Crypto's Biggest Investors Played a Role in Its Downfall

After the highs of 2020 and 2021, the crypto industry fell down to earth with a nasty bump last year. Not only did the crashes decimate investors' portfolios, but some investors lost everything when their crypto platforms collapsed. Now that the dust has somewhat settled, we're learning more about what caused those platform failures -- and how they might have been avoided.

A recent report from the Federal Reserve Bank of Chicago analyzed the bankruptcy filings of FTX, Celsius, Voyager Digital, and Genesis. In particular, it looked at withdrawals from the platforms in the 90 days before their bankruptcy declarations. The report highlighted one striking aspect of the crypto runs: The biggest investors were the quickest to withdraw their assets. Not only did this contribute to the platforms' downfalls, it also meant big investors were able to recover more of their assets than smaller ones.

How big crypto investors contributed to crypto runs

Bank runs (and crypto runs) happen when large numbers of customers get spooked and try to withdraw their funds en masse. A lot of financial institutions only keep a limited amount of money in liquid assets, so as fear snowballs into panic, a run can quickly cause a collapse or bankruptcy.

The Fed's analysis of last year's crypto platform collapses illustrates exactly this behavior. For example, it shows that 37% of customer funds were withdrawn from FTX in the five days before the platform declared bankruptcy. Indeed, it says almost all of the withdrawals took place in the final two days of FTX's operations. "In response to negative shocks, customers had an incentive to run in order to avoid taking losses that would be borne by others," it says.

The researchers were also able to pinpoint the types of investors who got out quickly and, in doing so, contributed to the runs. "The runs were spearheaded by customers with large holdings, some of which were sophisticated institutional customers," it says. For example, it estimates that accounts of over $1 million accounted for 35% of all the Celsius withdrawals.

Can large investors really tank a crypto platform?

Investors with over $500,000 or $1 million saw the warning signs and reacted quickly. The trouble is that in the scenario of a bank run, when large investors start to withdraw their assets, it's like pouring oil on a fire. Large investors can also have an outsized influence on crypto prices. So-called crypto "whales" can impact the market through their activity, enabled, in part, by limited levels of crypto regulation.

However, the huge investors are only part of the problem. The Fed report says that, in their efforts to generate high returns, the now-bankrupt platforms didn't keep big enough liquidity buffers. It also points out that, largely speaking, cryptocurrency platforms are not covered by FDIC insurance or SIPC insurance. Some top cryptocurrency exchanges have third-party insurance and some keep dollar deposits in FDIC protected accounts. But in most cases, unlike banks and brokerages, if your crypto exchange fails, there's no guarantee you'll get your money back.

In addition, the platforms were not transparent about the dangers involved. "Crypto-asset activities are sometimes described as unregulated," it says. "It may be more accurate to describe many crypto-asset firms as attempting to avoid the existing regulatory system." Those regulations would have demanded the platforms tell customers how risky their activities were.

Finally, several key figures have since been charged with fraud or making false statements. FTX's Samuel Bankman-Fried faces charges of securities fraud, wire fraud, and campaign finance violations. In addition to the fraud charges, the systems in place were disturbingly lacking. John J. Ray, the new CEO who's overseeing the bankruptcy proceedings, wrote, "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here."

Ultimately, those large investors may have been first to flee the sinking ships, and likely made them sink more quickly, but they were not the ones taking what the Fed labels "excessive risks" with customer money.

Bottom line

Cryptocurrency investing is risky. In addition to the price volatility and uncertainty about how the industry will develop, it is hard for investors to be sure about what cryptocurrency platforms are doing with their funds. Sure, some exchanges are transparent and honest. And regulators are trying to crack down on those with questionable practices. But if you aren't going to keep your assets in a crypto wallet that you control, it's important to do your due diligence on the platform you're using.

Plus, if you want to invest in a high-risk asset like crypto, make sure it only accounts for a small percentage of your portfolio. Open an account with a top stock broker and build a diversified portfolio with a mix of asset types and risk exposure. That way, if your crypto investments don't achieve everything you'd hoped, it will be a hiccup rather than a complete engine failure.