The market crash in crypto-assets has led to a slump in digital currency prices with billions of dollars wiped off the markets.
We are now in a period that has been dubbed the “Crypto Winter”. A spate of big insolvencies have been caused by a domino effect of distress in one crypto business causing distress in other crypto asset businesses.
This began in May 2022 when Terraform Labs saw the collapse of its “algorithmic stablecoin” Terra and its cryptocurrency Luna. This was a heavy contributor to the downfall of Three Arrows Capital (3AC), the Singaporean crypto hedge fund which was deeply invested in both Terra and Luna as well as a number of other troubled crypto-assets. 3AC was placed into liquidation by the BVI court on 27 June 2022. This contributed to Voyager Digital, a crypto lending firm, filing for Chapter 11 bankruptcy in the US on 5 July 2022 after revealing it had an outstanding loan of $650m to 3AC. On 13 July 2022, Celsius Network, a bank for cryptocurrency, announced it too had filed for Chapter 11 bankruptcy after having frozen its customer accounts in June citing “extreme market conditions”. Celsius is ~$1.2bn in the red with $5.5bn of liabilities, most of which represent customer holdings according to their bankruptcy filings.
This contagion we are seeing in the digital assets market shows no sign of slowing down in the foreseeable future. Where does this leave stakeholders that have invested in crypto businesses? Much will depend on how they hold their investment as this will underpin the level of recovery that might be made. Now is the time to review your crypto investments to see what you can do to try and insulate yourself as much as possible from losses that may be caused due to insolvency.
Understanding your creditor status in insolvency
Investors will generally hold their investment in one of three ways:
- via a custodian in a hot wallet
- in a cold wallet
- through investing in a fund like 3AC which invests in crypto-assets.
Holding cryptocurrency with a custodian is the most common method due to the ease with which you can invest. However, using a custodian may raise ownership issues which could affect your ability to recover your assets. If the custodian becomes insolvent you may become an unsecured creditor, and the assets you thought were yours will be treated as the assets of the custodian and realised for the benefit of all creditors. In those circumstances you may only recover a small percentage of your investment or even nothing at all. That certainly may be the case for the customers of Celsius and Voyager Digital, whose accounts were frozen just prior to their collapse.
If a custodian becomes subject to liquidation or another insolvency process, how the custodian holds the assets for the investor will be of paramount importance when it comes to making a recovery. If an investor can successfully argue that the crypto-assets are their assets and should not be treated as assets of the insolvent estate, they will be ringfenced for them and not available for all creditors. It will come down to the question of ownership or lack of ownership which is dependent upon whether or not the investor can establish that the custodian is essentially acting as a trustee and holding the assets for the investor. The contractual relationship between the investor and the custodian and the facts surrounding how the crypto-assets are actually held and documented are key.
Ruscoe v Cryptopia
The New Zealand Ruscoe v Cryptopia Limited (in liquidation)  NZHC 728 case, where Cryptopia found itself in liquidation due to a large-scale hack resulting in losses of around NZ$30m, highlights what a court will look at to determine if crypto-assets were held on trust for an investor. In Cryptopia, the court concluded that all of its cryptocurrency holdings were held on trust for account holders. This was because of:
- the express trust provisions in Cryptopia’s terms and conditions;
- the evidence showing Cryptopia kept records and took steps that were consistent with it being a custodian and trustee of the assets;
- Cryptopia’s financial statements and tax returns which showed it wasn’t asserting any rights of ownership over the assets; and
- the agency clause that was in the contractual terms, customer service manuals and a legal opinion that had been obtained on this issue.
Both the contractual relationship between Cryptopia and its clients and the factual evidence were consistent with Cryptopia holding cryptocurrency on trust for its account holders.
Wang v Darby
Contrast this decision with the High Court decision in Wang v Darby  EWHC 3054 (Comm) which involved Mr Wang and Mr Darby entering into contracts under which they agreed to exchange specific quantities of cryptocurrency on terms such that there would be reciprocal restoration of the same amounts of each currency after two years. Mr Wang alleged that the contracts involved a sale and buyback of 400,000 Tezos and that the Tezos and their traceable proceeds were held on trust for him by Mr Darby.
The court found that no trust arose – whether express, resulting or constructive – because the contractual relationship between the parties precluded any trust from arising. This was due to the economic reciprocity of the transactions being inconsistent with the parties having any objective intention to create a trust. In order for Mr Wang to be entitled to the return of the 400,000 Tezos, assuming they could be identified, he had to return corresponding value in (or equivalent to) Bitcoin to Mr Darby. The contractual relationship and facts in this case are in stark contrast to those in Cryptopia and so the outcome is unsurprising.
Mitigating your risk
These decisions highlight that the courts will look at whether transactions involving cryptocurrency create a trust in the same way as transactions involving any other type of property, which is important. The key for those investing in crypto-assets is to ensure that if they use custodial services to hold those assets, they check that the terms upon which they are investing via the custodian confirm that the custodian will act as agent and hold the assets on their behalf. It is also prudent to check that the custodian has in place appropriate measures to ensure that an investor’s assets can be identified as belonging to them.
At the time of writing, cryptocurrencies aren’t regulated in the UK, so they don’t offer investors the same type of protection as money in a bank account or shares held via a brokerage firm. If an exchange becomes insolvent, unlike cash deposited in a bank account with a UK authorised bank, which are to be insured up to a value of £85,000 per person per bank, any cryptocurrency held with that exchange will not be insured. In the circumstances, understanding ownership issues when it comes to investing in crypto-assets is important to mitigate the risk to your investment in the event of insolvency, which will be increasingly prevalent until we emerge from the current Crypto Winter into Spring.