In just three years, crypto conglomerate FTX Group went from start-up to a $40 billion global phenomenon to a company in “free-fall” Chapter 11. The debacle has been most brutal for millions of FTX customers, who are living through the Web 3.0-iteration of Depression-era bank failures.

In a new article, I provide a multi-disciplinary analysis of both the ongoing FTX bankruptcy and the crypto sector’s[1] broader crisis – which has claimed a dozen major players, including regulated lender Silvergate Capital Corp.

The article broadly posits that crypto insolvencies have been so problematic due not to the nature of crypto itself, but to the characteristics of many of the entities – termed “Crypto Platforms ” – undergoing bankruptcy, which are in simplest terms, unregulated financial institutions with a high propensity for fraud, making them ill-suited for Chapter 11 reorganization.

Correspondingly, the article posits such entities should follow the general bankruptcy template used for financial institutions and in cases of fraud:[2] appointment of a trustee to effectuate an orderly liquidation and prompt return of customer assets. At the same time, the article argues that much-needed crypto oversight need not start with bespoke legislation, but can largely be accomplished by shifting regulatory focus to Crypto Platforms while enforcing existing standards for governance and operations.

 Crypto’s Evolution and Ecosystem

In many respects, crypto perfectly captured the zeitgeist of the decade between the 2008 financial crisis and Covid-19, tapping into powerful themes around inequality, racial injustice, and distrust of institutions – particularly the government and financial system.[3] From Bitcoin’s relatively modest 2009 beginnings, the sector spawned thousands of highly heterogenous “coins” during a multi-phase boom-bust growth cycle, illustrated below.

As crypto evolved, a support ecosystem of entities developed alongside the sector (detailed below), a distinctive feature of Crypto Platforms, such as FTX and Binance. Crypto Platforms are essentially financial institutions, providing services – including lending, brokerage, clearing, custody, and exchanges – traditionally separated to reduce systemic risks while serving as customers’ crypto on-ramps and the nexus of activity within the oftentimes-speculative ecosystem.  Because of this, Crypto Platforms became highly interconnected, magnifying sector contagion risks – a dynamic with significant parallels to the 2008 financial crisis.

Unlike traditional financial institutions, however, Crypto Platforms have remained broadly unsupervised, with regulators instead concentrating on individual crypto projects – a critical distinction underlying the crypto bankruptcies’ unprecedented issues and representing a robust area for regulatory action.

FTX: Are You In?

FTX Group’s meteoric rise and Icarian fall epitomized crypto’s excesses. In 2019, Crypto wunderkind Sam Bankman-Fried – famed for his Alameda hedge fund – founded crypto exchange “for the masses” FTX, driving frenetic growth through celebrity-driven marketing and aggressive dealmaking, ultimately amassing millions of customers and $15 billion in client assets.

When other crypto companies ran into trouble in mid-2022, FTX led “white knight” rescues, claiming comfort with “incinerat[ing] . . . money” for the greater good.  The reality was far from altruistic; FTX was desperately trying to prop up Bankman-Fried’s empire, particularly his Alameda hedge fund, which was heavily exposed to the most troubled players.

FTX unraveled in little over a week, with the collapse triggered by a story highlighting “unusually close” ties between FTX and Alameda, while observing that both companies’ assets were largely FTT, a dubious “token” that FTX “invented.” Customers fled, with the bank run quickly followed by a free-fall bankruptcy. After John J. Ray III, a bankruptcy veteran who oversaw Enron’s liquidation, took over as CEO he remarked, “Never in my career have I seen such an utter failure of corporate controls and such a complete absence of trustworthy financial information.”  To put it differently, FTX came to resemble Lehman Brothers, if it were run by undergrads.

Key FTX Bankruptcy Issues

According to prosecutors’ allegations, Bankman-Fried directed FTX to use customer funds to bail out Alameda, purchase assets – including luxury real estate for executives and family – and channel millions to dark-money political contributions.

While unique for its size, prominence, and pervasive fraud, core issues at the center of FTX’s bankruptcy – status of customer accounts, asset recovery, and governance – are broadly applicable across Crypto Platforms’ proceedings. Perhaps the most critical question is the treatment of customers’ property – in other words, how do investors get their money back? The key legal issues are whether customer accounts become property of the bankruptcy estate and whether investors through different entities of the sprawling global empire will receive distinct treatment.

One of the critical means of repaying customers will be asset recovery, particularly pre-bankruptcy insider transactions – including $2 billion of loans and over $250 million of luxury real estate purchases – as well as dubious investments, hundreds of which are “under review.” In addition, the FTX bankruptcy estate is seeking to recover hundreds of millions in political contributions made to 196 members of Congress (about one-in-three).

Additional thorny issues turn on governance: specifically, who is charge of FTX, and what is the plan for moving forward? These challenges, the article argues, have few clear answers, underlying why the Chapter 11 process is ill-suited for an organization like FTX.

Crypto Platform Bankruptcies: Challenges and Strategies for Improvement

While the universe of legal complications implicated by Crypto Platform insolvencies is often attributed to the nature of crypto itself, my article posits a simpler root cause: Crypto Platforms are complex, unregulated financial institutions. Unlike most other types of companies, financial institutions are subject to specialized bankruptcy regimes predicated on priority for account holders and depositors, rather than creditors. Crypto Platforms’ haphazard, borderline-lawless pre-petition operations have further exacerbated the already-ill-fitted Chapter 11 processes.

To improve this unacceptable state of affairs, the article makes two sets of proposals.

First, Crypto Platforms – financial institutions with high propensity for fraud – should follow the bankruptcy template used for financial institutions and in cases of fraud: appointment of a trustee to effectuate an orderly liquidation that promptly returns customer assets. This approach offers numerous benefits, including treating customers as account holders, rather than unsecured creditors – a distinction with critical priority differences – while providing much-needed clarity, thus reducing legal costs and returning more money to victims.

Second, while oversight of Crypto Platforms is clearly necessary, it need not require developing crypto-specific legal frameworks. In fact, significant consumer protection gains can be achieved by holding Crypto Platforms to existing governance and operations standards, while shifting regulatory focus from crypto projects and influencers towards Crypto Platforms – the sector’s nexus of risk to consumers and markets – and ensuring that the traditional financial system remains protected.

ENDNOTES

[1] Given the relatively fluid and evolving taxonomy around crypto and digital assets, the Article uses the term ‘crypto’ quite broadly, often in reference to the sector as a whole. Please see Part I of the Article for additional taxonomical context and detail.

[2] Importantly, as detailed in the Article, the underlying policy rationales and operative mechanics of the trustee structures are considerably distinct for each of these two scenarios.

[3] Andrew Ross Sorkin, From Trump to Trade, The Financial Crisis Still Resonates 10 Years Later, N.Y. Times, (Sept. 10, 2018), https://www.nytimes.com/2018/09/10/business/dealbook/financial-crisis-trump.html (describing the 2008 crisis as “a moment that cleaved our country . . . break[ing] a sense of trust.”)

This post comes to us from Professor Lev Breydo at Villanova University’s Charles Widger School of Law. It is based on his recent article, “Crypto Contagion. FTX, A Sector’s Crisis & The Future of Digital Assets,” available here.