When Bitcoin Meets Bankruptcy: Issues for Consumers in Cryptocurrency Bankruptcy Cases

One year ago, the value of cryptocurrencies exploded. Some invested their life savings to purchase crypto, [1] and some made lucrative, life-changing returns doing so. [2] By the summer of 2022, though, crypto had crashed. Many consumers had purchased and held their crypto using phone-based apps hosted by popular — and wildly successful — cryptoexchanges. However, as the value of crypto plummeted, so did the value of those exchanges, driving two exchanges to freeze customer accounts and file for bankruptcy soon after. What happens, then, to customers’ crypto when it is held by a bankrupt exchange? Unfortunately, there is no clear answer.

Crypto got its start in 2008, [3] and it was created — at least initially — to replace fiat currency as a form of digital money. [4] Traditional fiat — like the U.S. dollar — is created, controlled and heavily regulated by central banks and governments. Theoretically, a central bank can print fiat without limit, diluting its value in your pocket. Transferring fiat internationally is expensive and slow, relatively speaking. But crypto is largely unregulated, may be transferred cheaply and almost instantaneously without an intermediary, and — importantly — has a limited supply.

Cryptocurrencies rely on the “blockchain” technology. [5] A “blockchain” is an online public ledger that records transactions made on its network — much like a physical ledger at a bank that records withdrawals, deposits and transfers. But unlike a bank’s ledger, a blockchain network is entirely online and “decentralized.” That means the ledger is not maintained by a single person on a single hard drive or server. Instead, a blockchain network is maintained by many volunteers — all over the planet — that each keep and maintain a copy of the ledger. These volunteers (or “nodes”) simultaneously work to verify transactions made across the network. They do not work for free, of course. Instead, nodes race to verify transactions on the network — in groups called “blocks” — by solving highly complex computer puzzles. The winner is then rewarded with a “token” of the cryptocurrency itself.

Take Bitcoin, for example. When two parties exchange Bitcoin on the Bitcoin network, nodes race to verify the transaction, along with others in a block. Once verified, the node receives one Bitcoin as a reward, the verified block is added to the blockchain, and the block is published to the network. In summary, cryptocurrency is a digital asset, and the blockchain network is the online ledger that tracks who owns what.

Crypto is traded and stored using a “wallet,” which is assigned two alphanumeric “keys”: a public key and a private key. [6] The public key is an address publicly available to which crypto is sent, while the private key is used to send crypto to another’s public key. When a user sends crypto via a private key to another user’s public key, that transaction is what nodes race to verify, confirming that the recipient’s wallet is to be credited and the sender’s wallet is to be debited. A “wallet” may be “hot” or “cold.” Hot wallets are digital and accessed entirely online (similar to an online bank account). A cold wallet, however, may be physical hardware, such as a USB drive, that is used by plugging it into a computer and connecting it to the web.

As the popularity of crypto eventually soared, so did its value. By November 2021, the price of Bitcoin had skyrocketed to $68,000 per coin. [7] Many have now heard of Laslo Hanyecz’s story. In May 2010, Hanyecz bought two pizzas for 10,000 Bitcoin. [8] That Bitcoin was worth around $41 at the time, but that same Bitcoin is worth $202 million today. [9]

As crypto’s value peaked, so did its adoption among mainstream consumers. While crypto was designed as an alternative to fiat, many consumers purchased crypto as an investment, and entrepreneurs stepped up to meet its growing demand. There are now several mainstream platforms (often called exchanges) for customers to purchase and trade crypto from an app on their cellphones.

These apps make trading and storing crypto simple. To do so, the exchanges typically host digital wallets for their customers, known as “custodial wallets.” [10] In this relationship, the exchange maintains the wallet’s keys. [11] When a customer trades crypto over the app, the exchange initiates the transfer using the custodial wallet’s keys, as opposed to the customer. [12] Some exchanges even hold and commingle all their customers’ crypto in an “omnibus account,” tracking their customers’ interests internally instead of on the blockchain network. [13]

However, after peaking in November 2021, crypto’s value crashed in the summer of 2022. Bitcoin’s price, for example, plummeted from $68,000 per Bitcoin to just under $20,000 per Bitcoin. [14] Some estimate that cryptocurrencies generally lost $2 trillion on value. [15] As a result, some of the most popular crypto exchanges faced significant liquidity issues and placed them on the verge of collapse. [16] Notably, Three Arrows Capital — a crypto firm based in Singapore — was forced into involuntary liquidation by a court in the British Virgin Islands. [17] Not long thereafter, two popular exchanges filed chapter 11 petitions in the U.S. — Celsius Network LLC [18] and Voyager Digital Holdings — after having to freeze the ability of customers to trade or withdraw crypto assets deposited on the exchanges. [19]

The obvious question, then, is what happens to customers’ crypto stored on a bankrupt exchange’s platform? Reports indicate that Celsius, for example, owes customers over $4.7 billion, [20] and the docket in Celsius’s bankruptcy case is filled with desperate letters from customers, many complaining that retirement funds and life savings had been invested in crypto that is now frozen on the exchange.

To date, no court has answered that question. While it is subject to debate, there are, however, several potential answers, depending on how an exchange is designed, the terms of the customer agreement and applicable state law.

On one hand, a bankruptcy court could determine that customers’ crypto stored on the exchange is property of the bankruptcy estate, leaving customers with general unsecured claims and the inability to access that crypto after the petition date due to the automatic stay. [21] If so, the bankruptcy court’s rationale may be that the purchase of crypto on the exchange is more akin to a “sale” than a bailment or other like relationship. Under that theory, the court may reason that the exchange — and not its customers — has custody and control over the wallet and, in turn, the crypto. [22] This is particularly true if the exchange has commingled its customers’ crypto in a single, omnibus wallet, making it difficult to trace. [23] It is also possible that, under the terms of the customer agreement, customers have authorized the exchange to use customers’ crypto as collateral for loans, offering customers’ interests or other rewards in exchange. [24] By granting the exchange those rights, customers are certainly more likely to be characterized as general unsecured creditors and no longer owners of the crypto assets they perhaps thought they owned. [25]

On the other hand, a bankruptcy court may find that customers’ crypto is not property of the estate, potentially allowing those customers to access and take possession of their crypto post-petition. [26] To the extent an exchange offers noncustodial wallets — in which the customer maintains access and control over the wallet’s keys — a court may reason that customers taking advantage of that feature own the crypto in the wallet, characterizing the relationship as a bailment. Or the customer agreement may expressly provide that the exchange is holding crypto in trust for the exchange’s customers, protecting their customers’ ownership in the crypto assets. [27]

Again, the answer ultimately depends on the specifics of each case, including the exchange’s structure, the customer agreement and state law. Given the current state of the cryptomarket, however, bankruptcy courts will be answering that question soon enough.