Bankruptcy of cryptocurrency exchanges: Risks, challenges and regulatory perspectives

Despite the growing number of companies owning cryptocurrencies, there is little clarity on how to handle these assets in bankruptcy scenarios. The lack of clear guidance from bankruptcy courts regarding the classification of cryptocurrencies under insolvency law creates uncertainty for creditors. Unlike traditional currencies, cryptocurrencies are in a regulatory gray area in bankruptcy proceedings.

The bankruptcy process of cryptocurrency exchanges

The bankruptcy process of a cryptocurrency exchange begins with the filing of an insolvency petition, after which the court begins the process of liquidating the assets of the exchange to satisfy creditors. The important question is who owns the funds - the exchange or the customers. The court then sets the order of distribution of assets, considering the priority of creditors and the possible value of cryptocurrencies. This can lead to significant losses for clients if their funds are recognized as corporate assets. Importantly, the valuation is affected by the high volatility of cryptocurrencies.

When a cryptocurrency exchange becomes insolvent, customer claims arise in two main areas: trading-related and asset custody-related. Trading-related claims arise when an exchange has been unable to execute a trade due to its bankruptcy. Often these situations are spelled out in contracts, and the exchange can avoid liability. Custodial claims relate to customers' rights to cryptocurrencies in trust wallets. If these assets are deemed to be the property of customers, they get priority for return. Otherwise, customers can only rely on the total liquidation amount, which increases the risk of loss.

Key issue: ownership of crypto assets

Clarifying the legal status of cryptocurrencies is critical to the distribution of assets in bankruptcy. For example, in Ruscoe v Cryptopia Ltd, New Zealand's highest court recognized cryptocurrencies as property, giving individuals ownership rights. However, different jurisdictions classify crypto-assets as either a property right (title) or a claim. 

The issue of ownership of digital assets in cryptocurrency exchange bankruptcy is key to determining the rights of customers and creditors. Assets held by an exchange may be recognized as part of a company's corporate property. This means they will be used to repay the exchange's debts to creditors, including those who are not customers. For example, in the Celsius Network LLC case, the court ruled that the assets held by the exchange belong to the company itself, not the customers. This decision leaves users in a less favorable position as their funds are shared with other creditors, which can result in significant losses. This precedent underscores the importance of clear regulation of digital asset ownership and fair distribution of assets to all parties in bankruptcy.

Cryptocurrency volatility in assessing damages and the Mt. Gox bankruptcy precedent

In 2014, Mt. Gox, one of the largest bitcoin exchanges, filed to bankruptcy after a massive cyberattack that resulted in the theft of 650,000 bitcoins. At the time of the bankruptcy filing, the company had 202,000 bitcoins remaining. During the process, their value grew significantly, reaching $1.5 billion by 2018. The receiver decided to value the assets at the value at the time of the bankruptcy filing, which allowed all creditor debts to be fully satisfied and kept a surplus of $1 billion. This case highlighted the importance of choosing a fixed date for asset valuation to avoid confusion and strategic delays from creditors. Mt. Gox also demonstrated the benefits of taking a strategic approach to managing cryptocurrency assets during the bankruptcy process, which can be beneficial for both debtors and creditors.

European regulation: MiCA and the new approach

MiCA Regulation (EU) 2023/1114, published on June 9, 2023, creates a single regulatory framework for cryptocurrency markets in the EU. Its main objectives are to protect investors, ensure financial stability and promote innovation. The regulation also addresses issues that arose during the FTX crash by imposing stricter governance, transparency and capital requirements on cryptocurrency companies. It requires most crypto asset issuers, traders and exchanges to be present in the EU for operations, which aims to improve oversight and compliance in the cryptocurrency market.

The crypto industry is a very young financial industry, and only with time and after precedents will a legal framework be developed to regulate assets at government levels. However, the lack of regulation is seen by many crypto-enthusiasts as more of a plus due to distrust of government regulations, but as we see from history, it carries significant risks. Still, looking forward, we see the prospect of digital currencies developing as full-fledged assets.