After multiple "giants" have gone bankrupt one after another, it is time for the crypto industry to stop its "barbaric growth."

Written by: LawPanda, an American lawyer focused on DAO compliance

Compiled by: Bai Ze Research Institute

Centralized cryptocurrency trading platforms such as FTX, Binance, Voyager, Celsius, and BlockFi (often referred to as Crypto Banks) seem to exist in a regulatory gray area—a space that fosters irresponsibility and may harm retail investors and the entire industry.

While many retail investors believe that these companies, registered in various jurisdictions and sometimes publicly disclosing information, have undergone regulatory scrutiny and consumer protection requirements, the reality is often different.

If a company can sponsor a Super Bowl ad, how could retail investors not think that the company has appropriate risk management or compliance processes? Unfortunately, as the bankruptcy turmoil of Three Arrows Capital spread to various "crypto banks" (owing up to $3.5 billion to 27 different companies), it became clear that regulators were busy complaining about DeFi but had no time to truly regulate these centralized crypto entities.

Celsius Network is one of the major "crypto banks." Since its establishment in 2018, Celsius has gradually grown to become one of the largest asset management companies in the crypto industry, managing approximately $12 billion in assets as of May 2022. Celsius uses its token CEL in a manner similar to equity, but it is completely unregulated. The lack of proper regulation, combined with other factors, led to Celsius filing for bankruptcy in June 2022 after freezing customer funds and suspending withdrawals. After filing for bankruptcy protection, retail investors suffered significant losses.

"Crypto Banks" Are Not Actually Banks

Celsius and other similar "crypto banks" are not regulated like traditional banks and financial institutions, meaning that customers' investment losses are not insured by the Federal Deposit Insurance Corporation (FDIC) or protected by the Securities Investor Protection Corporation (SIPC). According to former New Jersey Acting Attorney General Andrew Bruck:

Due to the volatility of the cryptocurrency market and the lack of regulation, these platforms pose higher risks to investors.

Essentially, Celsius and other "crypto banks" are not under the supervision of regulatory agencies. However, since Celsius uses its native token CEL as an equity issuance—therefore, it should be subject to oversight by financial industry regulators. Unfortunately, this is not the case.

How Safe Are "Crypto Banks"?

Regulatory scrutiny is often associated with assets classified as securities; however, Celsius claims in its "Risk Disclosure" that the CEL token is not a security:

[CEL] tokens have not been and are not intended to be registered under U.S. securities laws, U.K. Financial Services and Markets Act, or any other applicable laws in any jurisdiction. These constraints may limit the transferability, value, and liquidity of the tokens. Celsius does not intend to register the tokens for trading on any securities exchange. In the absence of clear regulation, there is a risk that [CEL] may be considered a security, financial instrument, specific investment, or other regulated asset.

Although CEL may not be viewed as a security by regulators, Celsius certainly uses it as one. An article from Seeking Alpha in 2021 explained this best:

[CEL] is used by the company as a security (like stock) and a utility token. Celsius can conduct token sales to raise funds, it can be used as collateral for loans, and to provide liquidity. It is also used to pay weekly dividends, which are conducted in the form of buybacks, where Celsius purchases [CEL] on the open market and deposits it into your account every Monday.

Furthermore, the SEC (U.S. Securities and Exchange Commission) pointed out in its 2019 report "Digital Assets: Framework for 'Investment Contract' Analysis" (a report aimed at defining which digital assets are considered securities) that certain characteristics of digital assets, while not necessarily determinative, may also make them securities. For example, if a digital asset relies on the "efforts of others" (active participants), it is more likely to be classified as a security:

[Active Participants (AP)] create or support the market price of digital assets. For example, this can include an AP that: (1) controls the creation and issuance of the digital asset; (2) takes other actions to support the market price of the digital asset, such as through buybacks, "burning," or other activities to limit supply or ensure scarcity.

Celsius continuously buys back CEL and uses mechanisms to increase prices by limiting supply, which clearly fits this description. According to a report from Arkham Intelligence, Celsius has used CEL in various ways to support its market and potentially manipulate the token's price.

Market manipulation refers to any attempt to interfere with the free and fair operation of the market. While there are regulations against market manipulation, there are no specific regulations targeting cryptocurrencies or crypto entities like Celsius. In publicly traded companies, regulations regarding market manipulation typically prohibit market participants from trading based on price-sensitive information (information that may affect the company's stock price) or artificially promoting stocks. Therefore, as an investor, you cannot take advantage of other investors without sensitive information.

Unfortunately, "crypto banks" do not have the same insider trading protections as banks or publicly traded companies. However, this situation may be changing.

Recently, the U.S. Department of Justice (DOJ) charged a former Coinbase product manager and two employees with wire fraud and insider trading. The DOJ stated in a press release that the employee shared specific information about which cryptocurrencies would be listed before the tokens went live. Subsequently, the SEC also brought insider trading charges against the three individuals.

Valued at $1 Billion Even in Bankruptcy (Though They Cannot Sell the Tokens)

When filing for bankruptcy protection, Celsius claimed to have over 1.7 million users and debts of up to $4.72 billion in frozen customer funds. The company only has $1.75 billion in crypto assets, excluding its holdings of CEL tokens, of which it holds approximately 658 million CEL tokens valued at around $600 million. This includes 279 million tokens owed to customers, leaving only 379 million tokens remaining.

During the market surge on August 15, 2022, the CEL held by Celsius appreciated to about $1 billion, nearly double its value at the time of filing for bankruptcy protection.

Although this seems like a windfall, most of the CEL token supply is locked on the platform, and the liquidity of CEL on cryptocurrency exchanges may be too low to support large trades. This is particularly important as Celsius is expected to run out of funds by October 2022. However, if the company attempts to sell part of its held CEL tokens to cover the asset-liability gap, the price of CEL is likely to drop to zero. "The assets held by Celsius could be worth nothing," said Thomas Braziel, founder of 507 Capital, an investment firm that provides financing for bankruptcies and restructurings. He further added that even if Celsius files for bankruptcy, the debts will still exist, as CEL token holders may seek claims against Celsius.

Lack of Disclosure and Transparency

Even if some centralized crypto companies choose to disclose their financial assets, you may still be unable to accurately assess their financial value.

In traditional finance, the most common method for valuing stocks is calculating the company's price-to-earnings ratio (P/E). The P/E ratio equals the company's stock price divided by its most recently reported earnings per share. A low P/E ratio means that investors buying the stock are getting an attractive value. For companies like Celsius, due to the lack of disclosure, retail investors do not know what happens to the funds when Celsius has a large amount of capital.

Celsius uses the CEL token as a security, and its price surge gives the impression that the company is performing well; this also significantly inflates Celsius's overall valuation. Although there is still debate about which tokens are securities and how they should be regulated, centralized "crypto banks" operating in a regulatory gray area should not issue equity tokens due to the potential for abuse.

Will More Crypto Institutions Go Bankrupt?

Although the cryptocurrency market has not fully recovered from the bankruptcies of top entities like Celsius and Three Arrows Capital, another cryptocurrency trading platform, FTX, collapsed in November 2022. While the reasons behind FTX's bankruptcy are much more complex than those of Celsius, a major reason was that most of the net assets held by the quantitative trading firm Alameda, associated with FTX, were FTX's native token FTT, which, like CEL or any trading platform token, became illiquid during the "trust crisis."

This once again highlights some potential issues with "crypto banks" and their regulation.

Whether it is Three Arrows, Celsius, or FTX, their bankruptcy turmoil further underscores the necessity of establishing appropriate regulations in the crypto industry to oversee centralized entities: to prevent them from wrongdoing.