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A crypto bankruptcy could be investors’ nightmare

The recent impotence of the cryptocurrency market teaches investors a painful lesson about the risks of trading digital tokens through intermediaries.

A bankruptcy restructuring would be breaking new ground for crypto investors.

“What can be predicted with certainty is that there will be litigation and delays,” said Adam Levitin, a Georgetown University law professor who studies bankruptcy.

Crypto exchanges and lending services offer individual investors a way into the markets, but the cryptocurrency that customers place on these platforms may not be theirs in the eyes of a bankruptcy court, according to regulators and legal experts.

When a cryptocurrency company goes bust, its users’ digital assets are likely to go into the bankruptcy estate, which lawyers, financial advisors, lenders, and other creditors split up. Customer assets could be returned at a loss instead of simply being returned to users. Even if customers of a troubled cryptocurrency company eventually gain access to their tokens, they could still suffer large losses if the market turns against them during bankruptcy.

Many people were motivated to invest in Celsius crypto assets to earn interest rates of up to 18%. The lender took customer deposits and put them into decentralized financial investments to earn a return, or loaned the funds to other users for a fee.

Celsius looks like a bank in many ways. But the company lacks the protections banks have, such as federally-backed deposit insurance. Celsius and other cryptocurrency intermediaries are also not registered as broker-dealers, which provide critical protection for account holders in the event of bankruptcy by keeping their funds segregated from broker-dealers’ own funds. In the US, most crypto intermediaries instead hold basic money transfer licenses issued by state governments and intended for companies like Western Union.

Here’s how Celsius’ crypto lending process works:

Celsius sets customer deposits into decentralized financial investments and lends funds to other users (including exchanges and market makers).

Customers lend money to Celsius in exchange for yield. (This is essentially an unsecured loan).

Celsius deserves a return of borrowers and investments.

Celsius sets customer deposits into decentralized financial investments and lends funds to other users (including exchanges and market makers).

Customers lend money to Celsius in exchange for yield. (This is essentially an unsecured loan).

Celsius deserves a return of borrowers and investments.

In a recent paper, Mr. Levitin argued that the easiest way to protect investors is for the Consumer Financial Protection Bureau, a federal regulator, to require cryptocurrency exchanges to hold customer funds in remote bankruptcy arrangements to segregate funds. He said the CFPB has clear authority from Congress to take such steps, but the agency has yet to do so.

A CFPB spokeswoman declined to comment.

Crypto companies like trading platform Coinbase Global inc

COIN 0.33%

have been trying to reassure investors for the past few weeks that their crypto assets are safe.

“We have strong legal and operational safeguards in place to ensure our customers’ assets are protected in all instances,” Paul Grewal, Coinbase’s chief legal officer, said in an emailed statement Thursday. “This includes accounting for these assets completely separately from any corporate funds.”

Coinbase shares plummeted after the company announced in May that customers could be treated as general unsecured creditors in a hypothetical bankruptcy.

Celsius also tried to reassure customers shortly before freezing withdrawals. A spokeswoman for the firm told The Wall Street Journal in an email on Friday that it has had no trouble fulfilling withdrawal requests and that it has enough ether — a popular cryptocurrency — to meet its commitments.

Celsius CEO Alex Mashinsky took to Twitter to slam skeptics who on Saturday suggested the company was on the ropes and accused them of spreading misinformation. The company froze accounts on Sunday evening. As of Wednesday afternoon, the assets were still frozen and Mr Mashinsky tweeted that the firm was “working non-stop” on the issue.

WSJ’s Dion Rabouin explains why Wall Street is now heavily into crypto and what that means for the new asset class and its future. Photocomposite: Elizabeth Smelov

In a bankruptcy situation, much will depend on the depositors they agreed to escrow their digital assets to. The terms of service for Celsius stipulate that the legal status of users’ crypto holdings will be unclear should the company go bankrupt.

Some lawyers say the type of contract between the investor and the company could make a difference and offer some protection of property rights in bankruptcy. Treatment of client assets may depend on the firm holding them in a manner consistent with client ownership under relevant commercial laws, said Jonathan Cho, bankruptcy and regulatory attorney at Allen & Overy.

For example, many firms have adopted a holding company model, available under most states’ commercial laws, that helps define ownership rights, Mr. Cho said. Celsius also has a lending arm that offers cash loans backed by people’s cryptocurrency assets.

A bankruptcy judge may also have to decide whether Celsius’ depositors are considered unsecured creditors at all, or just lower-ranked investors, said Jim Van Horn, bankruptcy attorney at Barnes & Thornburg LLP.

State laws regarding ownership of assets held in custody accounts could be helpful to depositors. But they may not even come into play in a bankruptcy case if a judge finds users are merely investors, Mr Van Horn said.

write to Paul Kiernan at [email protected], Alexander Gladstone at [email protected], and Soma Biswas at [email protected]

Corrections & Enhancements
Lending service Celsius Network LLC froze all customer withdrawals this week. In a previous version of this article, the company name was incorrectly stated as Celsius Networks LLC. (Corrected June 17)

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