Crypto Failures: Contract, Property and Regulatory Law

2022 and 2023 are widely regarded as the years of crypto bankruptcies. The collapses of Three Arrows Capital, Voyager, Celsius, FTX/Alameda, BlockFi, Genesis, Bittrex Inc. and other crypto enterprises raised important questions related to the fragility and economic viability of some of their business models, market integration and interconnectedness, corporate governance failures, inadequate regulatory frameworks and the high risks faced by crypto investors around the world. They also brought to light complex legal issues, the resolution of which necessitates the application of legal doctrines—often from different areas of law and crystallized in times before the emergence of the Internet. This is what makes the study of crypto bankruptcies particularly relevant and illuminating. In two recent articles (available here and here), I explore crypto failures, addressing a complex interplay of contract, property and regulatory law.

When crypto failures meet contract law

The examination of recent judgments (eg Re Gatecoin Ltd (in liquidation) [2023] HKCFI 914, In re Celsius Network LLC, 647 B.R. 631 (Bankr. S.D.N.Y., 2023), In re BlockFi Inc., Case No. 22-19361 (MBK) (Bankr. D.N.J. May 17, 2023) (No. 923)), primarily from common law jurisdictions (where a significant number of crypto insolvencies occur), reveals that the outcome of many cases hinges on contracts between customers and crypto-asset service providers (CASPs) like crypto exchanges and crypto lenders. In one such case dealing with customer entitlements in crypto-assets deposited with Celsius, a US bankruptcy court even observed that the ‘issue of ownership of the assets in the [accounts of Celsius] is a contract law issue.’

Having analysed the terms and conditions of major CASPs (eg Binance, Kraken, Voyager, Celsius, FTX), I conclude that these contracts tend to be long, complex, ambiguous, subject to frequent and material unilateral modifications, and may contain internal inconsistencies. For instance, when determining the relevant debtor entity within the Celsius group (for a corporate structure chart, see Exhibit B in the Declaration of John J. Ray III), the bankruptcy court observed that two conflicting interpretations of the contract were equally possible, and that reliance on extrinsic evidence was therefore necessary to determine the actual counterparty (see my case note). Combined with the fact that many customers do not read or understand standard form contracts—which exacerbates information asymmetries—one may wonder whether such contracts strike a fair balance. Until the court resolves the issue (which usually happens in an insolvency), it might be unclear what rights customers have against a CASP. For example, the Terms of Use of Binance, the largest crypto exchange ranked by volume, do not specify what rights its customers have in crypto-assets transferred to Binance accounts, leaving substantial scope for legal uncertainty.

To facilitate better contract drafting and enhance transparency in contractual relations, I propose interpreting ‘crypto contracts’ against CASPs and support the introduction of a general presumption of custody relationships. The term ‘custody’ is commonly used to describe a legal relationship or service involving the safekeeping of assets by one person (custodian) for or on behalf of another person (customer). The proposed custody presumption would apply when customers transfer their crypto-assets to a crypto platform, and the contract does not clearly rebut this presumption. I further advocate de lege ferenda for the expansion of certain consumer law rules and protections, specifically those related to the modification of digital contracts (eg as outlined in Article 19 of the Digital Content Directive), to encompass all customers of crypto-asset service providers, whether consumers or not.

When crypto failures meet property law

While the US bankruptcy court in the Celsius case proclaimed that the issue of ownership of crypto-assets transferred to a crypto lender was a contract law issue, I demonstrate that this may not hold true for other jurisdictions, especially civil law ones.

In the insolvency proceedings of a crypto exchange Bitgrail, the court in Italy found that the deposited crypto-assets became part of the debtor’s insolvency estate. This was mainly due to the fungible nature of crypto-assets, transfer of control to Bitgrail, and commingling of crypto-assets in the omnibus blockchain address of the debtor. Notably, the court did not examine the contract governing the relations between Bitgrail and its customers. I note that a similar outcome is likely to be reached under Dutch law. Where the law imposes specific requirements or limitations on the creation and transfer of property rights or provides for the title transfer in a situation of asset commingling, a contract and contract law could be of little help. Thus, it becomes essential to complement clear and transparent contract terms with an appropriate property law framework. For instance, one potential solution might involve granting co-ownership rights to crypto investors who deposit their fungible crypto-assets, such as bitcoin, for safekeeping with a CASP. This is a pragmatic approach that has been used for securities. Yet it may require a special statutory intervention.

When crypto failures meet regulatory law

An unambiguous contract law and property law framework for crypto-assets may not suffice to guarantee the adequate protection of customers’ rights. The exercise of such rights can be problematic or impossible if a CASP does not properly safeguard customer assets and uses them for its own account. The case of the failed crypto exchange FTX and the affiliated cryptocurrency trading firm Alameda is a probable example of such a scenario. Another scenario posing a risk to customers’ rights is where a CASP does not re-use (eg by investing or engaging in proprietary trading for its own account) customer crypto-assets, but pools them at an enterprise group level. Consequently, even if customers have property rights over commingled and unallocated crypto-assets, they may have to share with customers of other entities within the group, inter alia, in the event of a shortfall.

In these scenarios, the risk of loss does not originate from a contract or specific limitations of national property law, but rather from improper actions of a CASP. Neither contract law nor property law can prevent such abuses. Bad market behaviour and market failures are commonly addressed by administrative (regulatory) law rather than private law. An illustrative example of such administrative law is the EU Markets in Crypto-Assets Regulation (MiCAR). This regulation contains detailed rules prohibiting CASPs from using custodial assets for their own account and mandating operational, technological and legal segregation of crypto-assets. While supporting this approach, I point out that its success, judged from the perspective of consumer and investor protection, will depend on the efficiency of supervision and enforcement by public authorities. With MiCAR entering into force, the year 2024 promises to be the year of crypto regulation.

Overall, crypto bankruptcies raise challenging legal questions that demand a multi-dimensional legal response, involving different areas of law. In the table below, I summarise the key problems and potential solutions.

Ilya Kokorin is an Assistant Professor at the Department of Financial Law, Leiden University.