What Happens If a Cryptocurrency Exchange Files for Bankruptcy?

Exchanges play a key role in the cryptocurrency ecosystem, but no one seems to have given any consideration to so far is what happens when a cryptocurrency exchange that provides custodial services for its customers ends up in bankruptcy. We’ve never had such a crypto-exchange bankruptcy in the US—Mt. Gox, for example, filed in Japan—but it’s certainly a possibility.  These exchanges are not banks, so they are eligible for Chapter 11 if they have any US assets or incorporation, and they face substantial risks from hacking and their own proprietary trading in extreme volatile assets.

So what happens to a customer if an exchange files for bankruptcy?  I think it ends very badly for the customers, as explained below the break. I do not think customers understand the legal nature of the custodial relationships, and exchanges have no incentive to make the legal treatment clear to customers. In fact, the exchanges are lulling the consumers with language claiming that the consumer "owns" the coins, when in fact the legal treatment is quite likely to be different in bankruptcy. In bankruptcy, it is likely to be treated as a debtor-creditor relationship, not a custodial (bailment) relationship. That means that customers are taking on real credit risk with the exchanges, which is a particular problem because of the opacity of the exchanges and their lack of regulation.

Custodially Held Crypto Currency Is Likely Property of the Bankruptcy Estate

First, the custodially held cryptocurrency is property of the bankruptcy estate—that's the new legal entity that springs into existence upon the filing of the bankruptcy. The bankruptcy estate accedes to all of the debtor exchange’s property rights, and those include, at the very least, the exchange’s possessory interest in the cryptocurrency.

But wait, you bluster, the custodial agreement clearly says that I am the owner, that it’s my property, that I retain title to it. Yup, but that’s not how the law actually works. Just because they wrote that doesn’t mean it’s true.

For starters, the idea of “ownership” is a little more tricky. It’s not a binary concept in law. Legal thinking generally conceives of ownership as a bundle of sticks, and the sticks can be separated and doled out to different folks. For example, I might “own” an estate called Blackacre, but I can rent the back 40 to you, lease the westfold to your cousin, give you brother fishing rights in the stream, your sister an easement to cross the forest, and the bank a mortgage (that’s a contingent property interest). I still “own” Blackacre, but lots of other folks have property interests in it.  Same story with crypto. Once deposited with the exchange, the customer does not have the possessory interest and, as explained below, the customer might not have any interest at all, because the transaction could well be deemed a sale, not a deposit.

At the very least, the cryptocurrency exchange has a possessory interest in the cryptocoins. If that’s all there is, you might get your coins back, but it won’t be immediate or automatic, and you won't be able to trade in the interim. 

Things get much worse, however, if the exchange has any right to use the cryptocurrency—to rehypothecate it or to use its staking rights—that too is property of the estate.  Not to pick on Coinbase, but under its staking arrangement it gets  a 25% “commission” on any staking rewards and it indemnifies the customer for any slashing losses. The shared gains and internalized losses sure looks like an investment partnership there. 

But even if the exchange can’t use your crypto in any way, things could still be bad. If the exchange can commingle customers’ coins and is not obligated to return a specific cryptocoin (e.g., #25601), but just a cryptocoin—and that’s typically how this works—then the entire cryptocurrency deposit, root and stem, is property of the estate. 

The situation is no different than with your bank account—you have a general deposit—an unsecured claim for a dollar value, rather than a right to specific bills, as you would with a specific deposit in a safe deposit box.  Put in fancier terms, if the obligation isn’t to return the same or altered/improved good, then it’s not a bailment, but a sale, which makes the crypto property of the debtor and the customer a creditor. A recent SDNY case dealt with this issue in the context of a precious metal refining operation. Because of the commingling and lack of right to get back the specific metal given, the court said it was a sale, not a bailment. (The outcome might be different with fungible goods, but cryptocoins aren’t entirely fungible precisely because the ownership history is traceable for each coin. That means certain liabilities attach to particular coins and not others.)

The Automatic Stay Will Prevent Customers from Redeeming Their Crypto

Here’s why it matters whether the crypto is “property of the estate.”  When the exchange files for bankruptcy there is a stay that goes into place automatically of almost all attempts to collect from the property of the estate. If you knowingly transgress the stay, you're facing sanctions.  With a few exceptions, the stay prevents any attempt to collect from the debtor outside of the bankruptcy process. Instead, a creditor, like the exchange’s customer, would have to either wait to the end of the bankruptcy case to possibly get paid or would have to move for the court to lift the automatic stay. It doesn’t matter that the creditor says, “but it’s my cryptocurrency!” That’s not how this works. 

Now, there are a bunch of exceptions to the automatic stay. In particular, there’s a set for securities contracts (contracts to buy/sell a security), swaps (including currency swaps), repos, and forward contracts (contracts to buy/sell commodities in the future). You might think that this all takes us to the unresolved debate about whether any particular cryptocurrency is a security, commodity, currency, or something else. It doesn’t. The reason why is that none of these exceptions matter here. The exceptions are only for a creditor to terminate, accelerate, and liquidate or setoff the margin posted to guaranty performance of its counterparty’s obligations under these transactions. There’s no margin posted to guaranty the performance of any of the exchange’s custodial obligations. In other words, the automatic stay applies to the cryptocurrency exchange’s customers.

The cryptocurrency exchange’s customers can always move to lift the automatic stay, but that requires lawyering up and going to court.  It will involve cost and delay and even then it might not be successful. If the exchange has nothing more than a pure custodial interest and does not commingle its custodial holdings or use them itself, then perhaps the stay could be lifted “for cause.”

Unless the cryptocurrency exchange’s customers have a right to get back the specific cryptocurrency they deposited with the exchange (coin #25601), however, they are not likely to succeed because the court is likely to say that they do not “own” the coins.  They are just creditors of the exchange. 

The Customers Are Likely General Unsecured Creditors of the Exchange

Not only are the customers likely mere creditors, but they are also likely general unsecured creditors, which means they will have to wait at the back of the line for repayment with everyone else.  They will share on a pro rata basis whatever assets are leftover (if any) after the secured creditors and the priority creditors (including the expenses of running the bankruptcy) get paid, and any payment might not be for quite a while. That’s not a happy to place to be.  Recoveries could be pennies on the dollar.

(Perhaps the customers get a 507(a)(7) priority (which doesn’t guaranty any actual repayment outside of a Chapter 11 plan confirmation), but I’m skeptical of that because it’s not a downpayment for a purchase—the deposit is itself the transaction. In any case, that priority would only be for the first for $3,025 of their deposit.)

What’s worse for the cryptocurrency exchange’s customers, is that their claims will be for the dollar value of the coins as of the date of the filing of the bankruptcy, so any future appreciation will go to the debtor and thus be available to first to repay higher priority creditors.

All of which is to say that cryptocurrency exchange customers are taking on real credit risk with the exchange. This is exacerbated by the lack of regulatory oversight of the exchanges.  

That’s not the end of things, however. Once in bankruptcy, the cryptocurrency exchange can clawback certain pre-bankruptcy transfers, like redemptions by its customers as voidable preferences. If the transfers were made to unsecured creditors in the 90 days prior to bankruptcy, they are preferences. The only issue is whether an exception or defense applies. The only obvious exceptions would be the de minimis amount exception or the ordinary course exception, but the ordinary course exception requires that the withdrawal be made in the ordinary course of the customer’s business, not just the exchanges. Does the customer generally withdraw its funds? There’s some risk here. 

There is the possibility that the section 546(e) defenses—settlement payment or financial institution—apply as well. These defenses require determining if the cryptocurrency is a security or commodity or something else, something that might create uncomfortable law for the cryptocurrency world. But I can easily see a court saying that the 546(e) defenses are predicated on the application of extensive non-bankruptcy regulatory regimes (that’s what the 2nd Circuit basically said in Tribune), so they do not apply to cryptocurrencies that are not regulated under those regimes. All of which is to say that there is clawback risk, which in turn raises the question of whether the clawback is of the coin or its value and as of what date. I'm not going to try to figure that out here.

The big point here is the if you are a customer of a cryptocurrency exchange, you risk being a general unsecured creditor of the exchange if it should file for bankruptcy. It doesn’t matter that the exchange’s contract with you says that you “own” the currency. That’s not determinative of what will happen in bankruptcy. If you’re a cryptocurrency exchange customer you’re actually in a worse position than if you dealt with a traditional financial institution for a bank deposit or security, as the exchange is not regulated for safety-and-soundness and there’s no insurance protecting your assets.