The anatomy of crypto failures and investor protection under MiCAR

Abstract

This article explores the recent collapses of prominent crypto trading and lending firms Voyager and Celsius, investigates the prevailing business models of crypto firms and identifies potential causes of their failure. The insolvencies of Voyager and Celsius reveal complex legal problems, particularly concerning the determination and allocation of customer rights in deposited crypto-assets. The EU Markets in Crypto-assets Regulation (MiCAR) seeks to protect investors by requiring the safekeeping and segregation of crypto-assets held in custody. Yet it does not necessarily protect those investors who ‘lend’ their crypto-assets to crypto-lending platforms with the expectation of earning rewards. MiCAR lacks a dedicated legal framework for crypto-lending, which suffers from many classic financial sector vulnerabilities. To address this gap, we propose the adoption of a new instrument, MiCAR II. Drawing inspiration from existing regulations for financial intermediaries like banks, MiCAR II may incorporate five elements: (i) a large exposures regime, (ii) robust disclosure requirements, (iii) structural and organizational separation of custody and trading/investment activities, (iv) deposit-like guarantees and (v) a dedicated recovery and resolution regime for significant crypto firms. In 2022, the cryptocurrency market experienced a significant downturn (‘crypto winter’), which coincided with the downfall of several major market players. On 5 July 2022, the crypto trading and lending firm Voyager Digital Holdings, Inc. (Voyager) filed a voluntary Chapter 11 petition in the US Bankruptcy Court for the Southern District of New York.1 Shortly thereafter, on 13 July 2022, Celsius Network LLC, a leading crypto-lending platform, and its affiliated entities filed for bankruptcy in the same court.2 Both Voyager and Celsius acted as lenders to one of the world’s largest crypto hedge funds, Three Arrows Capital Ltd. (3AC), which since June 2022 is itself subject to the liquidation proceeding in the British Virgin Islands. In November 2022, the cryptocurrency market turmoil reached a critical point when one of the largest crypto exchanges, FTX, and its affiliated crypto trader, Alameda, collapsed. Given the complexities and ongoing investigations surrounding the cases of FTX and Alameda, we will not address them separately here.3 This article analyses the collapses of Voyager and Celsius, examines the likely causes of their demise and explores some of the typical legal issues accompanying crypto failures. It also questions whether the Markets in Crypto-assets Regulation (MiCAR), a recently introduced law aimed at harmonizing the regulation of crypto-asset service providers (CASPs) and crypto-asset services within the European Union (EU), can prevent or at least reduce the damaging effects of crypto failures and ensure sufficient protection of crypto investors. The article is structured as follows. Section 2 starts with a summary of the key features characterizing crypto failures. It continues with a discussion of a prominent issue observed in most crypto insolvencies, namely the attribution of rights in deposited crypto-assets in insolvency of a CASP. Section 3 introduces MiCAR and its provisions on the safekeeping and segregation of reserve and customer crypto-assets. Section 4 shifts the focus to Voyager and Celsius, examining their business models and addressing the legal challenges associated with crypto-lending more broadly. Section 5 consists of several parts. First, it considers the provisions of MiCAR that directly and indirectly impact the operations of crypto lenders. Second, it draws attention to the differences and similarities between crypto finance and traditional finance. Third, it puts forward several suggestions for future regulation, referred to as MiCAR II. Section 6 concludes. Instances of crypto failures are not unprecedented, with one of the most well-known examples being the infamous collapse of the Japanese crypto exchange Mt.Gox in 2014. Other notable cases include the failures of the Italian crypto exchange Bitgrail in 2019 and the New Zealand crypto exchange Cryptopia in 2020. The recent wave of crypto insolvencies raises some familiar questions, including: Are crypto-assets objects of property rights?4 Do crypto-assets transferred to a crypto exchange or another CASP become part of the insolvency or are property of between in and is the at which the of crypto-assets crypto-assets as The to questions on property and insolvency as as and by crypto firms. the crypto insolvencies of 2022 several First, the failures of crypto firms market crypto crypto hedge funds, crypto are and the in crypto-assets can The impact of a market downfall or the of a as a can to their and This not itself in the at least not to the same as Second, since the of in crypto-assets experienced or new as crypto-lending and of crypto firms to and the more recent collapses of Voyager and Celsius can at least to their and business business models crypto lenders to large exposures and and by finance and In some key the ongoing within crypto to the turmoil the financial of when issues as of and a significant impact on the Third, significant in the regulation of crypto services and crypto firms the The bankruptcy of Mt.Gox in financial and insolvency law issues which to for the in several The EU also to and crypto-asset This in which will from with the of the concerning which will on June as a for as it a of and This on the of that a crypto CASP. 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To address this disclosure and the of deposited crypto-assets and whether the to a crypto the disclosure the rights of in the of the of a and financial of a crypto of deposited crypto-assets by a crypto and with the of disclosure it is that disclosure is to ensure protection and market robust disclosure requirements, can investors with the to and in the crypto-lending of custody and trading/investment The cases of Celsius and the associated with custody and or trading activities, as as the that a in one of them can to the of of financial by some the the sector structural of 2019 that services and to and and from and a and by legal is in the with the of the which some on and of which include from in of financial and of crypto-lending and trading from services by crypto-asset service providers the of this will on the of the and the to and The collapses of Voyager and Celsius by which their This is in the referred to as can also subject to of from investors on the the to and leading to the to in a are not by or to traditional lending and guarantees and the to protect and prevent In the guarantees are to to a to investors the services of The of for the crypto-lending sector may The concerning the of and the by them separately to ensure their resolution regime and resolution regime with for can a in addressing the of financial that significant In the for resolution is by the and and the a and a and and MiCAR introduces for significant crypto-asset service significant crypto a to financial or causes significant a legal framework by the recovery and resolution regime, with of This article examines the regime for crypto-assets and crypto-asset service providers in the in of the recent of crypto failures. is the the of regulation and the of and from of and financial insolvency is not a new of the and most well-known cases is the collapse in of which the world’s largest trading we a wave of crypto failures which in the some legal in many crypto insolvencies, are to a business or a of business the is the determination and allocation of rights deposited crypto-assets. 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