Invest: Crypto bankruptcy works differently

Posted by

Oh boy, this is surely worrying.

Coinbase Global Inc. got a lot of bad press last month for describing how bankruptcy works, or might work, for cryptocurrency exchanges. “Because custodially held crypto assets may be considered to be the property of a bankruptcy estate,” Coinbase explained in a risk factor in its Form 10-Q, “in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors.”

This quite neutral description of a risk to Coinbase’s creditors sort of blew up, and Coinbase had to go on a weird apology tour in which they told people, well, we’re not planning to go bankrupt, and we don’t want to seize your crypto deposits. Coinbase was just warning its users, sensibly, that the law of crypto customer protection in bankruptcy is not all that clear or well developed, and that there is a serious risk that a crypto bankruptcy would not not work out the way you expect if you’re used to traditional financial-industry bankruptcies.

There is a lot of stuff like this in crypto. We talked last month about the blowup at TerraUSD, the algorithmic stablecoin. I wrote about a model in which TerraUSD was the “debt” of the Terra blockchain, while the Luna token was its “equity.” Intuitively, when it blew up, you would expect the holders of the debt to get whatever’s left (equity in the surviving company, any cash lying around, etc.), while the holders of the equity would get nothing. But in the case of Terra, things didn’t work that way: Terra launched a new blockchain, with some residual value, and gave most of it to Luna holders rather than TerraUSD holders. The thing that was supposed to be a senior claim with a fixed value turned out to be mostly worthless; the thing that was a risky bet on the growth of the network kept its value better (still not well). 

Or here is a CoinDesk story from last week about BlockFi, which announced a $250 million line of credit from FTX:

Cryptocurrency investment firm Morgan Creek Digital is attempting to raise $250 million from investors to purchase a majority stake in crypto lender BlockFi, a leaked investor call from Tuesday reveals. …

“I’ve been making calls all day,” Morgan Creek Digital managing partner Mark Yusko said on the leaked call.

According to Yusko, the FTX credit line proposal had a catch for BlockFi’s existing shareholders: It gave FTX the option to buy BlockFi “at essentially zero price.” If FTX were to exercise said option, it would effectively wipe out all of BlockFi’s existing equity shareholders, including management and employees with stock options, as well as all equity investors in the company’s previous venture rounds.

However, Yusko said on the leaked call that BlockFi founders Zac Prince and Flori Marquez had a valid reason for preliminarily accepting the terms: Of the several emergency financing offers BlockFi received, FTX’s was the only one that would not subordinate client assets to the rescuer.

In other words, unless BlockFi went with FTX, its depositors would have had to wait in line behind the new lender to be repaid.

Well they’re not “depositors” exactly, are they, not in the classic banking sense. They look like depositors, sure, but their legal rights are not so clear. 

Crypto has recreated the pre-2008 financial system, and is now having its own 2008 financial crisis. But this is an important difference. Traditional finance is in large part in the business of creating safe assets: You take stuff with some risk (mortgages, bank loans, whatever), you package them in a diversified and tranched way, you issue senior claims against them, and people treat those claims as so safe that they don’t have to worry about them. Money in a bank account simply is money; you don’t have to analyze your bank’s financial statements before opening a checking account. The short-term senior debt of financial institutions is “information-insensitive.” 

There is a sort of division of labor here: Ordinary people can put their money into safe places without thinking too hard about it; smart careful investors can buy equity claims on banks or other financial institutions to try to make a profit. But the careless ordinary people have priority over the smart careful people. The smart careful heavily involved people don’t get paid unless the careless ordinary people get paid first. This is a matter of law and banking regulation and the structuring of traditional finance. There are, of course, various possible problems; in 2008 it turned out that some of this information-insensitive debt was built on bad foundations and wasn’t safe. But the basic mechanics of seniority mostly work pretty well.

But they are in a sense unnatural. If you started a bank in the state of nature, and the bank had equity investors who were smart and rich and concentrated and heavily involved in the running of the bank, and then the bank took a lot of money from dispersed retail depositors who didn’t pay a lot of attention and just wanted their money back and had no real idea about the running of the bank, and then the bank ran into trouble, you might expect the equity investors to say “well we’ll take whatever money is left and stiff the depositors.” And you might not expect the depositors to be very effective at fighting back. And so the equity investors might in practice be senior to the depositors, in this state-of-nature bank. As they effectively were at Terra.

Of course if you started a bank in the state of nature nobody would give you any deposits. The reason people put their money in actual banks is that we live in a society and there are rules that protect bank deposits, and also everyone is so used to this society and those rules that they don’t think about them. Most bank depositors do not know much about bank capital and liquidity requirements, because they don’t have to; that is the point of those requirements.

Broadly speaking crypto banking (and quasi-banking) is like banking in the state of nature, with no clear rules about seniority and depositor protection. But it attracts money because people are used to regular banking. When they see a thing that looks like a bank deposit, but for crypto, they think it will work like a bank deposit. It doesn’t always.