How crypto exchanges hold assets: the crypto world after the collapse of FTX

Following FTX's rapid demise in November 2022, the fallout to the cryptocurrency market and beyond has been huge.

Cryptocurrency prices have gone into freefall and shockwaves have been felt by the market, most pointedly by institutional investors, many of whom now face an existential fight to survive.  Fellow exchange BlockFi, which held USD 10.4bn in accounts, filed for bankruptcy proceedings in the U.S. on 29 November 2022.  Others are reportedly on the verge of collapse – Coindesk has recently reported that Genesis has laid off 30% off its staff and is considering insolvency proceedings.

FTX has recovered $5bn since its crash on 11 November 2022, but the scale of losses to customers still remains unknown.  Sam Bankman-Fried's statement on Substack on 12 January 2023 suggests that millions of customers of FTX could get their money back and that “very substantial recovery remains potentially available”.
Below we consider the scope for recovering assets following the collapse of an exchange, the practicalities of how exchanges hold funds and the potential exposure to personal liability for individuals within a failed exchange.

How do exchanges hold funds?

The rapid demise of FTX was triggered by the revelation that its own token, FTT, was used as a significant portion of the balance sheet of an affiliate trading firm, Alameda Research.  FTX investors immediately lost trust and substantial withdrawals meant that FTX was unable to meet customer withdrawal demands.

However, creditors have argued proprietary rights over crypto assets within FTX's accounts.  Paras 8.2.6 (A)-(B) of FTX's terms of service stated that title to customer assets "shall at all times remain with [the customer] and shall not transfer to FTX Trading". Further, "… None of the [assets] in [the customer's] Account are the property of, or shall or may be loaned to, FTX Trading". On the face of it, client funds do not fall within the scope of FTX's assets to be distributed to, leaving billions of dollars outside the reach of creditors.

A simple retention of title argument has been attractive from a customer's perspective.  However, it is necessary to look behind the words in an exchange's terms of business and consider the realities of the exchange's relationship with its customers from a factual perspective to consider validity, not least given the global legal framework in which an exchange operates.  Paragraph 8.1.3 of FTX's Terms of Service permits the use of balances in customer accounts as "collateral for margin trading, or to fund trades, in relation to any Services or part thereof offered through the Platform by FTX or its Affiliates."  It is questionable whether such permission is consistent with the assets remaining the customer's property.

At many exchanges, client deposits are placed in a pooled "hot" wallet of commingled funds. While clients each have their account balances, their funds are not separated, and what they actually have is a simple debt claim against the exchange. Exchanges subsequently use these funds to carry out their own activities, similar to traditional banks. In the event of insolvency, the exchange would not be in a position to settle each customer debt in full.  This risk to customers is mitigated in the traditional banking world through the Financial Services Compensation Scheme and similar schemes worldwide, although such protection is not yet afforded to crypto assets.

Further complexities arise where exchanges segregate customer funds from their own funds using separate accounting ledgers, whilst using the same blockchain address to store digital assets owned by customers and those owned by the exchange.

The manner in which exchanges factually hold assets and the contractual relationship with their customers will continue to be tested over coming months.  Another fertile aspect of this debate is the extent to which an exchange can claim that it has standing to seek to recover customer assets following a hack suffered by it, or the extent to which victims of fraud may seek to recover losses directly from an exchange as a constructive trustee of assets.

Exposure to personal liability and criminal sanctions

For those working within an exchange, the above point may appear to be trite: if an exchange enters insolvency, the rankings of creditors may not be of a great concern.  Such a simplistic view should be met with caution.

Individuals working within an exchange should ensure that client assets are handled in a manner consistent with the regulatory framework applicable to that client.  Failure to comply could lead to a breach of the requirements under the Financial Services and Markets Act 2000 and similar legislation across the world, as well as potentially criminal exposure for failing to safeguard client assets.

Similarly, civil and criminal liability may arise in a personal capacity in circumstances in which an exchange fails to maintain the distinction between client and office funds.  It has been reported that FTX allowed Alameda Research to borrow unlimited customer funds understood to be in the region of $8bn and Sam Bankman-Fried has recently been indicted with counts of wire fraud and conspiracy to defraud. 

Individuals at other exchanges should take heed that being naïve is not a full defence and criminal sanctions may apply even if activities are far less nefarious than those reportedly undertaken by the individuals behind FTX.