The FTX problem – do you really own your tokens?

The news cycle is awash with reports of the insolvency of the various entities which operated the ‘FTX’ group of exchanges. That includes two Australian entities, FTX Express Pty Ltd and FTX Australia Pty Ltd, both of which appointed KordaMentha voluntary administrators  yesterday,  11 November 2022.  

Tim Edwards, who is a Parter and the Head of HopgoodGanim’s Digital Assets Practice, outlines some key takeaways arising from this controversial situation.

It may be weeks before the public is able to learn precisely what went wrong there. The upshot of the allegations in the media is that the exchanges were purporting to hold funds for customers, but then using those funds how they liked without keeping enough in reserve to meet withdrawal requests when they came in. The result was allegedly a situation reminiscent of a ‘bank run’ of the kind seen throughout the Great Depression era. Not a good marketing pitch for crypto. Regardless of the specifics, the fact it is possible for such a large and prominent exchange to end up this situation points to two obvious key shortcomings that need to be remedied.  

The first pertains to regulation and oversight. That’s a topic for another article and varies from jurisdiction to jurisdiction. The custody of digital assets is subject to limited regulation in Australia and is likely to be the subject of upcoming reform. That said, don’t forget that FTX Australia Pty Ltd has an AFSL; it wasn’t entirely unregulated, by any stretch of the imagination. 

The second key shortcoming is something that insolvency lawyers will find familiar: uncertainty or misapprehension, in the minds of exchanges and investors alike, as to who actually owns the digital assets held by a digital exchange. The issue is rarely as simple as it sounds in an insolvency context.  In my experience, most people seem to assume that tokens they purchase and leave on an exchange are their property at law. Unfortunately, many of them are wrong.

Exchanges are different to banks and should not be treated like banks.  But for context, even banks don’t give you true ownership over money held in your bank accounts. The bank owns the money, and you only own the right to ask them to give you that money. That’s why banks use the term ‘account’.  That system works fine in Australia because Australian banks are heavily regulated and backed by the Commonwealth. But exchanges aren’t, and they can work very differently. Generally speaking, modern digital asset exchanges do one of three (3) things:

1. hold tokens on trust for users. This means the exchange holds legal title to user tokens, and users retain a beneficial interest in the tokens. There are two key implications of this. The first is that users don’t typically have to join the line of unsecured creditors in a liquidation scenario; trust property usually sits outside the liquidation pool. The second is that exchanges using this model likely owe stringent duties as trustee to their users. They will therefore need to be careful to do things like adequately segregate user assets, use them only as directed or permitted, and keep good records. These obligations can be extremely onerous for some businesses;
2. in truth, borrow user assets, but agree to return them when asked. Why is this good for the exchange? Namely, flexibility – subject to their terms and conditions and local financial services laws, such exchanges can potentially do what they like with a user’s assets until the user asks for them back – invest them, trade them, whatever. Why is this bad for the user? Well, if the exchange goes under, the user is then typically just another unsecured creditor standing in line with every other unsecured creditor. On the other hand, some exchanges utilising this model can and do offer very lucrative terms to their users – they can afford to, because they’re able to trade with user assets to earn additional revenue. Still, users need to be aware what they are giving up in exchange for this perk. Some Australian providers use this model. Critically, I should also mention that an arrangement will not necessarily be a loan, as opposed to a trust arrangement, just because an exchange describes the arrangement as a loan in its terms and conditions and/or its books and records. The Australian Courts look for substance over form in that regard, and exchanges need to be careful that any monies they treat as borrowed are not actually trust property; or 
3. take no interest in user’s assets, leaving both legal and beneficial title with the user. This leaves the exchange as little more than a secure digital interface between buyer and seller (think eBay), and typically this model is seen in decentralised exchanges with no centralised operator. Decentralised exchanges are often the hardest to access and use for all but the very tech savvy, but they are still the favoured option of crypto diehards looking to keep control of their own money.   

So how do you discern which arrangement an exchange is utilising?  

By analysing both their user terms and conditions, and their actual conduct – that is, how they actually treat investor assets in practice.  The relevance of conduct why I have said above that the mere fact an exchange says and believes it is utilising a particular arrangement, does not necessarily mean that it is. 

Discerning which sort of arrangement is being utilised is critical for investors and exchanges alike.  It’s important to investors for obvious reasons, but it’s important to exchanges too because they need to know what they can and can’t do with investor assets, and what policies they need to implement and follow in order to avoid breaching a myriad of legal obligations.  Again, exchanges should not assume that just because their terms say their arrangement is a loan, that it really is.  Substance over form is key.

So what should exchanges do now?  

Make sure they are comfortable that they know the nature of their relationship with users and what obligations that imposes on them.  What should investors do?  Make sure they understand the arrangement they have with their exchange before they deposit funds or assets; and remember, as a general rule, that whoever exclusively holds the private keys to a digital asset controls that digital asset. 

For more information please contact Tim Edwards or our Digital Assets team.