The Challenges Associated with Trying to Get Your Funds Out of a Collapsed Crypto Exchange Platform

Legal experts around the world believe that crypto traders who are hoping to regain their funds from failed cryptocurrency exchanges anytime soon are likely to end up disappointed.

In August 2022, crypto trading and lending firms Celsius and Voyager Digital both filed for bankruptcy, leaving millions of user’s assets trapped inside their platforms. Both firms froze their clients accounts after an influx of withdrawals related in liquidity issues.

Celsius operated much like a bank, taking customer deposits and lending them out or making risky gambles on so-called decentralised finance products to generate high yields.

Voyager had a very similar model. The company got caught up in the collapse of high-profile crypto hedge fund Three Arrows Capital, which itself went belly up after defaulting on a $660 million loan from Voyager.

Such interconnectedness has left the crypto market vulnerable to contagion, with major firms falling like dominoes as a plunge in token prices has unwound excessive leverage in the system.

It is important to understand that cryptocurrencies aren’t regulated. This means that they don’t offer individuals the same protections they would get with money held in a bank or shares in a brokerage firm.

For example in country such as the USA, the US Securities Investor Protection Corporation insurers traders up to $500,000 in cash and securities if a member broker runs into financial difficulties.

The US Federal Deposit Insurance Corporation, meanwhile, offers bank depositors protection of up to $250,000 if an insured lender fails.

There are similar schemes in place in Europe and many other countries.

However, since there are no laws governing cryptoassets, there’s no guarantee investors would be able to recoup their funds if an exchange were to freeze someone’s account or, worse yet, completely collapse.

“There isn’t such a scheme like that at this point” for crypto, says lawyer Daniel Besikof, a partner at Loeb & Loeb.

“It wouldn’t surprise me if one happens down the line. This will ramp up calls for enhanced regulation,” continued Daniel Besikof.

At the present time it is extremely unclear what happens if a crypto exchange collapses and if there are any ways investors can regain their assets.

In 2014, a Japan based crypto exchange platform called Mt. Gox went offline and eight years later its users are still waiting to get repaid billions of dollars’ worth of the crypto they had earned.
The problem with centralized crypto platforms is they can mix different clients’ funds together to make risky bets, according to Daniel Saval, a lawyer with Kobre & Kim. Such commingling may lead to a ruling that the assets are the property of the exchange, not users.

“Users may be surprised to learn that, in a bankruptcy scenario, the crypto and funds held in their accounts may not be considered their own property. Exchanges will often pool different customers’ crypto and funds together in the same storage wallet or account,” says Daniel Saval.

Daniel Besikof asserts that what happens to customers’ funds in bankruptcy cases will hinge on the company’s user agreement and how it used their assets.

Celsius’ terms of use outline that any funds deposited with the firm “may not be recoverable” in the event of bankruptcy. The firm filed for Chapter 11 protection last week, revealing a $1.2 billion hole in its balance sheet and owing users around $4.7 billion.

Celsius claims to have $167 million in cash on hand. However, it’s still not letting customers withdraw their funds, and hasn’t offered clarity on when it will reopen withdrawals.

Voyager says its customers’ dollars are kept in an FDIC-insured account at Metropolitan Commercial Bank in New York. However, this claim was contested by legal experts and the bank itself. The FDIC only offers protection of funds in the event of a bank’s failure, not a crypto exchange.

Voyager has been saying that it’s currently in the process of working through a “reconciliation and fraud prevention process” with its banking partner, after which users will be able to regain access to their cash.

Voyager also outlined that it had a plan to reimburse users with crypto in their accounts, Voyager shares and the company’s own token, as well as any debt recovered from Three Arrows Capital.
Celsius and Voyager have both hired Kirkland & Ellis, the prestigious law firm, to represent them in court.

“Investors holding crypto assets through Voyager Digital and now Celsius have been placed in a difficult position, with their accounts frozen, their lawsuits stayed and the value and timing of any recoveries unknown. There is a lot of work for them to do in bankruptcy court before these issues will be resolved,” says Daniel Besikof.

Under the American legal system Celsius and Voyager both filed for what’s known as Chapter 11, a form of bankruptcy protection that allows firms to restructure their debts. The aim is to make sure that there’s still a viable business by the end of the process.

Legal experts have said that there is a strong likelihood that Celsius and Voyager’s users will be treated as “unsecured creditors”. This is a categorisation that puts them in the same bucket as a business’ suppliers and contractors.

This means they would likely be at the back of a long queue of creditors lining up for a payout from the court proceedings — behind banks, employees and tax authorities.

Furthermore, in a regulatory filing made in May 2022 by crypto exchange company Coinbase, Coinbase said that its users would be treated as “general unsecured creditors” in the event of bankruptcy.

“In general, most customers in cryptocurrency exchanges are unsecured creditors, so when an exchange collapses, secured creditors are paid back first, along with legal fees,” said Dustin Palmer, managing director at consulting firm Berkeley Research Group.

Customers will be paid last on a pro rata basis. In a typical bankruptcy, this is pennies on the dollar. “Customers will likely have to wait until the full bankruptcy process is complete before receiving remuneration, and bankruptcy usually lasts years, Lehman took years. Some Mt. Gox customers, for example, still haven’t received any remuneration,” continued Dustin Palmer.

Daniel Saval elaborated that customer recoveries in bankruptcy proceedings “may be further diluted by other unsecured creditors such as vendors, lessors and litigation claimants,” says Daniel Saval.

The Challenges Associated with Trying to Get Your Funds Out of a Collapsed Crypto Exchange Platform