Navigating the Crypto Maze: Mitigating Risks and Maximizing Opportunities

The cryptocurrency market has captivated both retail and institutional investors, cementing its status as a fast-developing yet high-risk asset class. Global adoption has surged, with the total market capitalization reaching over $2.57 trillion.¹  As investors and businesses alike seek to capitalize on the potential of this dynamic market, navigating the complex crypto maze has become crucial.

The current state of the cryptocurrency market reflects both the immense potential, and the inherent risks associated with this novel asset class. On one hand, the global cryptocurrency trading volume in one recent 24-hour period alone² was $100.80 billion, highlighting the significant capital inflows and liquidity in the crypto ecosystem. But the market is also prone to extreme volatility, as evidenced this year, when the total market capitalization dropped from $2.51 trillion in May 2024 to $1.95 trillion as of early August.³

The lack of regulatory oversight has enabled fraudulent activity and led to unsustainable business models. Investors have fallen victim to these schemes, leading to losses and a tarnished reputation for the crypto industry. Kroll’s recent successful restructuring of the Vauld cryptocurrency exchange in Singapore exemplifies the challenges faced by stakeholders navigating the complexities of the crypto landscape.

Due Diligence and Risk Mitigation in the Crypto Sphere

Comprehensive due diligence is the key to success in the crypto markets. By delving into the nuances of blockchain networks, token economics and cross-border legal implications, investors can position themselves to weather the volatility of the crypto space. This research-driven approach allows them to identify and mitigate the unique risks inherent in digital assets, including the ongoing threat of fraud and insolvency.

Investors must adopt a rigorous due diligence process that goes beyond the surface-level analysis of market trends and price movements. Uncovering the technical specifications of the underlying blockchain, the tokenomics and incentive structures, and the regulatory landscape in relevant jurisdictions is essential. This level of scrutiny enables investors to understand the potential vulnerabilities, assess the viability of the project and make informed decisions that align with their risk appetite and investment objectives.

Unlocking the Long-Term Potential of Cryptocurrency

To navigate the crypto maze and mitigate the inherent risks, thorough due diligence encompassing commercial, legal and operational considerations is paramount. The terms and conditions and the underlying operational structure of a crypto business are crucial in determining the nature of an investor’s claim to the digital assets.

A key distinction lies in whether the tokens are held under a proprietary claim or a personal claim. Under a proprietary claim, typically structured through a trust arrangement, the counterparty owes a fiduciary duty to customers, and in the event of insolvency, depositors will have to be paid back exactly the tokens they deposited. This is achieved through segregated wallets and accounts for each depositor, ensuring no confusion between the operational funds and the balance sheet of the business. In contrast, a personal claim means that, in the event of insolvency, depositors will become unsecured creditors of the company, ranking equally alongside all other secured creditors, with no guarantee of receiving the exact tokens they deposited.

In our experience, centralized exchanges do not have operational structures that lend themselves to trust arrangements, particularly with the typical hot wallet/cold wallet structure used to commingle user deposits with the business’s operational funds.

Another key indicator of whether a trust arrangement is in place is the ability for the business to deal in customer assets without their explicit approval. For example, crypto lending business models require the business to have the contractual and operational ability to redeploy user capital to generate yield, such as in the Vauld case study, where users were classified as unsecured creditors of the business and not under any form of trust arrangement.

In contrast, crypto custodians who hold crypto under trust arrangements will typically have specific segregated on-chain wallets for each customer. These wallets can only be accessed via a multi-signatory approval structure that requires the explicit approval of the user to authorize transfers and transactions. Crypto technology evolves rapidly, and keen insights into the latest state of technology and implications for operational implementation are best obtained from technically-minded professionals who live and breathe blockchain technology.

The entity structure and jurisdiction of the crypto business also have profound implications. Jurisdictional variations in insolvency law can lead to vastly different approaches to how crypto is viewed (as property or money) and handled in terms of claims and distributions. This can significantly impact the value of recovery, as token distributions allow for the price movement (and risk) of the distributed token to be assumed by the recipient, while distributions in fiat call into question the basis of the valuation, which in the context of crypto’s significant volatility can result in materially different claims held by creditors. In the Vauld case study, the Kroll team that facilitated the platform’s restructuring was able to leverage the flexibility of a Singapore scheme of arrangement to cater to creditor preferences and make distributions in tokens. This is not a given, though, as many jurisdictions have legal frameworks that do not allow in-specie distributions and only authorize distributions in fiat.

Segregated wallets provide a clear-cut solution, but commingled assets require a detailed understanding of operational approach to token custody and resource utilization.

The operational approach of the crypto business is also a crucial consideration. The extent to which token assets are blended can make it challenging for creditors to determine which tokens belong to them. Segregated wallets provide a clear-cut solution, but commingled assets require a detailed understanding of operational approach to token custody and resource utilization to understand deposits and allocation—a process that can be severely compromised if key knowledge-holding employees leave or are terminated. This was a fundamental consideration in the Vauld restructuring, where Kroll professionals prioritized the maintenance of key employee arrangements and infrastructure to ensure the support system was in place to facilitate an orderly restructuring for the benefit of creditors. Without this emphasis, a liquidation scenario would have taken significantly longer and cost significantly more, which would adversely affect creditor recoveries.

While thorough due diligence is essential, it is important to recognize that the crypto market remains a high-risk asset class that is not yet globally understood and consistently regulated. Insolvency risk remains material, and partnering with professionals experienced in the fast-moving crypto space is critical to ensuring downside is protected in the event of market volatility.

The Growing Importance of R&I Professionals in Crypto

As the regulatory landscape evolves, the role of restructuring and insolvency (R&I) practitioners becomes increasingly important. R&I professionals like Kroll can provide valuable expertise in navigating complex cross-border issues and the unique nature of cryptocurrency cases. This expertise can be leveraged to mitigate investors’ risk through pre-investment diligence or to assist cryptocurrency companies in understanding restructuring options for business planning.

As technology evolves, the need to factor in a technical understanding of blockchain mechanics and how it translates to operational implementation gets more pronounced. Professional blockchain analysis teams like Kroll’s Investigations, Diligence and Compliance team perfectly complement the commercial acumen of Kroll’s R&I team to work hand-in-glove on such assignments to carry out an in-house, multi-faceted assessment from commercial, legal, and technical angles for a holistic view of the crypto business under assessment.

The cryptocurrency market presents both immense opportunities and significant risks. By conducting rigorous due diligence, understanding the legal and operational intricacies and partnering with experienced professionals, investors and crypto businesses can navigate the crypto maze and maximize the potential of this rapidly evolving asset class.