How Will Bankruptcy Courts Shape Crypto Regulation?
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Last year’s cryptocurrency market crash a/k/a “the crypto winter” did not cause trembles in the U.S. economy, but it caused enormous losses to its investors. The near collapse of this decentralized currency market resulted in bankruptcy filings by several cryptocurrency exchanges. Creditors have been waiting with bated breath to see how the courts will decide key questions such as how will the tussle between the US courts and the Bahamian authorities play out; what assets are allocated to which entity; what will recoveries look like for creditors; and would criminal restitution against founders and directors be part of the US bankruptcy? How judges rule on these issues will certainly provide crucial insolvency guidance for the owners, investors, and regulators of crypto assets.
Given recent governmental actions in this sector, it appears that 2023 will be the year of crypto regulation. As the issuer of the dominant global fiat currency, the U.S. would be the most likely venue for devising a global crypto regulatory framework. Cryptocurrency currently lacks a centralized framework of trust aka “intermediaries” and its “trust” relies solely on the verification methodology with the blockchain for those transactions. The absence of regulation has certainly made it possible for the rapid growth of exchanges but unfortunately for investors has also allowed undetected fraud. The U.S. system of a centralized finance is credited with protecting consumers and investors, ensuring financial institution stability, curbing illicit finance, and maintaining economic competitiveness. Not surprisingly, the U.S. bankruptcy courts are the first official tribunal confronted with issues of first impression with respect to debtor and creditor rights. The decisions made by bankruptcy judges in these initial cryptocurrency cases will guide the course of regulatory framework and compliance protocols for this new asset class. Current and future crypto investors need to monitor these court decisions along with regulatory activity that will likely occur this year.
The Regulation of Money
The U.S. dollar has been the dominant global currency for decades. Money is regulated through the U.S. central bank – The Federal Reserve aka the “Fed”. This oversight body regulates U.S. currency and essentially controls the supply of money. This allows banks to operate for consumers within a centralized finance system with multiple layers of monitoring and compliance. While a structured regulatory approach creates an atmosphere of trust, it is extremely expensive to maintain. Processing funds and confirming balances on this system requires extensive staffing for a majority of critical functions, monitoring tools, investigations, and much more.
The U.S. has continued to refine its monetary policies throughout the past century. The Fed was in fact created as a response to the Panic of 1907 when a cooper mining trust collapsed along with all its investors’ funds. Regulatory policy historically arrives soon after major financial disruptions like the Great Depression, the 1987 Stock Market Plunge, September 11th, the Great Recession, and the Covid-19 Pandemic. More recent policy examples of those are the Sarbanes-Oxley Act of 2002 and Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Sarbanes-Oxley mandated several reforms to enhance corporate responsibility, enhance financial disclosures, and combat corporate and accounting fraud. In 2010, Congress passed the Dodd-Frank Act in response to the crippling financial crisis of the Great Recession in 2008. This law aims to reshape the U.S. regulatory system in areas such as consumer protection, trading restrictions, credit ratings, regulation of financial products, corporate governance, and disclosure and transparency.
After the Great Recession, the U.S. made it a priority to institute regulatory controls that would “contain the contagion” in the event of future collapse of any aspect of the financial system. This protection is evidenced by the limited effect that the crypto market crash had on the overall economy. Despite the containment within the crypto sector, the crypto winter hurt hundreds of thousands of investors and caused billions of dollars in losses. This decline in cryptocurrency values has prompted several bankruptcy filings which position bankruptcy judges at the forefront of providing guidance to the crypto industry, its investors, and federal regulators.
The crypto crash can serve as a guide on how to protect investors in this new asset class. What are the lessons to be learned? First, the rapid decline of the crypto market in such a short period of time points to the shortcomings of a decentralized financial system. Because of the lack of structural trust, many investors suffered great losses that could have been avoided or at least limited if there was some federal oversight.
Second, because of the declining value of the crypto market, investors are signaling that they want more transparency and faith in the stability of currency. Preliminary investigations have revealed that this was not an issue concerning any failure of the underlying blockchain technology, but rather the actions of the exchange principals. The crypto winter was a direct result of the absence of checks and balances on this decentralized financial system. Supporting a system of compliance to ensure things are above board and comply with future regulations will be necessary to instill a baseline of trust in this sector.
Regulation often comes on the heels of a crisis. With a new session of Congress just beginning, crypto regulation will definitely be a hot topic on the table. Lawmakers are becoming more educated about digital assets and any law on this topic will need bipartisan support. What is likely to happen is that crypto industry will be subject to newly created regulations and well and lawsuits for violations of exciting securities laws. These rules will most likely come from several federal agencies: The Securities and Exchange Commission (SEC), The Office of the Comptroller of the Currency, The Federal Deposit and Insurance Corporation (FDIC), and the Federal Reserve. In fact, these agencies just issued a joint letter voicing their concerns about all crypto assets. After the fall of the FTX exchange, the federal government and Congress turned its focus on this sector. The decisions from the bankruptcy courts will provide guidance on many legal aspects of these assets when the exchange is insolvent. The decisions made by these courts could expedite the regulatory framework required to support a stable cryptocurrency market.
Below are three predictions on what may happen soon:
Any regulation that is enacted will have some aspects of our existing financial regulations. Decentralized finance systems are proven fairly unstable when tested so there must be some protections built into its structure. The case for stronger oversight is more compelling as we’ve seen these exchanges seek bankruptcy protection but it is unclear how they will emerge and make distributions to creditors.
- Estimates of creditor recoveries are not known at this time. Bankruptcy courts will need to determine the order of creditor payments, which will set precedent for future matters.
Additionally, here is a recap of important activity in the crypto regulatory space:
- The agriculture committees in both the Senate and House have been brainstorming bills that would provide the Commodity Futures Trading Commission (CFTC) crypto regulatory powers. In a February conference, the CFTC stated that it would be well-suited to regulate cryptocurrency that is not viewed as a security to ensure these assets are monitored effectively. Some have expressed concern that strict rules and CFTC oversight would hinder the decentralized finance model.
- The White House recently released a statement outlining a roadmap to mitigate crypto risks. This included a call to action for Congress to expand regulatory powers to combat misuse of customer assets. Also, to strengthen transparency and disclosure requirements for crypto companies.
- The SEC has been cracking down on crypto-related enforcement. In February, the SEC filed charges against Kraken for failure to register the offer and sale of their crypto asset “staking as a service” program. Kraken instantly acted to settle this matter by paying $30 million and stopping the program.
- The SEC also notified the crypto firm Paxos that it will commence an action against them for issuing of the Binance-branded BUSD stablecoin that the agency views as an unregistered security because it was pegged to the U.S. dollar. The SEC points to the company’s lack of appropriate financial disclosures and notice to investors concerning the risk associated with stablecoins. Paxos has expressed intent to litigate the issue of whether BUSD should be considered a security, as it disagrees with the SEC’s characterization. The New York Department of Financial Services has also ordered Paxos to stop issuing BUSD in February 2023.
- On January 3, 2023, the Federal Reserve System, the Federal Deposit and Insurance Corporation, and the Office of the Comptroller of the Currency issued a joint statement on crypto assets to banking organizations. These regulators warned U.S. banks that there is increased fraud potential, uncontrolled risks, and volatility with crypto that could cause immense harm if allowed to seep into the banking system.
- Money-center banks are backing away from crypto companies as talk of regulation crack-down threatens their access to traditional banking products. The inability to use bank accounts in the US will severely hamper their ability to transfer fiat currency.
Crypto is a new frontier that needs some oversight to survive. Once the bankruptcy cases are resolved, there will be guidance on some important issues and how to reorganize or liquidate these digital asset companies. In the meantime, keep track of enforcement trends and how agencies like the SEC, FDIC, OCC and the Federal Reserve System. Also, whether any traction is made by Congress establish new laws – especially after the White House spoke recently on this topic. It appears that 2023 will be the year of crypto regulation.
Deirdre O’Connor is a managing director in Epiq’s corporate restructuring business in New York. With over 25 years of restructuring experience in law, corporate finance, government and technology enabled solutions, Ms. O’Connor drives enterprise-wide initiatives to strengthen and expand Epiq’s corporate client relationships.
The contents of this article are intended to convey general information only and not to provide legal advice or opinions.