A Crypto Bankruptcy Could Be Investors’ Nightmare

In a bankruptcy restructuring, crypto investors would be navigating uncharted territory.

“What can safely be predicted is that there will be litigation, and there will be delay,” said Adam Levitin, a law professor at Georgetown University who studies bankruptcy.

Crypto exchanges and lending services provide individual investors an on-ramp to markets, but the cryptocurrency that customers put on these platforms might not belong to them in the eyes of a bankruptcy court, according to regulators and legal experts.

If a cryptocurrency company goes bust, its users’ digital assets will likely go into the bankruptcy estate that lawyers, financial advisers, lenders and other creditors divvy up. Customer assets could be repaid at a loss, rather than simply returned to the users. Even if customers of a troubled cryptocurrency firm eventually get access to their tokens, they still could suffer big losses if the market turned against them while the bankruptcy played out.

Many people were motivated to put crypto assets in Celsius to earn interest rates as high as 18%. The lender took customer deposits and put them in decentralized finance investments to get a return or lent the funds out to other users for a fee.

Celsius looks like a bank in many ways. But the company lacks the protections that banks have, such as federally backed deposit insurance. Celsius, and other cryptocurrency intermediaries, also aren’t registered as broker-dealers, which provide account holders with critical protections in the event of bankruptcy by keeping their funds separate from the broker-dealers’ own funds. In the U.S., most crypto intermediaries instead possess simple money-transmitter licenses issued by state governments, intended for companies like Western Union.

How Celsius’s crypto lending process works:

Celsius puts customer deposits in decentralized finance investments and lends out funds to other users (including to exchanges and market makers).

Customers lend money to Celsius in exchange for yield. (This is essentially an unsecured loan).

Celsius earns a return from borrowers and investments.

Celsius puts customer deposits in decentralized finance investments and lends out funds to other users (including to exchanges and market makers).

Customers lend money to Celsius in exchange for yield. (This is essentially an unsecured loan).

Celsius earns a return from borrowers and investments.

In a recent paper, Mr. Levitin argued that the easiest way to protect investors would be for the Consumer Financial Protection Bureau, a federal regulator, to require that cryptocurrency exchanges hold customer funds in bankruptcy-remote arrangements to segregate funds. He said the CFPB has clear authority from Congress to take such steps but that the agency has yet to do so.

A CFPB spokeswoman declined to comment.

Crypto companies such as trading platform

Coinbase Global Inc.

COIN -0.98%

have sought to reassure investors in recent weeks that their crypto assets are safe.

“We have strong legal and operational protections in place to ensure that our customers’ assets are protected in any eventuality,” Coinbase Chief Legal Officer

Paul Grewal

said in an emailed statement Thursday. “This includes accounting for these assets completely separately from any corporate funds.”

Coinbase shares plunged following a disclosure by the company in May that customers could be treated as general unsecured creditors in a hypothetical bankruptcy.

Celsius also sought to reassure customers shortly before it froze withdrawals. A spokeswoman for the firm told The Wall Street Journal in an email Friday that it had not had any issues meeting withdrawal requests and that it held enough ether—a popular cryptocurrency—to meet its obligations.

Celsius Chief Executive

Alex Mashinsky

lashed out at skeptics on Twitter who suggested Saturday that the company was on the ropes, accusing them of spreading misinformation. The company froze accounts Sunday evening. On Wednesday afternoon, the assets were still frozen, and Mr. Mashinsky tweeted that the firm was “working nonstop” on the issue.

In a bankruptcy setting, much will depend on the contract depositors agreed to when they put their digital assets in. Terms of use for Celsius specify that the legal status of users’ crypto holdings will be unclear if the firm were to become insolvent.

Some lawyers say the type of contract between investor and firm could make a difference and offer some protection of ownership rights in bankruptcy. The treatment of customer assets may depend on whether the firm holds them in a way that is consistent with customer ownership as established under relevant commercial laws, said Jonathan Cho, a bankruptcy and regulatory lawyer at Allen & Overy.

For example, many firms have adopted a holding model, available under the commercial laws of most states, that helps define what the ownership rights should be, Mr. Cho said. Celsius also has a lending arm that offers cash loans, collateralized by people’s cryptocurrency assets.

A bankruptcy judge may also have to decide whether Celsius’s depositors would even be considered unsecured creditors or merely investors, which rank even lower, said Jim Van Horn, bankruptcy lawyer at Barnes & Thornburg LLP.

State laws on ownership of assets in custodial accounts might be helpful to depositors. But they may not even come into play in a bankruptcy case if a judge determines that users are merely investors, Mr. Van Horn said.

Write to Paul Kiernan at [email protected], Alexander Gladstone at [email protected] and Soma Biswas at [email protected]