Bankruptcy and civil court clashes vindicate industry skeptics like Sen. Elizabeth Warren (D-Mass.) and Securities and Exchange Commission Chairman Gary Gensler, who have long warned that crypto firms are defying basic rules that would protect investors and retail traders.
They also fuel calls to enforce current laws and regulations, which the industry has fiercely resisted.
“There are already many regulatory tools to deal with this,” Warren said in an interview. “We need regulators to use these tools, and Congress needs to make sure those regulators have the resources they need to be an effective beat cop.”
Legal disputes are injecting even more uncertainty into a market that has lost two-thirds of its value since November 2021. For merchants and retail customers – including those who have been lured by risky loan products with promises safe and reliable returns on investment – there is no safety net.
Battles over the corporate remnants of once high-flying digital asset startups can take years to resolve. More litigation is on the horizon as contagion appeared last spring makes its way through the markets.
“In traditional finance, there are ways and mechanisms to liquidate institutions. On the crypto asset side, because they grew so quickly — in a space that had light regulation — you don’t have the same kinds of well-established procedures,” said John Rizzo, a former head of the US Treasury who is now a senior official. Vice President of Public Affairs at Clyde Group.
Some crypto firms that have become underutilized as banks, brokers, custodians, and agents for their clients — a combination of services that doesn’t exist at regulated financial institutions — are making their bankruptcy process even more chaotic.
Bankrupt lending platforms like Celsius Network and Voyager Digital solicited clients with investment products that guaranteed double-digit returns in exchange for crypto deposits. FTX’s marketing campaigns have assured crypto traders that its exchange provides a safe place to buy, sell, and store digital tokens.
But these customers were blocked from their accounts when these platforms encountered problems. They now have to compete in bankruptcy court with major creditors who secured massive loans to these companies.
“The likelihood of these individuals ever being cured is reduced to next to nothing,” said Martin Auerbach, a former federal prosecutor who leads the white-collar practice and investigations at the Withers law firm.
Gensler has already started throwing the hammer down on the industry. This month, the SEC accused crypto exchange Gemini and a widely used brokerage firm known as Genesis Global of securities law violations in connection with a loan product that froze about $1 billion. of client assets after the fall of Bahamas-based FTX.
Genesis had used Gemini’s client assets to make loans to groups like Alameda Research, the personal hedge fund of FTX founder Sam Bankman-Fried, as well as defunct hedge fund Three Arrows Capital, according to the SEC. Genesis, which is owned by crypto giant Digital Currency Group (DCG), filed for bankruptcy a week after the SEC announced its charges, and Gemini, which is run by the Winklevoss twins, is facing a class action lawsuit .
“It’s devastating,” said Hee-Jean Kim, an attorney leading the class action lawsuit against Gemini. “People really felt it was safe.”
Gemini and the Winklevoss twins, who accuses DCG and Genesis of accounting fraud in a public letter, did not respond to requests for comment. DCG beckoned to allegations as publicity stunt. Genesis also did not respond to requests for comment.
Meanwhile, as multi-billion dollar failures multiply across the industry, survivors are shedding a dwindling pool of assets.
“The crypto ecosystem is currently working on solutions through markets and market forces without government bailouts or government assistance,” Mike Katz, vice president and chief legal officer at DCG, told POLITICO before Genesis went bankrupt.
The calamity in the crypto markets was “a terrible outcome for the unsuspecting, but the customers wanted them back,” said William Baldiga, a partner at Brown Rudnick’s bankruptcy group, which advises Bahamian officials on the restructuring of FTX. “If you’re going to promise customers 6%, 12% returns, how is the company going to make money for giving them those returns? Well, too often just playing with the funds the client gave you.
“You go into the hole, some people keep digging,” he said.
Crypto trading platforms and brokers are highly interconnected, so when a company’s investments go south, those losses are felt by its lenders and trading partners.
This problem became acute in mid-2022 after a widely used crypto token lost value and pushed one of its backers, hedge fund Three Arrows Capital, into liquidation.
Others soon followed. Celsius Network and Voyager Digital, two trading platforms on which millions of retail customers held accounts, both filed for bankruptcy in July. Genesis, which had loaned Three Arrows nearly $2.4 billion, faltered in the market downturn until DCG managed to absorb some of the losses.
It was just a dress rehearsal for FTX’s main event. Exposure to Bankman-Fried’s investment empire, which included dozens of exchanges, digital startups and venture capital investments, crippled Genesis and other crypto firms that survived the downturn initial.
As regulators circle around and the value of crypto assets plummets, the bankruptcy of FTX and the restructuring proceedings of Three Arrows, Celsius, Voyager and the assets of crypto lender BlockFi have become hot spots for creditors recoup their losses.
“The domino effect is significant, in part because FTX has positioned itself as such a successful and dominant player in the market,” Auerbach said. When a market stalwart of this size falls, he said, “the ripples and waves are…dramatic.”
Celsius, FTX, Three Arrows and Genesis did not respond to requests for comment.
FTX’s restructuring team claims to have recovered more than $5 billion from Bankman-Fried’s crumbling empire, but it’s far from clear if that will be enough to compensate millions of clients and creditors whose funds were lost when the platform imploded last year.
Meanwhile, a new ruling in Celsius Network’s bankruptcy has determined that customers will be in line for any claims against its assets. Feds have warned against Voyager selling its assets to Binance.US — a deal the company’s restructuring team pursued after FTX’s planned acquisition of the wallet was derailed by its collapse.
Even if Binance.US completes its acquisition of the assets of Voyager, Voyager does not guarantee that its customers see the value of their accounts restored.
“It’s a mole problem,” Rizzo said. “You make a whole party, and then here are less resources for another party.”
Zachary Warmbrodt contributed to this story.