Safeguarding Assets in Times of Financial Crisis

Ranking Banks, State-Chartered Trust Companies, and Cryptocurrency Fintechs

Introduction

The financial system is a complex organism. Understanding the intricacies of banking structures and the implications of insolvency is crucial for protecting one's hard-earned assets. Three common scenarios that individuals and businesses might face in times of financial crisis are bank receivership, state-chartered trust company receivership and bankruptcy, and cryptocurrency Fintech bankruptcy.

While these situations involve the management of insolvent financial institutions or companies, the differences between them can significantly impact the safety and recovery of one's assets. In this article, we'll explore the distinctions and explain why having assets in a U.S.-regulated bank could be far superior if insolvency becomes a reality.

Legal Framework and Oversight

Banks are not eligible to become debtors under Chapters 7 and 11 of the Bankruptcy Code and are generally thought not to be subject to the Bankruptcy Code. When a bank faces insolvency, it enters a state of receivership. This process is regulated and overseen by federal regulatory agencies, namely the Federal Deposit Insurance Corporation (FDIC) in the United States.

The FDIC's primary role is to ensure that insured deposits are protected, and it works to minimize disruptions to the financial system. Most often, the FDIC will cover the hole in the failed bank’s balance sheet and help transition the troubled bank’s assets and liabilities to new ownership by a stronger bank that can withstand the risk.

The Federal Deposit Insurance Act (FDIA) grants depositors priority in the event of failure. This means that if the FDIC sells off the bank and repays depositors the amount they have insured, the FDIC will be entitled to the rights and claims of the depositors. As a result, the FDIC becomes the largest preferred creditor of the estate.

Additionally, the FDIC, in its role as the receiver, is given legal powers that are either the same as or stronger than those of a bankruptcy trustee.

Insolvency is handled differently with state-chartered trust companies. State-chartered trust companies usually start in a receivership. The receivership process for these entities is generally subject to particular state laws and court systems, which can vary significantly from state to state. The lack of uniformity in the process can potentially lead to confusion and longer resolution times, especially if it results in bankruptcy.

Prime Trust is one such example. Prime Trust is a Nevada-chartered trust company that, as a FinTech, aimed to provide B2B custody, escrow, compliance, fiat processing, transaction software, and other services.

Unfortunately for its customers, Prime Trust was placed in receivership by Nevada’s Financial Institutions Division (NFID) in June 2023. There is no insurance guarantee for any of the shortfalls, so the NFID is working under the laws of Nevada to maximize value for depositors.

Under receivership, a special committee was appointed and that committee has now filed for Chapter 11 Bankruptcy as of August 2023. The end result of recovery is yet to be determined. It's likely this case will set a precedent for customers looking to assess the risk of using Nevada-chartered trust companies in the future.

Lastly, there are examples of cryptocurrency Fintechs like FTX, Voyager, and Celsius Network that misappropriated user funds and/or committed outright fraud, causing them each to go bankrupt.

The courts have decided that the cryptocurrency held by these exchanges is the property of the bankrupt company’s estate, not the property of their respective customers. By placing funds on the Fintech platform, users were giving up ownership of the assets according to bankruptcy proceedings.

The recovery is ongoing for these three cases and attorneys are enjoying much of the spoils as they argue a myriad of issues in bankruptcy court. To be sure, the process is long, arduous, and expensive regardless of the outcome. Sadly, customers will only recover a fraction of their cryptocurrency.

Deposit Insurance

Banks that are members of deposit insurance programs, like the FDIC in the U.S., provide a level of security for depositors. In case of insolvency, insured deposits are typically protected up to a certain limit (e.g., $250,000 per account in the U.S.). This ensures that a significant portion of customer funds remains safe even if the bank fails.

For cryptocurrency at a regulated bank, it is clear that the FDIC will not cover any losses. However, one could surmise that the structure of receivership vs. bankruptcy lends itself to a greater likelihood of recovery in the event of insolvency.

State-chartered trust companies might not always offer the same level of deposit insurance as banks. The absence of a standardized insurance program means that the protection of customer assets could be limited, exposing customers to potentially more significant losses.

As seen with cryptocurrency Fintechs, customers are most at risk since there is limited insurance and the bankruptcy courts assert that customer assets are a part of the failed company’s estate. This means that other creditors may be in line for recovery ahead of their customers.

Asset Recovery and Timelines

In bank receivership, the goal is to stabilize the bank's operations, sell off assets, and return assets to depositors as quickly as possible. The FDIC, for instance, typically aims to ensure that insured depositors have access to their funds within a short period, often over a weekend.

Receivership for state-chartered trust companies might involve complex legal processes that extend over longer periods. Delays in asset recovery could leave customers waiting for extended periods, causing financial strain and uncertainty.

The receiver for a state-chartered trust company may take the company through bankruptcy protection as in the case with Prime Trust. This process will no doubt take several months to complete.

A similar scenario to state-chartered trust companies likely plays out for insolvent cryptocurrency Fintechs. The process has shown to draw out for several months or years as creditors vie for position and courts grapple with complicated challenges for not-yet defined legal issues.

Other Solutions

Many states have established legal frameworks for entities that provide cryptocurrency services.

New York State Department of Financial Services (NYDFS) began issuing non-deposit trust company charters to virtual currency businesses in 2015 as an alternative to the BitLicense.

Wyoming, Nebraska, South Dakota, and others have moved to create specialty entities, but much of how the courts would handle these entities if they became insolvent isn’t fully known.

Custodia, a full-reserve financial institution in Wyoming, was licensed to become a Special Purpose Depository Institution (SPDI) alongside Kraken. The argument is that these SPDIs offer better customer protections because they are also exempt from the federal bankruptcy process and they are specifically designed for digital asset custody.

Conclusion

In conclusion, while no one hopes to experience financial institution insolvency, understanding the key differences between bank receivership, state-chartered trust company receivership and bankruptcy, and cryptocurrency Fintech bankruptcy is essential for safeguarding one's assets.

Opting for a bank that is part of a deposit insurance program can provide you with a more predictable and secure path for asset recovery in the event of insolvency. The established legal framework, standardized procedures, and governmental oversight associated with bank receivership offer a level of protection that state-chartered trust companies and cryptocurrency Fintechs do not provide.

The wildcard is the new SPDI structure. While these services are new and not yet available in all states, it is also not completely known what would happen in the event of insolvency. It’s presumed that a receivership process would be the path to best protect customers. Let’s hope full-reserve and profitability are possible (without the ability to lend like a normal bank).

When choosing where to entrust assets, it is wise to consider the regulatory environment and deposit insurance options available to ensure financial well-being, even in the worst-case scenario.

If we had to rank them from safest to least safest with the information available today, here are the results: 1) Banks, 2) SPDIs, 3) State-Chartered Trusts, and 4) Cryptocurrency Fintechs.

The last question is, which banks will emerge as leaders in this space? They are no doubt coming!

Self-custody was not addressed in this article as we only set out to make third-party comparisons for relative safety.