Your crypto is stuck in a ‘liquidity crisis.’ Now what?

The recourse offered to consumers when their crypto is held by entities that are in trouble is slim to none, but that doesn’t mean businesses are getting away with it.

A piggy bank with a hole in the bottom

There are few protections for crypto investors.

Illustration: Christopher T. Fong/Protocol

The chaos that has wiped out tens of billions of dollars in crypto wealth has brought the issue of investor protections to the forefront. Consumers promised high returns and safe investments lost big in the UST-luna collapse, which in turn has caused DeFi entities like the Celsius Network to freeze withdrawals. Alongside the general crypto market downturn, the damage is tangible, giving urgency to efforts to regulate crypto with basic guardrails.

Celsius attracted lots of consumers because of the yields it offered, which were higher than traditional bank accounts. After Celsius paused withdrawals, swaps, and transfers between accounts last Sunday due to “extreme market conditions,” it left investors anxious about how and when access to their assets stuck in Celsius might be restored.

Regulators have been thinking about these issues for a while, but for many of the new investors drawn to crypto recently, the questions of what happens to crypto held hostage by an exchange or a DeFi lender are freshly puzzling.

In the context of DeFi lenders like Celsius, it’s unlikely consumers will be able to access their crypto deposits unless they are unfrozen by the lenders themselves. How existing investor protection laws might apply to digital assets is largely untested, and the global and decentralized nature of many DeFi entities makes it hard to figure out where to start in pursuing a claim.

“A lot of people have losses who didn’t understand the risks they were taking,” former Commodity Futures Trading Commission chairman Timothy Massad told CoinDesk, stressing that there is a need for stronger regulation especially for lenders in the crypto industry.

SEC Chair Gary Gensler has echoed similar sentiments. He highlighted how crypto markets promise high returns and don’t “give a lot of disclosure” at an event Tuesday: "I caution the public. If it seems too good to be true, it just may well be too good to be true."

Even centralized exchanges can seem unsteady given the unsettled state of crypto regulation. After Coinbase added a new disclosure in its 10-Q SEC filing in May, it caused another wave of anxiety in the crypto community.

“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,” the filing said, which wasn’t a good look on Twitter.

Chief legal officer Paul Grewal quickly clarified that the new disclosure was only to comply with new guidelines issued by the SEC, and that there would never be a situation where “customer funds could be confused with corporate assets.” Coinbase updated a user agreement to reflect that customer assets would be protected under Uniform Commercial Code Article 8.

That UCC provision is one of the few rules lawyers might try to use against crypto entities, because the usual protections that cover deposit or brokerage accounts are tough to apply. Crypto doesn’t have protections like FDIC insurance has for traditional bank accounts or SIPC coverage for brokerage accounts.

For entities based overseas, investor protection laws vary from jurisdiction to jurisdiction, but because of how new the crypto industry is, many jurisdictions have yet to come up with laws to safeguard crypto assets for consumers.

But risky behavior by crypto companies isn’t flying under regulators’ radar. A look at the ongoing investigations Terraform Labs is under after the UST-luna stablecoin collapse gives an idea of the repercussions a DeFi company can face from causing losses for investors.

In one case that predates the current crypto crash, the SEC triumphed over Terraform in establishing its regulatory jurisdiction. A judge ruled that even if Terraform is based overseas, because it was in business with U.S.-based consumers, investors, employees and entities, it could be sued here. Investigations were also opened in Terraform founder Do Kwon’s home jurisdiction, South Korea, alleging losses for about 280,000 citizens.

U.S. state regulators have also stepped up in the Celsius case. Securities regulators in Alabama, Kentucky, New Jersey, Texas and Washington are reportedly probing Celsius about the withdrawal and transfer freeze, stating that the investigation was a “priority” because of concerns over consumer access to financial accounts.

With the introduction of the Responsible Financial Innovation Act in Congress and Biden’s executive order outlining how federal agencies should be working together for a regulatory framework for the crypto industry, federal legislation and regulations could be expected in the next few years.

In the meantime, SEC Commissioner Hester Peirce, a frequent critic of the agency’s scant rulemaking on crypto, gave one piece of advice to consumers back in May. “I think no matter what you're doing with your money as an individual, you need to be using your own brain, first and foremost. You need to be looking out for red flags,” she told Protocol.


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Photo: Carolyn Van Houten/The Washington Post via Getty Images

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