Crypto Decline Will Bring Legal Clarity

This past summer, the crypto industry experienced a significant downturn. Triggered by interrelated factors in the traditional economy and the crypto sector, the industry’s distress caused a crash in cryptocurrency prices and several high-profile insolvencies.

Notably, crypto firms Voyager Digital, Celsius Network and Three Arrows Capital have all filed for Chapter 11 or similar proceedings.

This crash has affected many individual cryptocurrency traders. As the insolvencies progress, the courts may clarify open questions of insolvency law related to crypto.

It has focused attention on the need to resolve lingering regulatory uncertainty in the space with more thorough controls. And it could provide clearer rules for the crypto sector.

Steady decline

Starting in late 2021 and continuing into this year, cryptocurrency prices fell from all-time highs to much lower levels. Between November 2021 and June 2022, the price of bitcoin – which is widely regarded as a proxy for the crypto market – fell from an all-time high above $68,000 to just below $20,000 where it is today.

The roots of this crash date back to the earliest days of Covid-19. As central banks and governments enacted relief programs to ease economic turmoil, asset prices soared across several sectors, including cryptocurrency. In 2022, however, these stimulus programs began to taper off.

Their end coincided with Russia’s invasion of Ukraine and a resulting spike in commodity prices as governments imposed sanctions on Russia.

Fears of an impending recession spread throughout the economy, and technology assets of all kinds fell in value. Crypto assets did not escape this broad downturn, and their values ​​fell steadily throughout the beginning of 2022.

This decline accelerated in May when the stablecoin UST lost its link to the US dollar. Stablecoins – a type of crypto asset – seek to maintain a specific value relative to another asset. UST aimed to maintain a value of exactly $1.

But in May, the system that maintained this value failed, users rushed to sell their holdings of UST and its sister cryptocurrency Luna, and both coins became completely worthless.

Due to UST’s consistent price, cryptocurrency traders relied heavily on the stablecoin to buy and sell other crypto assets. As this common medium of exchange lost its value, users sold other assets to recoup their losses, causing the previously steady decline in crypto prices to accelerate into an outright crash.

This downturn affected companies and investors throughout the sector. Companies with significant exposure to UST and Luna were most negatively affected, and their inability to meet financial obligations led to a domino effect on other companies.

When crypto investors heard this news, they pulled investments from crypto exchanges, leading to further price drops and liquidity problems.

As a result of the crash, crypto exchange Voyager Digital, lending platform Celsius Network and crypto fund Three Arrows Capital all started insolvency proceedings. These cases are still pending in US bankruptcy courts and elsewhere.

Need for regulatory and legal clarity

The crypto slump could eventually result in clearer rules for the space as courts in these insolvency proceedings resolve open legal questions and regulators consider tighter controls on cryptocurrency in response to the crash.

The Voyager, Celsius, and Three Arrows bankruptcy proceedings may provide some long-awaited legal clarity regarding cryptocurrency. As these cases progress, the courts may engage with—and resolve—various open legal questions, including:

• Whether crypto accounts become the property of the estate (or the client’s property) when the custodian enters Chapter 11;
• How bankruptcy claims are valued when cryptoassets fluctuate in price during a bankruptcy;
• Whether certain cryptocurrencies qualify as securities, commodities, currencies, another asset class or a combination, which may affect issues such as exceptions to the automatic stay; and
• Where digital cryptoassets are legally “located”

A committee of account holders in the Celsius Chapter 11 cases has petitioned for a declaration that escrow accounts are not property of the bankruptcy estate. As these cases progress, the courts may soon resolve this and other similar legal issues.

The industrial dive has also caught the attention of US regulators and lawmakers. Because stablecoins pose particular financial risks—as evidenced by the impact of the UST and Luna collapses—regulators are focusing specifically on these assets.

On March 9, President Joe Biden signed an executive order encouraging federal action regarding cryptocurrency. Among other measures, the order called for the Treasury Department to develop policy recommendations and an oversight regime to address the growing crypto sector.

Legislators have also set their sights on crypto, and several major bills are being discussed. The proposed Stablecoin Transparency Act, which is pending in the Senate, would require any issuer of stablecoins to register as a money transfer business, an insured depository institution or a new category of business.

Separately, the Responsible Financial Innovation Act, also pending in the Senate, would require issuers of stablecoins to maintain traditional assets equal to the value of their outstanding coins, preventing the kind of collapse that UST and Luna experienced.

And an as-yet-unnamed bill pending in the House of Representatives would reportedly allow banks to issue stablecoins and appoint the Federal Reserve as the overseer of non-bank stablecoin issuers.

For these reasons, the crypto downturn could result in clearer rules for the crypto space as courts resolve open legal issues and regulators introduce new controls.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Ronit J. Berkovich is a partner in Weil, Gotshal & Manges’ restructuring department where she represents debtors, creditors, lenders, investors and acquirers of assets in all aspects of distressed situations.

John Marinelli is a solicitor in Weil’s restructuring department.