said.

Sterling concluded that an important question people aren’t asking is: “What elements of the digital assets ecosystem need to be regulated as part of the financial system?”

“It is not obvious that the whole ecosystem needs to fall within the guise of prudential regulation, or even financial market regulation, potentially. All this is best for Congress to decide, as
representatives, before the regulators go off on their own,” Sterling added.

--Ellen Schneider
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