How Centralized Entities Go Rogue Due to Regulatory Uncertainties
Written by lawpanda
Centralized crypto exchanges (often called crypto banks) such as FTX, Binance, Voyager, Celsius, and BlockFi seem to fall into a regulatory gray area — one that facilitates unaccountability; and could potentially damage retail investors and the industry as a whole.
While many retail investors believe that these companies — which are registered in various jurisdictions and sometimes publicly traded — are subject to regulatory scrutiny and consumer protection requirements, that is often not the case. If a company can sponsor a Super Bowl ad or brand a sports arena, why would a retail investor not assume that the company has appropriate risk management or compliance processes in place? Unfortunately, as the contagion from Three Arrows Capital spread to various crypto banks, it became apparent that, much like with investment banks in 2008, regulators were too busy complaining about DeFi to actually regulate these registered crypto entities.
Chief among retail-focused crypto banks was the Celsius Network. After its inception in 2018, Celsius grew into one of the largest asset managers in crypto, with about $12 billion under management as of May 2022. While Celsius wasn’t publicly traded, its token (CEL) was used in a manner similar to equity, only that it was completely unregulated. Lack of proper regulation coupled with other factors led to the happenings of June 2022 — Celsius filed for bankruptcy after freezing client funds and pausing withdrawals. Following its bankruptcy filing, retail investors were left to bear the brunt of massive losses in their investments.
Just to be Clear, ‘Crypto Bank’ Celsius Isn’t Actually a Bank
Celsius and other similar companies are not regulated like traditional banks and brokerage firms, so investment losses are not insured by the Federal Deposit Insurance Corporation or protected by the Securities Investor Protection Corporation. According to General Andrew Bruck, New Jersey’s former Acting Attorney General:
Due to the volatility of the cryptocurrency market and the lack of regulatory oversight, these platforms present a heightened risk of loss to investors.
In essence, Celsius and other crypto banks are not subject to oversight from regulators in either the investment or banking sectors. However, because Celsius used its native CEL token as an equity offering — often in a manner that was improper in a publicly or privately traded company — it should have been subjected to oversight from regulators in the finance industry; unfortunately, that wasn’t the case.
Security or Non-security?
Regulatory scrutiny is often associated with assets that are classified as securities, however, Celsius’ risk disclaimer claims that the CEL token is not a security, stating in full:
[CEL] Tokens have not been, and are not intended to be, registered under the U.S. Securities Act, the UK Financial Services and Markets Act, or the applicable Laws of any other jurisdiction. In the absence of regulatory clarity, there is a risk that the Tokens may be viewed as a security, financial instrument, specified investment, or other regulated instrument. In any such event, the Tokens may not be offered or sold except pursuant to an exemption from, or a transaction not subject to, the applicable registration requirements of the applicable Laws. These restrictions may limit the transferability, value and liquidity of the Tokens. Celsius does not intend or undertake to register the Tokens for trading on any securities exchange.
While CEL may or may not have been considered a security by regulators, Celsius certainly used it as one. This is best explained by a Seeking Alpha article from 2021:
[CEL] is used by the company as a security (like a stock) and a utility token . . . whereby Celsius can conduct token sales from the treasury to raise money, it can be used to provide collateral, to provide liquidity, and it can be used for lending. It is also used to pay weekly dividends with company revenues. These dividends are in the form of buybacks where the company purchases CEL tokens in the open market and deposits them in your account every Monday.
In addition, the SEC’s 2019 Framework for “Investment Contract” Analysis of Digital Assets — a publication that aims to define what digital asset passes as a security — points that certain characteristics, while not necessarily determinative, make it more likely that a digital asset is a security due to the factor of relying on the ‘efforts of others’ (an Active Participant):
An [Active Participant (AP)] creates or supports a market for the price of the digital asset. This can include, for example, an AP that: (1) controls the creation and issuance of the digital asset; or (2) takes other actions to support a market price of the digital asset, such as by limiting supply or ensuring scarcity, through, for example, buybacks, ‘burning’ or other activities.
Celsius’ constant buybacks and other mechanisms to limit supply and increase price clearly fit this description. According to Arkham Intelligence, Celsius used CEL in several ways that supported its market and possibly manipulated the token’s price.
Market manipulation refers to any attempt to interfere with the free and fair operations of the market. While legislation against market manipulation exists, there is none specific to cryptocurrency or entities like Celsius. In publicly traded companies, rules on market manipulation generally prohibit market participants from trading based on price-sensitive information (information that has the potential to influence a particular company’s share price) or artificially pumping stock into a sale. Accordingly, as an investor, you cannot take advantage of other investors not having the price-sensitive information you have.
Unfortunately, crypto banks do not specifically have the same insider trading safeguards as a bank or publicly traded company. That, however, may be changing. Recently, the U.S. Department of Justice (DOJ) charged a former Coinbase product manager and two accomplices with wire fraud and insider trading. The DOJ alleged in a press release that the employee shared information about what cryptoassets Coinbase would list prior to the actual listing. The SEC also brought charges against the three individuals tied to the same insider trading allegations. The regulatory uncertainty regarding CEL’s characterization as a utility token vs. a security may ultimately indict Celsius’ CEO, Alex Manshinsky, and other insiders.
Even in Bankruptcy, the Company is Worth $1 Billion (Albeit in Tokens They Can’t Sell)
At the time of its bankruptcy filing, Celsius claimed to have more than 1.7 million users and up to $4.72 billion of its debt in locked client funds. The company had only $1.75 billion in cryptoassets excluding its CEL token holdings, which it valued at $600 million (658 million CEL tokens). The company owed 279 million of these tokens to clients, leaving the firm with a 379 million surplus. At the short-squeezed market pump in August 15, 2022, the net value of Celsius’ CEL position would have been about $1 billion, almost double what it was at the time of its bankruptcy filing.
Despite this seeming windfall, most of CEL token’s supply is locked on the platform and CEL pair liquidity on exchanges is likely too thin to support large transactions. This is particularly relevant because Celsius was projected to run out of funds by October 2022. However, if the firm attempts (or is even able) to sell portions of its CEL tokens to cover a part of its balance sheet shortfall, prices (which were artificially inflated due to buybacks in the first place) would most likely tank. “The asset side of the CEL holding is probably worth zero”, said Thomas Braziel, founder of 507 Capital — an investment firm that provides financing around bankruptcies and reorganizations. He further adds that the liabilities are still there because CEL token owners will likely pursue claims against Celsius in the bankruptcy court.
How Do I Value a Crypto Bank?
Except centralized crypto companies choose to disclose their financial holdings, you can’t accurately evaluate their financial value.
Unfortunately, crypto banks do not specifically have the same insider trading safeguards as a bank or publicly traded company.
In legacy finance, the most common way to value a stock is to compute the company’s price-to-earnings (P/E) ratio. The P/E ratio equals the company’s stock price divided by its most recently reported earnings per share. A low P/E ratio implies that an investor buying the stock is receiving an attractive amount of value. With a company like Celsius, due to the lack of disclosure requirements, retail investors didn’t specifically know what was happening with their funds while Celsius had them. Though, unlike a bank or investment firm, Celsius was not bound by standard risk management and compliance practices in how it invested retail funds.
Celsius used the CEL token like a de-facto security and its price pump gave the perception that the company was doing well; this also significantly inflated Celsius’ overall valuation. While there are still arguments about what tokens are securities and how they should be regulated, centralized crypto banks operating in regulatory gray areas should not be issuing tokens that masquerade as de-facto equity due to the potential for abuse.
More Bankruptcies to Come?
Image credit: lawpanda via Midjourney
While the crypto market is yet to fully recover from the collapse of top entities like Celsius and Three Arrows Capital, November 2022 saw another cryptocurrency exchange, FTX, collapse. The bankrun on FTX followed a report from CoinDesk highlighting potential leverage and solvency concerns with FTX’s associated trading firm, Alameda Research. While the facts underlying FTX’s insolvency are significantly more convoluted than that of Celsius, a primary cause of the FTX’s collapse was that most of the net equity being leveraged by Alameda/FTX was in FTX’s native FTT token — a token, as with the CEL or arguably any exchange token, that becomes functionally illiquid during a crisis of confidence.
This once again demonstrates some of the underlying issues with so-called crypto banks and their regulatory problems. All these further highlights the need for proper regulations in the crypto space to keep centralized entities in check; preventing them from going rogue.
This article initially appeared in BanklessDAO’s Decentralized Law newsletter on August 31, 2022.
lawpanda is a U.S. attorney with an active litigation and counseling practice. He is a member of BanklessDAO’s Legal Guild, LexDAO, the LexPunkArmy, and member/consultant/contributor to a variety of DAOs and protocols. When he’s not writing for Decentralized Law, he is working to reduce operational and governance friction between on-chain and legacy entities through corporate structuring and common-sense legal solutions. Connect on Twitter, LinkedIn, or at firstname.lastname@example.org.
BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.
This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.
More Like This
Brick and Mortar Banks Begin to Build On-Chain by Samantha Marin
The Tornado Cash Sanctions by Austin Foss
Dialing in DeFi by Bankless Africa