The crypto crash: a catalyst for further crypto litigation?

An earlier version of this article first appeared in the September 2022 issue of Butterworths’ Journal of International Banking and Financial Law.

Introduction/Abstract:

In recent years, the cryptoasset market has developed rapidly, with market capitalisation for cryptoassets estimated to have been around USD2.6 – 3 trillion in 2021¹. The market for decentralised finance (DeFi), although still relatively small, has also expanded quickly from less than USD10 billion in 2020 to nearly USD100 billion in 2021². However, over the last few months the cryptoasset market – specifically cryptocurrencies – has been seeing one of its worst selloffs since a market rally in 2020. This has sparked panic amongst investors, causing substantial financial losses. Inevitably, this has seen a flurry of litigation globally in recent months. This trend is likely to continue. We consider the causes of the crypto crash and the likely litigation risks for financial institutions and advisers.

The ‘Crypto Crash’

The recent crypto crash appears to have resulted from three main causes:

First, many economists consider that the interest rate cuts by the Federal Reserve in the US in early 2020 resulted in inflation which in turn drove prices upwards, particularly in the cryptocurrency markets. However, the recent interest rate increase in May 2022 to curb inflation appears to now have had the opposite effect, causing investors to become nervous about a potential recession and leading to a mass exodus of digital assets.

Second, the collapse of the “stablecoin” TerraUSD in May 2022 (a stablecoin which was pegged to the US Dollar 1:1) and its sister coin Luna caused panic amongst investors. Large Luna holders “cashed out”, causing the supply of Luna tokens to increase and, therefore, its price to crash. This, in turn, caused the smart contract algorithm (as intended) to create more Luna to re-establish the peg leading to further downward pressure on the price of Luna.

Third, as crypto prices have plummeted, this has prompted other investors (usually younger, less sophisticated and more fickle investors who are more susceptible to hype and social media manipulation) to panic and sell their assets, perpetuating the losses and, in turn, the crypto crash.

Key Litigation Risks

Given the scale of the losses suffered, it is likely that investors will be seeking to recoup their losses by commencing litigation. We consider below some of the potential types of claims and/or litigation risks for financial firms/advisers arising out of the crash:

1.     Social media has played a significant role in fuelling interest and hype over crypto assets. Coupled with the lack of regulation in the crypto markets, it is likely that consumers that have lost money through cryptocurrency investments will seek to bring mis-selling claims, particularly in relation to misleading ads on social media. In particular, investors are likely to bring claims relating to certain types of cryptoassets e.g. “stablecoins” which were seen or promoted as being “safe” or low risk investments given they were pegged to fiat currency. In the US, class actions have already commenced against Kim Kardashian and Floyd Mayweather for alleged misleading cryptocurrency posts on Instagram. In the UK, the Advertising Standards Authority has, to date, required more than 50 crypto firms to review their ads to ensure proper compliance with advertising rules.

2.     Investors are also likely to consider claims against financial advisers for alleged failures in connection with cryptocurrency portfolios. Investors could potentially argue that financial advisers either breached their duty of care by acting negligently by advising/recommending and/or investing in unsuitable cryptoassets which have ultimately led to financial losses or made un1, unclear or misleading statements.  

3.     Given the dramatic loss of value of cryptoassets, investors may seek to bring claims against crypto platforms and/or exchanges in circumstances where their trading position(s) may have been closed due to a lack of collateral and/or exposure on a trading account. It is likely that investors may allege they did not have adequate opportunity to provide additional margin prior to the closure of their trading position(s) which resulted in losses.

4.     The unregulated nature of cryptoassets means that there will be greater suspicion arising out of unforeseen losses by investors. There is a risk therefore that investors are likely to bring market abuse claims, alleging manipulation of cryptocurrency prices by exchanges, perhaps through artificial price inflating tactics (e.g. through the sale/purchase of crypto assets) and/or dissemination of 0 information.

Practical Tips

Financial institutions operating in the crypto sector should consider the following:

1. Review and ensure that they have robust AML, surveillance and security processes to mitigate the risks of market abuse claims from investors.

2. Review carefully any statements or representations made in relation to the success or likely returns from cryptoassets.

3. Incorporate basis and/or non-reliance clauses into their T&Cs and contractual documents to make clear that no advice is being provided to and/or being relied upon by the end customers.

Sohail Ali is a partner in the Litigation & Arbitration team at DLA Piper. He advises clients on complex financial and corporate disputes. Suhail Mayor is a trainee solicitor at DLA Piper.

¹ https://www.coingecko.com/.
² https://www.bankofengland.co.uk/speech/2021/october/jon-cunliffe-swifts-sibos-2021.