How will bankruptcy courts shape crypto regulation? | Epic

by Arthur · April 5, 2023

[author: Deirdre O’Connor **]

Last year’s cryptocurrency market crash a/k/a the “crypto winter” did not cause tremors in the US economy, but it did cause huge losses to investors. The near collapse of this decentralized currency market resulted in the bankruptcy filings of several cryptocurrency exchanges. Creditors have been waiting with bated breath to see how the courts will decide key issues such as how the dispute between the US courts and the Bahamian authorities will play out; which assets are allocated to which entity; what will recoveries look like for creditors; and would punitive restitution against founders and directors be part of the US bankruptcy? How judges decide these questions will surely provide crucial insolvency guidance for owners, investors and regulators of cryptoassets.

Given recent government actions in this sector, it seems that 2023 will be the year of crypto regulation. As the issuer of the dominant global fiat currency, the United States would be the most likely venue for drafting a global cryptoregulatory framework. Cryptocurrency currently lacks a centralized framework of trust, also known as “intermediaries”, and its “trust” is solely dependent on the blockchain verification methodology for these transactions. The absence of regulation has certainly allowed for the rapid growth of exchanges, but unfortunately for investors, it has also allowed fraud to go undetected. The American system of centralized finance is credited with protecting consumers and investors, ensuring stability in financial institutions, curbing illicit financing, and maintaining economic competitiveness. Not surprisingly, the US bankruptcy courts are the first official court to be confronted with questions 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 frameworks and compliance protocols for this new asset class. Current and future crypto investors will need to monitor these court decisions along with regulatory activity that is likely to occur this year.

Table of Contents

The regulation of money

The US dollar has been the dominant global currency for decades. Money is regulated through the American central bank – The Federal Reserve aka “Fed”. This supervisory body regulates American currency and essentially controls the supply of money. This allows the banks to operate for consumers within a centralized financial system with several layers of monitoring and compliance. Although a structured regulatory approach creates an atmosphere of trust, it is extremely expensive to maintain. Processing funds and verifying balances on this system requires extensive staffing for most critical functions, monitoring tools, investigations and much more.

The United States has continued to refine monetary policy throughout the past century. The Fed was actually created in response to the Panic of 1907 when a cooper mining trust collapsed along with all of its investors’ funds. Regulatory policies historically come soon after major economic disruptions such as the Great Depression, 1987 Stock Market Plunge, September 11^th, the Great Recession and the Covid-19 pandemic. More recent policy examples of these are the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Sarbanes-Oxley mandated several reforms to strengthen corporate accountability, improve financial disclosure and combat corporate and accounting fraud. In 2010, Congress passed the Dodd-Frank Act in response to the crippling financial crisis during the Great Recession of 2008. This law aims to reshape the US regulatory system in areas such as consumer protection, trade restrictions, credit ratings, regulation of financial products, corporate governance and disclosure and transparency.

After the Great Recession, the United States made it a priority to introduce regulatory controls that would “contain contagion” in the event of a future collapse of any aspect of the financial system. This protection is evidenced by the limited effect 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 led to several bankruptcy filings that place bankruptcy judges at the forefront of providing guidance to the crypto industry, its investors and federal regulators.

Takeaways

Crypto crashes 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 time points to the shortcomings of a decentralized financial system. Because of the lack of structural trust, many investors suffered large losses that could have been avoided or at least limited if there had been some federal oversight.

Second, due to 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 a 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 that things are above the line and compliant with future regulations will be necessary to create a fundamental trust in this sector.

Regulatory predictions

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. Legislators are becoming more educated about digital assets, and any legislation on this topic will need bipartisan support. What will likely happen is that the crypto industry will be subject to newly created regulations and well and lawsuits for violating 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 expressing concerns about all crypto assets. After the fall of the FTX exchange, the federal government and Congress turned their focus to this sector. The decisions of the bankruptcy courts will provide guidance on many legal aspects of these assets when the stock exchange is insolvent. The decisions made by these courts could accelerate the regulatory framework required to support a stable cryptocurrency market.

Below are three predictions about what could happen soon:

Any regulations adopted will have some aspects of our existing financial regulations. Decentralized financial systems have proven to be quite unstable when tested, so there must be some protection built into the structure. The case for stronger supervision is more compelling as we have seen these exchanges seek bankruptcy protection, but it is unclear how they will emerge and make distributions to creditors.

The bankruptcy courts will make key decisions about the interaction between different courts that claim jurisdiction, what belongs to the bankruptcy estate and which entity and whether these companies will ultimately liquidate or survive. For example, in the Celsius case, the judge relied on the disclosure of the terms of use to find that the users no longer had ownership rights over the digital assets. This means they will be treated just like any other unsecured creditor.
Estimates for recovery from creditors are not yet known. Bankruptcy courts must determine the order of creditor payments, which will set a precedent for future cases.

In addition, here is a summary of important activity in the crypto regulatory area:

The agriculture committees in both the Senate and the House have brainstormed bills that would give the Commodity Futures Trading Commission (CFTC) crypto-regulatory powers. At a February conference, the CFTC stated that it would be well-suited to regulate cryptocurrency that is not viewed as a security to ensure that these assets are effectively monitored. Some have expressed concern that strict regulations and CFTC oversight will hinder the decentralized finance model.

The White House recently released a statement outlining a roadmap for mitigating crypto risk. This included a call to action for Congress to expand regulatory powers to combat misuse of customer funds. Also to strengthen transparency and disclosure requirements for crypto companies.

The SEC has cracked down on crypto-related enforcement. In February, the SEC filed charges against Kraken for failing to register the offering and sale of its crypto-asset “staking as a service” program. Kraken immediately acted to settle this case by paying $30 million and halting the program.

The SEC also notified crypto firm Paxos that it will initiate an action against them for issuing the Binance-branded BUSD stablecoin, which the agency sees as an unregistered value because it was tied to the US dollar. The SEC points to the company’s lack of appropriate financial disclosures and messaging to investors about the risks associated with stablecoins. Paxos has expressed its intention 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 US banks that there is increased fraud potential, uncontrolled risk and volatility with cryptos that could cause enormous damage if allowed to penetrate the banking system.

Money center banks are pulling back from crypto companies as talk of regulatory disruption threatens their access to traditional banking products. The inability to use bank accounts in the United States will greatly inhibit their ability to transfer fiat currency.