Crypto bankruptcy markets are booming after FTX’s collapse

In 2019, when he was 20 years old, Aleksandar – who asked that his name be changed so he could discuss his private financial affairs – took out a loan of $5,000 to invest in cryptocurrencies. It was a risk, but he had seen the market fall and felt he could make a bargain. As it happened, he ended up timing the dip almost perfectly. Two years later, after crypto had gone on another hot streak, Aleksandar was sitting on more than $105,000. In North Macedonia, he says, it’s almost like winning the lottery.

But that was where the luck ran out. Aleksandar traded on FTX. When the crypto exchange, whose founder faces 13 charges, went bankrupt in November, Aleksandar’s savings were locked away. With little money, he had to sell his car and take loans from family members to get by. He found that he could not sleep without drinking. But the worst part, he says, was how “stupid” he felt for being made a sucker. “I was in a very dark place. The first few months were literal hell.”

Aleksandar is one of hundreds of thousands of people around the world who are unable to access their money after the turmoil in the crypto industry took down some of its leading players. Along with FTX, crypto lenders Celsius, Voyager Digital, BlockFi and Genesis Global Capital, as well as hedge fund Three Arrows Capital (3AC), collapsed, leaving investors – from small traders to financial institutions – at the mercy of bankruptcy proceedings.

These collapses, and the dire situations that investors have found themselves in, have helped fuel the growth of digital marketplaces for trading bankruptcy claims, giving speculators willing to wait out the lawsuits a chance for big returns and cut-price exposure to crypto. Some, like Open Exchange, which is run by the former founders of bankrupt hedge fund 3AC, are even trying to tokenize these claims, turning crypto failures into new tokens that holders can either sell off or pledge as collateral.

Some claimants accuse the marketplaces and buyers of exploiting distressed sellers. But with their money locked up, potentially for years, others must make the hard decision to sell their claims now for a fraction of their paper value.

Aleksandar chose to sell directly to investment fund Cherokee Acquisition, which also operates Claims Market, one of the largest public bankruptcy claims marketplaces. He received less than 20 cents on the dollar for his FTX claim, he explains, but at least it allowed him to “get it over with and move on.”

The market for bankruptcy claims is not new; it has been going on since at least the 1980s. When someone buys a bankruptcy claim, they’re buying an IOU—a right to a portion of the money returned to creditors at the end of a bankruptcy case. The length of bankruptcy proceedings varies drastically, depending on the extent of the mess, but some (like with crypto exchange Mt. Gox) can take as long as a decade to close.

The motivations on each side of the damage sale are different but complementary. The seller either needs cash immediately to cover bills, wants to write off their losses for tax purposes, or believes they can earn a greater return by investing the money elsewhere. The buyer, meanwhile, is betting that the value ultimately returned to the creditors will exceed the amount they paid for the claims.

Bad sales have usually occurred behind closed doors, taking place between financial institutions. But in recent years, public marketplaces for bankruptcy claims, such as Xclaim and Claims Market, have emerged, bringing some transparency to what was an opaque market and allowing almost anyone with a claim to list it.

“We empower people to make a choice they wouldn’t otherwise have,” says Matthew Sedigh, founder of Xclaim.

The growth of these marketplaces has been catalyzed to a small extent by bankruptcies in the crypto sector. Between $20 billion and $30 billion is currently locked up in crypto bankruptcies, according to estimates from Open Exchange and Xclaim.

In late 2022, Xclaim pivoted to focus exclusively on crypto bankruptcies. Since then, the marketplace, which by January had recorded more than $200 million in total claims, has attracted more users and pulled in more revenue than in the previous two years combined, Sedigh says.

Buying claims in crypto bankruptcies is seen as a way to invest in crypto at a discount. Although each creditor’s claim is valued in dollars on the date of the bankruptcy filing, not denominated in crypto, the balance sheets of these firms are largely comprised of crypto assets. Therefore, if crypto were to increase in price, claim holders would receive a greater return. As for Mt. Gox, the judge even ruled that claim holders should share fully in the rise in crypto prices, meaning they are set to make a return of over 100 percent on their claims when the redistribution begins on October 31.

Purchase demands are not for the faint of heart, however, says Thomas Braziel, founder of 507 Capital, an investment firm specializing in distressed debt, which has a large position in Mt. Gox bankruptcy and others. Not only do creditors sometimes misrepresent the value of their claims, intentionally or otherwise — some people “finish around the edges,” Braziel says — but some claims turn out to be outright fraudulent.

In other cases, a buyer may discover that a claim is subject to repayment because the original holder made undisclosed withdrawals shortly before the bankruptcy, eating away at any profits they could hope to make. In bankruptcies, funds withdrawn during the 90 days before a filing are later returned to the estate, to avoid a scenario where a minority of creditors are rewarded for being quicker on the trigger.

For these reasons, says Muhammed Yesilhark, investment manager at asset management company NOIA Capital, thorough due diligence is essential. “If we can’t find three or four people in the industry to vouch for the seller, we won’t get involved. We don’t touch anything that is remotely smelly, he says. “It’s not like buying toilet paper on Amazon.”

As competition for claims in the FTX bankruptcy began to increase, NOIA settled on a strategy that would help the firm minimize risk and outbid other buyers: It would pay below the going rate for claims, but promise the original claim holders 20 percent of upside on payout.

Some victims of crypto collapses have reacted badly to offers to buy their bankruptcy claims. Michael, a Celsius creditor from New York who asked to be identified by first name only to discuss private financial matters, says he hoped to sell the $450,000 claim “ASAP” to reinvest in the crypto market. But he rejected 20 cents on the dollar offered to him by the Cherokee, whom he describes as “vulture thieves.”

Bradley Max, CEO of Cherokee, is baffled by the “demonization” of buyers and marketplace operators. He says companies like his own provide important liquidity, and give those who want to sell the opportunity to do so. And anyway, buyers are far from guaranteed to make money.

“The market is efficient; The competition to buy these claims should result in a fair market price, based on the relevant facts and circumstances in each case, says Max. “Like any investment, sometimes investors get it right, sometimes they don’t. It can happen that claims buyers end up paying much more than is ever recovered.”

But Michael’s attitude is not unusual in the Telegram channels where creditors gather to discuss the progress of bankruptcies. When Aleksandar asked about selling his FTX claim, he received angry messages, he says, telling him not to “come in here with that doomsday attitude.” In a separate meeting, in September, a Cherokee representative trying to drum up business in a Celsius group chat was told by an administrator that his messages were “tacky” and made him sound like a “used car salesman.”

New entrants to the bankruptcy claims market have attracted a similar level of scorn, such as Open Exchange, the firm developing a way to turn bankruptcy claims into easily tradable tokens. The fact that the project is led by Davies and Zhu, the 3AC founders, and executives from crypto exchange CoinFLEX, which filed for restructuring in August, is an irony not lost on anyone.

The plan first came to light on January 16, when CoinDesk obtained a pitch deck. Not only was the new marketplace tentatively branded as “GTX” – simply “because the G comes after the F” – but it would also allow customers to trade claims in 3AC. In a chirpingNic Carter, partner at venture capital firm Castle Island Ventures, questioned whether it was ethical for Davies and Zhu to “skim fees” on claims in their own company’s bankruptcy.

However, Leslie Lamb, CEO of Open Exchange, says this is an unfair characterization. “Our first priority is to give people the opportunity to be able to trade their claim,” she says. “We want to find as many avenues to help creditors recover value, across as many bankruptcy estates as possible.”

Whether bankruptcy claims can be safely tokenized is another question. Because each claim is unique, it is difficult to aggregate them and turn them into a set of homogeneous tokens. But Lamb insists the system is viable and will help creditors “benefit from more liquidity and fairer pricing”, regardless of the size of their claims. Open Exchange is preparing to launch its claims trading service in the spring and says thousands of claimants have already signed up.

While bankruptcy marketplaces present themselves as a place for small investors to cash out and move on, the reality is that smaller creditors tend to receive a raw deal on pricing — or at least, large claims demand a premium. Because of the cost of investigating a claim and managing a sale, the majority of buyers are looking for a small number of large claims, not a large number of small ones.

While a number of institutional investors, such as the hedge fund Galois Capital, have been forced by circumstances to sell, others are as reluctant to sell as the creditors of Telegram. Kyle Samani, managing partner of Multicoin Capital, an investment firm with tens of millions of dollars tied up in FTX, says the company has never even considered selling its claim. “The type of people who buy claims are obviously aiming for very high returns,” says Samani. “So why should we sell to them?”

There is a degree that ordinary people are never going to come out of bankruptcy in good shape, whether they choose to sell their claim or not. The hard truth, Braziel says, is that the game is rigged against anyone who lacks the resources or expertise to fight their corner.

“In bankruptcies, the squeaky wheel gets greased,” he says. “The guys with millions of dollars at stake can hire expensive bankruptcy lawyers to argue for them. The ones who really get hurt are the little ones [creditors]that just got damned gone.”

The decision to sell is not an easy one for people caught up in FTX and other crypto bankruptcies, whose desire to end a painful chapter rubs up against a will to avoid being exploited twice. But at least, Aleksandar suggests, sales allow creditors to take back some degree of freedom of action, even if it comes at a financial cost.

Aleksandar is well aware of the inequities in the bankrupt food chain – and that made his decision to sell one easier. “The big fish,” he says, “shall eat first.”