Restructuring

            In recent months, the crypto industry has experienced an unprecedented downturn that some have dubbed a “Crypto Winter.” While cryptocurrencies typically fluctuate in price more than most other assets, their values dropped dramatically in the first half of 2022 as several interrelated factors in the traditional economy and the crypto sector collided. The effects of this crash have rippled through the space, causing a number of companies to experience significant financial distress. Notably, crypto firms Voyager Digital, Celsius Network, and Three Arrows Capital all faced insolvency and filed for chapter 11 or similar foreign proceedings this summer.  The crypto market has rebounded somewhat since the June 2022 low, but the future remains uncertain.

            This crash, along with the longstanding regulatory uncertainty in the sector, also prompted U.S. regulators and legislators to consider more stringent controls on cryptocurrencies. Notably, the United States is not alone in grappling with these issues.  This June article from Weil’s London office describes the UK regulatory situation and also discusses systemic risks certain cryptocurrencies may pose to the broader economy.

            As the crypto insolvencies progress, courts in the United States and elsewhere may have the opportunity to decide and clarify open questions of law regarding cryptocurrency. And regulation responding to this distress may further alter the legal landscape around these assets. Thus, the present Crypto Winter may ultimately result in significant changes to the legal rules governing the sector.

The “Crypto Winter”

            Beginning in late 2021, the price of cryptocurrencies experienced a significant downturn, and the impact of this crash has affected participants throughout the industry.

            The roots of this downturn date back to the early days of the COVID-19 pandemic. The spread of the coronavirus led to a sharp crash in traditional asset markets, and cryptocurrency prices fell in tandem. However, as central banks and governments enacted relief programs designed to alleviate this economic turmoil, asset prices skyrocketed to never-before-seen levels. In 2022, these relief initiatives began to taper off. This stimulus wind-down coincided with increasing fears of a coming recession, a broader selloff in tech assets, and a rise in commodity prices following sanctions imposed in response to Russia’s invasion of Ukraine. Crypto prices did not escape the resultant downturn, and values dropped steadily throughout early 2022.

            This decline accelerated in earnest in May 2022, when the stablecoin UST lost its “peg” to the U.S. dollar. Stablecoins—a particular kind of crypto asset—seek to maintain a specific value relative to some other asset or commodity. UST aimed to maintain a consistent value of $1.00 by enabling users to exchange the coin for its sister cryptocurrency, Luna. Users could sell UST for Luna when UST prices rose above $1.00, and could buy UST at a discount when prices fell below $1.00. In May, 2022, however, this system failed, users rushed to sell their holdings of the cryptocurrencies, and both Luna and UST became completely worthless.

            The collapse of Luna and UST erased nearly $18 billion in value. And, because cryptocurrency traders relied extensively on UST as a medium of exchange for other cryptocurrencies, the “de-pegging” of the stablecoin caused the previously steady decline of crypto prices to accelerate into an outright crash. For example, between May 1, 2022 and June 1, 2022, the price of a Bitcoin plummeted from roughly $30,000 to below $20,000.  Just six months before the crash, on November 2021, Bitcoin prices reached all-time highs in excess of $68,000.

            This crash has impacted many crypto-focused companies and funds. Firms with significant exposure to UST and Luna have experienced particular distress. And the Crypto Winter has led to the insolvency of major cryptocurrency exchanges Voyager Digital and Celsius Network, as well as crypto-focused hedge fund Three Arrows Capital.  Both Voyager and Celsius are seeking to sell significant assets in chapter 11, which may be good news for investors who believe in the future of crypto and seek to expand their crypto capabilities while the market is relatively low.  Contact Weil for more information about these asset sales, and see this April 2021 article from Weil’s private equity group for a discussion of issues unique to crypto-related mergers.

            Courts grappling with the unique issues inherent to these crypto insolvencies may soon clarify open legal questions regarding these digital assets. As such, the present Crypto Winter and its impact in the industry has the potential to generate a body of case law that shapes the space going forward.

Regulatory Response

            In light of this recent distress, and because the United States currently lacks a comprehensive framework for cryptocurrency regulation, officials at all levels of the federal government have begun to consider regulation of the space. Because stablecoins create particular economic risks, as evidenced by the collapse of Luna and UST, regulators have begun to focus on those assets in particular.

            The United States has not yet adopted any clear regulatory framework for cryptocurrency. For that reason, a number of federal agencies have claimed provisional authority over the sector by declaring that certain digital tokens meet the definition of a class of assets within their purview.¹ For example, the Securities and Exchange Commission (“SEC”) claims authority over some cryptocurrencies by declaring that they qualify as “securities.”² And the Commodity Futures Trading Commission (“CFTC”) has done the same by declaring that certain assets are “commodities.”³ The Financial Crimes Enforcement Network (“FinCEN”) has also clarified that entities that transmit and accept virtual currency must register as money services businesses and maintain formal anti-money laundering programs.⁴ Other regulatory agencies have also taken an interest in cryptocurrency, and this October 2021 article from Weil’s Washington, D.C. office details additional guidance issued by the Department of the Treasury.

             Officials at all levels of the federal government have begun working to resolve this regulatory confusion, especially where stablecoins are concerned. In November 2021, the President’s Working Group on Financial Markets, along with the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency issued a report on stablecoin risks and potential regulations.⁵ That document identified a number of risks inherent to the stablecoin ecosystem, including the possibility of a loss of value and resultant run on stablecoins, the use of digital assets for illicit financing, and the potential for investor abuses like insider trading.⁶ The report further recommended legislation to, among other measures, require stablecoin issuers to register as insured depository institutions.⁷ On February 8, 2022, the House of Representatives Financial Services Committee held a hearing to review this report and begin considering potential legislation on the subject.⁸ 

            On March 9, 2022, President Biden signed an executive order broadly encouraging federal action with respect to cryptocurrency.⁹ Along with other measures, the order called for the Department of the Treasury to develop policy recommendations and an oversight regime to address the implications of the growing crypto sector.¹⁰ The order also directed the Federal Reserve to research the issuance of a U.S. Central Bank Digital Currency, which would function as a government-issued digital version of the U.S. dollar—essentially an official stablecoin.¹¹ In June 2022, the Department of the Treasury, in consultation with several other agencies, issued the first regulatory framework to respond this order and established a regime for international coordination on the subject of cryptocurrency.¹²

            U.S. legislators have also begun to focus on stablecoins, and two major bills on the subject have been introduced in the 117th Congress. In March 2022, Senator Pat Toomey introduced the Stablecoin Transparency Act.¹³ This Bill would require any issuer of stablecoins to register as either a money transmitting business, a national limited payment stablecoin issuer, or an insured depository institution.¹⁴ The bill would also clarify that stablecoins are not securities, and thereby prevent the SEC from regulating them. The law would instead grant the Office of the Comptroller of the Currency authority to regulate stablecoin issuers, and would also require issuers to disclose the assets backing their coins’ value.¹⁵

           Separately, in June 2022, Senators Kristen Gillibrand and Cynthia Lummis introduced the Responsible Financial Innovation Act.¹⁶ The Gillibrand-Lummis bill covers the entire crypto industry, and grants the CFTC primary regulatory authority over the sector. The bill would also require stablecoin issuers to maintain liquid assets equaling 100 percent of the face value of all issued stablecoins, make monthly disclosures describing those assets, and redeem coins for the equivalent value in fiat currency on demand.¹⁷

           In the U.S. House of Representatives, a bipartisan bill to regulate stablecoins has stalled for the time being.¹⁸ While co-drafters Patrick McHenry and Maxine Waters have kept the language of the bill under wraps, the legislation would reportedly allow banks to issue stablecoins and appoint the Federal Reserve as overseer of non-bank issuers.¹⁹

            All three bills would go a long way toward managing the risks associated with stablecoins and would also resolve the overlapping authority in the space by identifying a primary regulator. Officials in the Biden Administration seem hopeful for the pending bills.²⁰ But, given entrenched gridlock in the U.S. Congress, a legislative solution is far from guaranteed. It is also important to note that state regulations, which are beyond the scope of this article, should also be considered and can be more comprehensive than the developing federal framework.

Conclusions

            The crypto sector remains volatile, even as the space has matured. The collapse of Terra and Luna show how stablecoins in particular can create risk in the space. And the recent insolvencies of Voyager, Celsius, and Three Arrows Capital, as well as other firms like the Singapore-based crypto lender Vauld, demonstrate the potential for this volatility to result in financial distress for firms with exposure to cryptocurrency. Crypto insolvencies raise novel legal issues, and case law that emerges from these insolvencies may soon shape the sector going forward. Regulators in the United States and elsewhere have also begun considering significant changes to cryptocurrency rules, singling out stablecoins for immediate attention. These factors together mean that the present Crypto Winter is likely to result in significant changes to legal rules governing the crypto industry.

          Weil will be following closely the regulations and court rulings that result from this interesting period in an industry that likely is here to stay and will continue to grow.

*The authors thank Weil Corporate Counsel Timothy C. Welch for his helpful comments and insight.