In what can either be described as an extraordinary example of turning the negative into a positive or an extraordinary act of cynicism, the founders of the failed crypto hedge fund Three Arrows Capital, which faces $3.5 billion in creditors' claims according to its bankruptcy filings, are pitching a new crypto exchange that would allow creditors in crypto bankruptcies, most notably FTX and Celsius, to tokenize their bankruptcy claims. Given the unceasing reports of bankruptcies among the biggest players in crypto over the last year, such an exchange is bound to attract some interest, so it is worth going over what exactly it means to buy creditor claims of a bankrupt company and the possibility of tokenizing those claims.
First, a slight primer on what happens in bankruptcy is in order. When a business declares that it is unable to pay its debt obligations as they come due, it enters a court-enforced bankruptcy proceeding. The bankruptcy court then oversees the bankruptcy proceeding which, in the United States, can proceed by two routes. In a Chapter 11 bankruptcy, the business continues operating through the bankruptcy process (subject to court supervision) and seeks to exit bankruptcy as a going concern with a restructured debt. In a Chapter 7 bankruptcy, the business liquidates any remaining assets which are distributed to creditors, and if the funds remain to shareholders, and is dissolved. There are two classes of creditors in a bankruptcy proceeding. Secured creditors are those who have a lien or other security interest in specific assets of the debtor, such as a mortgage on a property. In a bankruptcy proceeding, secured creditors generally have a priority claim to the assets securing the debt. This means that they will be paid from the proceeds of those assets before unsecured creditors. Unsecured creditors are those who have extended credit to the debtor without having a security interest in specific assets. Unsecured creditors generally have lower priority than secured creditors and will only be paid—on a pro-rata basis—if there are sufficient assets remaining after the secured creditors have been paid. Almost invariably, client depositors are unsecured creditors as they did not take a security interest in any specific asset of the company.
Thus, anyone purchasing the creditor claims on a bankrupt crypto exchange is making the bet that after all the secured creditors are paid off (generally banks or other big lenders), there will be sufficient funds leftover to pay the clients whose deposits were wiped out. This is a risky bet, which reflects the highly discounted price such claims are sold for, often for pennies on the dollar. Moreover, the time horizon over which the purchaser can expect the payoff can be very lengthy. In the US, Chapter 11 bankruptcies can drag on for years in some cases, and in other countries can be worse. For example, in the Mt. Gox bankruptcy reimbursement only began last year although Mt. Gox filed for bankruptcy protection in 2014. Moreover, the market for creditor claims in bankruptcy proceedings has many transactional costs. It consists primarily of over-the-counter contracts which have to be negotiated and, in some cases, can be litigated. Nonetheless, the buying of creditor claims can be a good investment, with investors in Mt. Gox bitcoin claims earning as much as 18 times their investment. Perhaps unsurprisingly, in recent years there has been a push to standardize the terms of small claim assignments and have them trade in centralized marketplaces.
Tokenizing small claims could present the next step in facilitating a more efficient small claim assignment market, though doing so effectively would require several steps. First, it is important that the token issuer has some means of effectively verifying the actual right to the claim, and that not every person can, for example, mint tokens representing rights to the FTX bankruptcy proceeds without having had FTX deposits. Second, it would be essential that the token function as a bearer instrument for all the rights that attach to the claim, such that the holder of the token unquestionably has the right to the proceeds of the eventual bankruptcy and that such rights will be recognized by the court. The use of NFTs as bearer instruments of real-world rights could provide a good case study of how to do this – the important thing is that the terms and conditions which attach to the token unequivocally prevent the bifurcation of the token and the creditor rights or else such tokens will become worthless. However, if done correctly such a market could facilitate a more efficient market for small claims assignment and allow the value of the claims to be used as collateral in other transactions more readily.