What Happens If Your Brokerage Firm Goes Bankrupt?
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today's episode 393 is titled, What Happens If Your Brokerage Firm Goes Bankrupt?

Four years ago in the summer of 2018, for four episodes, one of our sponsors of the show was Circle Invest. It was an app to purchase and store cryptocurrency. Circle Invest had been around since 2013, and the app allowed you to buy the crypto market. You could spread your bets across a number of cryptocurrencies in one trade.

I tried it out and purchased about $500 of Zcash and Monero. My son, Camden, also tried it out. In the ads, I was very specific that cryptocurrency was a speculation. And by speculation, I mean there's disagreement over whether the return will be positive or negative.

and that in the worst case, the speculator could lose all of their investment. It could go to zero. That's what speculations are. We did the spots. We moved on. And in February 2020, a company named Voyager purchased Circle Invest. At the time, Voyager's co-founder and CEO, Stephen Ehrlich, wrote...

This product line acquisition signifies a tremendous development for Voyager as we welcome a substantial number of new users to our platform. This transaction also helps us deliver on our promise to investors, providing regulated brokerage services and resources to as many users as possible in the digital asset marketplace.

At the same time, in a blog post on the Voyager website, they wrote, we couldn't be more excited to welcome Circle Invest 40,000 plus customers to the Voyager community. Like Circle, Voyager offers a safe and licensed crypto destination with popular features like commission-free trading and instant funding with U.S. dollars.

Notice the words they used. Regulated brokerage services. A safe, licensed crypto destination.

In April 2020, I received an email from Voyager saying your Circle Invest account has been converted to Voyager. They had transferred the fund to the Voyager account and I just needed to activate it. And I could start trading dozens of top coins commission free. They wrote Voyager also offers up to 6% interest on your crypto holdings. No lockups, they said. I activated the account and forgot about it.

The vast majority of my cryptocurrency is not stored with an online broker. Instead, I use the Treasure Suite desktop app with a separate Treasure USB wallet to store my private keys. In order to access the crypto, including transferring it, I need to plug that USB key into my laptop, insert a four-digit code, and then I can access my crypto holdings. This added layer of security is a big advantage. Over

over storing cryptocurrency with a brokerage firm. Still, I have some cryptocurrency and altcoins stored at Coinbase Pro, but it's a very small amount and smaller than it was given the significant sell-off in the crypto space.

On June 14th this year, I received an email from Stephen Ehrlich, along with the millions of other Voyager customers. The email said, Hi, Voyagers. When we started Voyager, we made the decision to be one of the first public companies in the crypto industry. We could have easily kept things private and some elements of our business would have been a whole lot easier. But we didn't. We chose to be public because we are here to prioritize our customers' assets at all times, period.

That means going the extra mile to be transparent about our balance sheet and providing regular updates on the state of our assets. The market is seeing some tough volatility right now, exacerbated by the news that Celsius has paused customer withdrawals.

Ehrlich mentioned that Voyager had zero exposure to Celsius and had never engaged in DeFi lending activities. Celsius Network is a cryptocurrency lender that offered interest of up to 18% on crypto deposits. It was similar to BlockFi, a cryptocurrency lender whose account I closed in May and have talked about in a number of episodes. I closed BlockFi because

Because there wasn't sufficient transparency. And with cryptocurrencies prices dropping, I was concerned with the risk of BlockFi because they're lending money. But this was a savings account. And I knew BlockFi was lending assets. And that was the risk. That's how they funded paying interest.

BlockFi has since been struggling to stay solvent and is in the process of closing a loan to bail them out from FTX, another cryptocurrency exchange. On June 12th, Celsius Network halted custom withdrawals because they didn't have enough liquidity to meet demands. There was a bank run on the Celsius Network and they're still fighting to stay solvent.

On June 14th, in that email from Stephen Ehrlich, he assured customers they had no exposure to Celsius. Then he wrote, as many of you know, Voyager has the benefit of seasoned lenders who have been through multiple market cycles. In other words, we have the experience to plan for volatile markets and the ability to stay agile. On our balance sheet, Voyager is well capitalized and positioned to weather the bear market.

As you personally consider which crypto platform can support you through all market cycles, I urge you to look at how the company is disclosing the details of its financial position. Very few in the crypto industry are doing that today. Here's the thing. I thought along while using Voyager to hold some cryptocurrency, I wasn't earning interest. It was a custody relationship. It was just like having an account at Coinbase or Charles Schwab's for traditional assets.

I thought it was a safe and licensed crypto destination offering regulated brokerage services, as they said. Consequently, I shouldn't have to concern myself with Voyager's well-capitalized balance sheet because the crypto assets should have been segregated from Voyager's corporate assets, their lending activity, if they did any of that. The best practice for traditional brokers is to segregate those assets.

U.S. brokers, for example, must comply with SEC's Rule 15C3-3. It's known as the Customer Protection Rule. It requires brokerage firms that have custody of customers' assets to keep those assets separate from their other accounts. The cash assets and even assets that are held in securities, they should be kept separate and not commingled with the corporate assets of the brokerage.

That is best practice. On July 1st, I got another email from Voyager that stated, Today we made the difficult decision to temporarily suspend trading, deposits, withdrawals, and loyalty rewards. We understand the significant impact of this decision, which is why we tried hard to avoid it, including by securing a credit facility from Alameda Ventures and lowering daily withdrawal limits.

Voyager was also experiencing some type of bank run. But if the assets had been segregated, the custodied assets, it wouldn't have been an issue. But Voyager points out that because one of their borrowers, Arrows Capital, a $10 billion hedge fund, at least a $10 billion hedge fund this past March,

That fund's failure to repay a substantial loan to Voyager led them to halt withdrawals. They continue, as a result, while far from optimal, this decision gives us time to strengthen our balance sheet, a necessary condition to protect assets and preserve the future of the Voyager platform we have built together.

Voyager Digital lent 15,250 Bitcoins and $350 million in U.S. dollar coins to Three Arrows Capital. That amounted to about $666 million between the USD and the Bitcoin. Supposedly, Voyager, who benefits from seasoned lenders who have been through multiple market cycles, made a huge bet.

a hedge fund that had bet over $600 million of their assets in Luna, an altcoin that fell to zero. We discussed Luna back in episode 387, why most money fails. Now the lawyers for Three Arrows Capital can't even find the founders. The founders have gone missing. The hedge fund needs to liquidate, but Voyager has exposure to

to Three Arrows Capital. And as a result, on Wednesday, July 6th, Voyager filed for Chapter 11 bankruptcy. At the time, the company said it had three and a half million active users and over a billion in cryptocurrency assets.

Later that week, in Voyager's first bankruptcy hearing before U.S. bankruptcy judge Michael Wiles in Manhattan, Voyager attorney Christopher Marcus of Kirkland & Ellis said the company had proposed a bankruptcy restructuring plan as early as it could in order to assure customers that they had not, quote, lost everything after the company froze their accounts.

Marcus said the company's management had received personal threats because customers were angry. Marcus said, we are focused on a path forward. It is not correct to think that there is no hope.

Here's the thing, though, according to Reuters, even though Voyager is trying to reassure customers, and I've gotten emails from them, their attorneys argued in bankruptcy court that their customers, Voyager's customers, did not own the specific crypto assets in their accounts. Voyager considers those assets to be the company's property, saying that its customers hold unsecured claims

for the value of their assets. Rather than keep them segregated, they were commingled and now they're considered unsecured claims against Voyager. That's egregious. Now, Voyager drew a distinction between the assets that it had in cash because those were actually held at Metropolitan Commercial Bank, which has FDIC insurance.

Judge Wiles said at the hearing he wasn't even sure Voyager had filed the right bankruptcy case, that it wasn't clear legally that Voyager owned the crypto assets. Typically, when there's a brokerage bankruptcy, it's liquidated and customer accounts are protected.

Voyager, on the other hand, who supposedly believes their customer assets are the most important thing, their loyalty to them, argues that their customers are unsecured creditors and that they own the customer's Bitcoin that they hold on the Voyager app.

In a traditional brokerage bankruptcy, and this is from a memo by Ropes and Gray, a traditional broker dealer in the U.S. is not eligible to reorganize under Chapter 11 like Voyager is trying to do. Typically, there's a liquidation proceeding, and it's done under the provisions of the Securities Investors Protection Act.

The Securities Investors Protection Act established the SIPC, a nonprofit organization that was created in 1970 that provides protection for customers if their broker goes bankrupt or if the securities are stolen. Up to $500,000 in securities and $250,000 in cash. And that $500,000 coverage is for each legal customer.

So each account, if there's one held individually, one is in a joint account and perhaps an individual retirement account, each account is considered a separate legal customer and gets that coverage. There is no SIPC or other insurance coverage with crypto brokers because they're not registered with the SIPC. When there is a broker that goes under, typically those customer assets, which

which have protection, they're transferred to a different broker.

Voyager was far from a traditional licensed broker, even though they said they offered regulated brokerage services and were a safe and licensed crypto destination. They didn't segregate the custodial assets. They were not a member of SIPC, so no insurance. And in bankruptcy, rather than seeking protection for its clients' assets, it argues that those assets are the company's. Before we continue, let me pause and share some words from this week's sponsors.

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Voyager presented a reorganization plan, and they outlined this in a blog post and an email. They said customers that had their cryptos stored at Voyager would get a pro rata share of crypto, a pro rata share of proceeds from the

the 3AC, the three arrows hedge fund recovery, if there is anything. They would get pro rata shares of common stock in the newly reorganized Voyager company, and they would get a pro rata share of existing Voyager tokens. I'm not sure what those are worth, but probably close to zero.

There were customers that had well more than the $250 or so I have with Voyager at this point. One user, it goes by Robert, didn't give his last name, said he had about $100,000 on the platform, 70% of his life savings. Every day, honestly, I cry, Robert said. I don't know what to tell my wife. As partners, we decided to invest on Voyager, but she trusted me more than anyone else to make the proper decision.

Robert said, I had no idea that Voyager would be lending customers USDC out to a hedge fund. Had I known that it would be possibly lent out, I probably would have just kept it in cash in my safe. Voyager didn't really describe, at least in their emails to me, what they were doing. Again, I thought it was a brokerage. Even last month on the

The money for the rest was plus for him. A member asked, had I looked at Voyager to replace BlockFi? This member kept some USDC at Voyager was paying 9% and mentioned the Voyager was soon coming out with a debit card to spend USDC, the stable coin, just like cash.

The member wrote, I just hope they aren't investing it riskily like you mentioned BlockFi was. I think they do loans with it so people don't have to cash out and create a taxable event. But I really haven't looked into what they're doing with my USDC. They're U.S. based and regulated, I believe. Just thought it might be worth looking into replace BlockFi.

I replied, I've not looked closely at Voyager, but they have a definite advantage in that they are publicly traded, so there are financial statements and releases to better analyze risk. Still, the company went bankrupt within a month.

Another customer of Voyager was Scott Melker. He says he has seven figures worth of funds with Voyager. Listen, I'm out of millions of dollars, he said. And he says he's embarrassed about being overexposed to Voyager, despite often talking about risk management and protecting assets. He said, I understand that people make their own decision, but they wouldn't have even thought about it if I had not brought Voyager to their attention. And

And frankly, that's worse than losing my money. Online cryptocurrency custodial accounts have no protection. They are at risk if the company goes bankrupt, unlike traditional brokerage firms.

Coinbase, where I mentioned I have some crypto assets, in their March 31st, 2022 statement, they said they had $256 billion in custodial fiat currencies and cryptocurrencies on behalf of customers. And in that disclosure, they said because

Custodially held crypto assets may be considered to be the property of a bankruptcy estate. In the event of bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings, and such customers could be treated as our general unsecured creditors.

That's what's happening with Voyager. Unsecured creditor will not get all their money back. Now, this risk disclosure by Coinbase said, if customers knew this, and most probably did not, it could result in customers finding our custodial services more risky and less attractive, which means maybe their clients will leave and move their crypto assets out. Yeah, they should.

When a traditional broker goes bankrupt, FINRA, which is the regulator for brokers, said in virtually all cases, when a brokerage firm ceases to operate, customers' assets are safe and typically are transferred in an orderly fashion to another registered broker. There are multiple layers of protection. The customer's accounts are segregated.

There are minimum capital requirements that brokerage firms have to exceed to provide a buffer in case of losses. There's the insurance, the Securities Investors Protection Corporation.

There is a process in place to liquidate these brokers. Even when there's lending by brokers, such as securities lending, when a broker lends out securities that a client can give permission for the brokerage firm to lend out some stock holdings that a customer might have, and then they can earn some additional interest. When they do that, they're over collateralized.

The broker requires collateral, which is typically cash, treasury bills, or other government securities. And they require 102% value of the securities for each dollar lent. It's very, very low risk. They're not lending your securities to hedge funds that are taking big bets on other cryptocurrencies.

The risk of a brokerage failure, a traditional stockbroker, a Schwab, a Vanguard, a Fidelity, incredibly, incredibly low. When brokers in the past have commingled accounts, there has been regulatory action taken against them. MF Global was a brokerage firm that dealt with commodities. John Corzine, who was a

a former U.S. Senator and New Jersey governor, joined MF Global in 2010. He wanted to turn this commodities organization into an investment bank. And the Commodities Futures Trading Commissions filed an enforcement action against MF Global in 2013 because MF Global failed in 2011. They took big bets. And as they did so, they were running low on cash. And

And they dipped in to over a billion dollars of customer funds. Their treasurer at the time, in October 2011, said MF Global was skating on the edge without much ice left. He said, we have to tell John that enough is enough. We need to take the keys away from him because they were trying to save the firm by going after customers' deposits for liquidity.

The firm failed and the customers got paid back and there was an enforcement action against MF Global. David Meister, the CFTC's enforcement director, said, turning a profit is not the only job of the person at the top of a CFTC regulated firm. Particularly in times of crisis, the person in control, like the CEO here, must do what's necessary to prevent unlawful uses of customer money. So,

so that customers' money is still there if and when the music stops. Crypto brokers aren't doing any of that. They're not segregating their customers' money. In many cases, could be taking big lending risk, even though they say they're experienced lenders. It's unacceptable. It's a blatant disregard of acting in the client's best interest, of acting like a fiduciary.

It's no wonder cryptocurrency isn't taken seriously by many in traditional finance, because they don't act like traditional finance with the protections that are there. Consequently, don't keep your cryptocurrency assets with a brokerage firm unless you're willing to lose it all. In fact, don't hold any crypto unless you're willing to lose it all. We've seen crypto fall 80% or more.

Cryptocurrencies make up only about 3% of my net worth. It has been higher in the past, and I have sold cryptocurrency to lock in gains, and I've lost money on cryptocurrency. But I was willing to do that. I scaled my position. One of the things that bothers me about the crypto space is a lot of the advertising that play on consumers' fear of missing out, that they have to get caught up, that they're falling behind, and cryptocurrency is the way to do that. It

It's not. It's a speculation. We can lose it all, just like we're seeing in so many cases.

Cryptocurrency is private money. It's uninsured. It's incredibly volatile. Be careful both how you invest in crypto and be careful how you store crypto. And if you have meaningful amounts, get it out of these brokerage firms and store it offline using something like Trezor, T-R-E-Z-O-R, that I use. And

One of the other risks that Coinbase points out is they could lose the private keys for the crypto assets that they custody, and the money could be lost that way also. So be very, very careful when dealing with speculations like cryptocurrencies and where you hold it.

As for traditional brokers, holding your stocks, your IRAs and other assets, you're okay. There are definite layers of protection and those protections need to be there for all types of brokerage firms, including crypto brokers. That's episode 393. Thanks for listening.

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