A failure of trust?
Trust has been a key theme that has emerged in crypto in 2022. Going back to the original Bitcoin "White Paper"1, the very stated purpose of crypto and blockchain technology was to transcend a "trust based model" of the traditional financial system to enable payments – and later, with the development of smart contract platforms such as Ethereum, more complex transactions – to be entered into and executed without reliance on trust in counterparties and intermediaries, those being replaced by code and distributed consensus.
However, many of the largest crypto failures in 2022 have resulted from the reliance on, and ultimate failure of, the very kind of trust the need for which crypto was supposed to eliminate. The explanation for this lies largely in the distinction between so-called "centralised (crypto) finance" ("CeFi") and "de-centralised (crypto) finance" ("DeFi"). A detailed exposition of the distinction is for another time. However, as a broad generalisation, DeFi seeks to utilise the underlying blockchain and smart contract technology, whilst CeFi continues to rely on traditional legal and operational structures, such as natural language contracts and the promises of counterparties to perform their obligations. There is no black and white distinction; rather, projects and ventures sit within a spectrum. Furthermore, there are pros and cons to each model. However, the more centralised an operation, with decisions made by a concentrated group of people, and the greater the reliance on the promises of counterparties as opposed to automated and irrevocable smart contracts2, the more important will the role of good old-fashioned trust will be.
Trust, custody and proprietary interests
However, this piece is primarily concerned with another kind of trust; namely, a legal trust over crypto-assets. It is now widely accepted that under English law, crypto-assets are a form of personal property which can be the subject of a trust3. In the context of FTX's insolvency, this may give some hope to certain customers of FTX of establishing a proprietary claim over their crypto-assets, which could take those assets outside of the relevant FTX entity's insolvent estate. It has recently been reported that such claims are to be pursued in the US Chapter 11 proceedings4.
The most recent version of the Terms of Service for FTX International (i.e. the non-US exchange), stated to be governed by English law, provides a promising start. They state at clause 8.2.6 that: "Title to your Digital Assets shall at all times remain with you and shall not transfer to FTX Trading" and "None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading". It seems arguable that these terms evince an intention between the parties to create a custody arrangement whereby the customer would retain beneficial (equitable) ownership of the assets under a trust.
However, and even leaving aside the cross-border insolvency issues for the time being, matters are unlikely to be straightforward.
First, there must be certainty over the subject matter of trust5. This may prove challenging in circumstances where customers' assets were apparently commingled with FTX's and/or Alameda's own assets from the outset6. Customers may, however, seek to argue that crypto-assets being intangible property, there need not be the same degree of certainty over the subject matter as there is with tangible property and commingling of assets would not be detrimental to the formation of a trust7. Furthermore, though, it is not entirely clear whether when a customer "purchased" crypto-assets on FTX there were any actual crypto-assets on the relevant blockchain ledger backing or corresponding to such a transaction, or whether there was only a credit entry on FTX's internal ledger. If the latter, there would never have been any crypto-assets for there to have been a trust over in the first place.
Second, clause 8.2.6 refers specifically to "Digital Assets", whose definition encompasses crypto-assets such as BTC and ETH, as well as stablecoins, but not fiat commercial bank money. This may mean that fiat balances deposited with FTX will not have been subject to a trust and/or that once a crypto-asset was exchanged for currency, any proprietary interest will thereby have been extinguished. The same may be true of customers who entered into synthetic derivatives contracts, which were to be (fiat) cash settled.
Third, whilst the most recent version of FTX International's Terms of Service (dated 13 May 2022) contain the helpful language referred to above, it appears that previous versions did not contain any such language suggesting a trust-custody arrangement. It may therefore be that those customers who deposited crypto-assets prior to May 2022 are in a different position to those who did so afterwards.
Finally, even if proprietary rights could be established as a matter of legal principle, the practicalities of tracing those rights through the myriad of interwoven and apparently poorly documented transactions8, both internally within the FTX group and with third parties, are likely to prove challenging. In addition, such equitable proprietary claims may be defeated by an innocent third-party who received the assets in return for good consideration without notice of the prior claims of customers.
Conflicting interests amongst customers
As seen from the above, the merits of any given customer's proprietary claim, and the arguments that could be deployed to establish it, are likely to be highly fact specific. For example, a pure "buy-and-hold" customer who deposited crypto-assets on chain may be in a different position, and may wish to make different submissions, to another customer who engaged in high-frequency, algorithmic trading, trading in and out of various crypto-assets, synthetic derivatives positions and/or fiat currencies multiple times a day. Given that there is likely to be a shortfall in assets to cover the claims of all FTX customers (let alone other creditors), there are likely to be conflicting interests between different customers as to how wide the net should be cast in terms of who should be entitled to proprietary claims.
2 See, however: Smart contracts and the limits of the "rule of code" by John Lee, first published in the November 2022 edition of Butterworth's Journal of International Banking and Financial Law: https://www.traverssmith.com/knowledge/knowledge-container/smart-contracts-and-the-limits-of-the-rule-of-code/
3 See, for example: the Law Commission's Consultation Paper on Digital Assets (CP 256), paragraphs 16.52 onwards; and recently, Jones v Persons Unknown  EWHC 2543 (Comm)
5 Knight v Knight (1840) Beav 148, 9 LJ Ch 354. Money paid into the general capital of a company cannot be treated as a trust asset: Space Investments Ltd v Canadian Imperial Bank of Commerce Trust Co (Bahamas) Ltd  1 WLR 1072.
7 Hunter v Moss  1 WLR 452; Re Harvard Securities Ltd (in Liquidation)  2 BCLC 369; and Re CA Pacific Finance Ltd (in Liquidation)  BCLC 494.
8 "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": John Ray III, the newly appointed CEO of FTX, in the Declaration in support of Chapter 11 Petitions and First Day Pleadings (Case 22-11068-JTD Doc 24).