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Irony in crypto lender filing for Chapter 11 protection

Lacey Donley

Within the bankruptcies of crypto lenders, there is a genuine irony: The centralized governmental authority cryptocurrency denounces is its savior.

Earlier this month, FTX filed for Chapter 11 bankruptcy in Delaware. Citing significant exposure to FTX, BlockFi announced this week that it, too, seeks to reorganize under Chapter 11 protection.

The Bahamas-based FTX Group selected the locale for its relaxed regulatory environment. One possible reason FTX filed for bankruptcy outside of the Bahamas is that it engaged in so-called venue shopping. Debtors using the tactic select a favorable jurisdiction or judge. Historically, Delaware and New York handle a disproportionately large number of cases.

Bankruptcy is a notably American concept. Chapter 11 allows companies to operate while reorganizing. Ireland and France only adopted similar protections in 2015. Prior to reforms in Germany, debtors remained liable for up to 30 years. Managers at bankrupt German companies were personally liable for criminal penalties. In China, the names and addresses of debtors may be published in railway stations, some accompanied by a manager’s photo.

The U.S. opted for protection over punishment. By the late 19th century, almost 20% of the American railroad had failed. Having no use for a seized track, creditors urged rail companies to continue working to pay their debts. Hence, the American bankruptcy system was born.

Why does the U.S. forgive debts even when companies have borrowed irresponsibly? It promotes entrepreneurship. Research indicates that countries offering bankruptcy protection realize greater innovation. As Theranos CEO Elizabeth Holmes, sentenced to 11 years for fraud, posed, “What would you attempt if you knew you could not fail?”

Sam Bankman-Fried, former executive of FTX, also espoused a disregard for down-side risk. He stated in his October 2022 white paper, “Possible Digital Asset Industry Standards”:

“[T]his is one of the strengths of DeFi: even during one of the largest crashes in crypto history, truly decentralized platforms didn’t suffer losses – because rather than rely on vague credit checks, they verified the assets used for margin by requiring them as collateral.”

DeFi, or decentralized finance, he claimed can withstand crashes. We’ve since seen that FTX perished for reasons opposing the strengths purported by Bankman-Fried. FTX’s insolvency followed that of two other crypto lenders, Celsius Network and Voyager Digital, both filing for bankruptcy in New York in July 2022.

Contrary to decentralization, these companies utilized centralization at calculated moments. FTX dabbled in centralization in the Bahamas, then it committed to centralization in Delaware. After all, only a centralized authority could achieve the bizarre phenomenon of bankruptcy – the counterintuitive process of protecting the wrongdoer.

The DeFi movement began with the peer-to-peer electronic cash system introduced by Bitcoin. As envisioned, peer-to-peer transactions are posted to a public ledger, thereby circumventing traditional intermediaries. However, the movement failed to specify which intermediary is dispensable. For example, DeBa (decentralized banking) might have honed the mission. Instead, DeFi proposed a small name for a big concept.

Decentralized finance might start with peer-to-peer transfers. It further implies peer-to-peer lending. A truly decentralized finance system also entails peer-to-peer debt collection – but the cryptoverse is silent on this point.

Peer-to-peer debt collection is not articulated by the DeFi movement because it’s carried out by Tony Soprano. It involves broken kneecaps and sleeping with the fishes, not protection.

Arguably, the financial industry needs improvements worthy of the insurance bankruptcy affords. Indeed, a public ledger may promote low-cost transparency. Even so, a public ledger neither regulates nor enforces. Regulations, including mandatory audits, registration of broker-dealers, prohibited proprietary trading and lengthy disclosures are ubiquitous in securities exchanges.

We mustn’t confuse the absence of such investor protections in crypto exchanges with innovation. As a first step, DeFi should coin a new acronym.

Lacey Donley is an assistant professor of accounting at Fort Lewis College and CPA.