In order for stablecoins to operate like money, there cannot be any issuer credit risk. Otherwise coins will be discounted based on the financial strength of the issuer. That will cause transactional friction because buyers and sellers might not agree on the appropriate discount. It also means that different coins cannot possibly be good delivery for each other.
The GENIUS Act tries to reduce issuer credit risk as much as possible. First, it requires payment stablecoins to be backed by reserves and creates a regulatory oversight system to create some confidence that the claimed reserves are in fact there. That’s basically replicating what the National Bank Act of 1864 did when it created national bank notes and a federal bank regulator to inspect the national banks that issued those notes.
Second, the GENIUS Act has a provision regarding the insolvency of a payment stablecoin issuer. It aims to reduce credit risk by saying that the holders of payment stablecoins have first priority, coming ahead of all other claimants, for the issuer’s reserves. And second, it directs the bankruptcy court to pay out on the stablecoins as soon as possible, namely within 14 days of “the required hearing.” The idea here is to ensure that there is minimal liquidity disruption.
Here’s the thing. The GENIUS Act fails miserably at both of these bankruptcy goals. Holders of payment stablecoins actually will rank fifth in a bankruptcy distribution, coming after (1) repo and margin lender claims, (2) the DIP lender, (3) the bankruptcy professionals via the DIP lender’s carve-out, and (4) set-off claims from depositaries and brokers. Those claims will gobble up a huge chunk of any reserves, so recoveries for payment stablecoin holders will be severely diminished.
Moreover, because of the nature of the DIP lender and professionals’ claims, no distribution to the payment stablecoin holders will be possible until well into the case, if not the very end of it. That might mean waiting months or years for a distribution.
Let me put it bluntly: a stablecoin issuer bankruptcy won’t be like an insured deposit claim against an FDIC insured bank, where you get 100¢ on the dollar back incredibly fast (perhaps next day). In a payment stablecoin issuer bankruptcy there will be a large haircut on the stablecoins and the payment won’t be any time soon.
1. Priority
The GENIUS Act doesn’t give stablecoin holders the priority they think they got. GENIUS provides that:
the claim of a person holding payment stablecoins issued by the permitted payment stablecoin issuer shall have priority, on a ratable basis with the claims of other persons holding such payment stablecoins, over the claims of the permitted payment stablecoin issuer and any other holder of claims against the permitted payment stablecoin issuer, with respect to required payment stablecoin reserves…
Sounds good, no? If you read this you’d think that the holder of a payment stablecoin gets repaid first because they “have priority…over any other holder of claims against the permitted payment stablecoin issuer.” Couldn’t be more plain, right? Moreover, GENIUS amends 11 U.S.C. § 507 to provide that if the reserves aren’t sufficient to pay off all the payment stablecoin holders, that the stub claim after an initial distribution “shall have first priority over any other claim, including over any expenses and claims that have priority under [11 USC 507(a)], to the extent compliance with section 4 of the GENIUS Act would have required additional reserves to be main- tained by the permitted payment stablecoin issuer for payment stablecoin holders.’’ Again, sounds good.
A. The Bankruptcy Code’s Priorities Are Only About Unsecured Debt; Secured Debt Isn’t “Priority”
But there’s a catch, and to see it you have to be really well versed in the internal structure of the Bankruptcy Code. The Bankruptcy Code’s priority provision is section 726. But that’s all about the relative priorities of various types of unsecured claims, with section 507 just being the top run of section 726 priority. Nothing in section 726—or anywhere else in the Bankruptcy Code—addresses the priority of secured claims.
So how do we know that secured claims get paid before unsecured claims, then? Because everyone knows that to be true. The answer is because section 725 directs that estate property subject to a lien shall be disposed of “before final distribution of property of the estate under section 726 of this title.” Notice that section 725 is not a priority provision. The language of “priority” is not used anywhere in section 725. It is not a parallel to 726 even, as it does not addresses priority among secured claims, which is determined by non-bankruptcy law.
This seemingly strange structure is just a function of the fact that lien priority is distinct from payment priority. You can see this in intercreditor agreements among syndicated loan facilities which provide solely for lien priority, not payment priority, allowing the junior lien holder to get repaid first to the extent that there is competition among the facilities’ unsecured stub claims. You can also see this in the design of the cramdown provision, section 1129(b), as the famous “absolute priority rule” has no application to secured claims, which are given a distinct cramdown treatment that effectively accords with section 725–they get their collateral or its value.
So here is looks like GENIUS just messed up. Even though payment stablecoin holders’ claims have the higher payment priority, they still sit after all secured debt, and secured creditors get their collateral or its proceeds before any payments are made to unsecured creditors. In other words, stablemen holders aren’t at the top of the stack.
B. What Secured Claims Could Exist Against a Stablecoin Issuer?
Ah, you say, so what? Section 4(a)(2) of the GENIUS Act provides that an issuer’s reserves “may not be pledged, rehypothecated, or reused by the permitted payment stablecoin issuer, either directly or indirectly.” So no need to be worried about secured claims.
1. Margin, Repo, and Setoff
Not so fast. First, there’s a sect of exceptions to section 4(a)(2), including for margin requirements, repos, and “satisfying obligations associated with the use, receipt, or provision of standard custodial services”. That last one is actually a real humdinger. A standard deposit or brokerage agreement will allow the bank or broker to engage in setoff against any assets it holds for the client against any obligations owed to the bank or broker. The Bankruptcy Code’s automatic stay prevents the exercise of setoff, but a party having setoff rights has a secured claim in bankruptcy. To illustrate, Tether deposits its reserve T-bills with Cantor Fitzgerald and separately Tether borrows $500 million from Cantor Fitzgerald. In that scenario, Cantor Fitzgerald would likely have a setoff right–meaning a secured claim–against Tether for $500 million, secured by those T-bills. That will come ahead of any payment stablecoin holder.
2. DIP Lending + Carve-Out for Professionals
Second, if a stablecoin issuer files for bankruptcy, it is, by definition, going to be insolvent–it won’t have enough reserves to pay the payment stablecoin holders. That’s what’s going to trigger the bankruptcy. At the same time, that stablecoin issuer is going to need to pay professionals—lawyers and bankers and accountants—to run the bankruptcy. Gravediggers don’t work for free. Accordingly, the stablecoin issuer is likely going to seek DIP financing on the first day of the case just to fund its operations in bankruptcy. There’s two ways this could go.
One possibility is that GENIUS Act 4(a)(2) makes it impossible for the stablecoin issuer to borrow against the reserves in a bankruptcy; they can’t be used as collateral for a DIP loan. If so, I don’t know who is going to pay the professionals needed to handle a distribution to the stablecoin holders. This sort of situation might result in the case being a Chapter 7 liquidation with an independent trustee. That trustee is entitled to a cut of all assets distributed (3% of assets over $1 million), and the trustee isn’t going to pay out the assets unless he knows he will get his vig. But there will still be the problem of paying the trustee’s professionals, whose claims will sit below that of the stablecoin holders. This will result in a fubar bankruptcy mess. An administratively insolvent estate is the nightmare everyone in the bankruptcy world wants to avoid.
The other possibility is that a court says that GENIUS Act 4(a)(2) does not control over section 364 of the Bankruptcy Code, not least because 364 applies to the “debtor in possession” not to the “debtor” and only the “debtor” is subject to the GENIUS Act. (Stephen Lubben and I have a forthcoming paper about the DIP vs. debtor distinction, which we think has a lot of purchase broadly.) Someone might litigate this, but bankruptcy appeals are slow, and I am not sure if stablecoin holders would be on an Official Unsecured Creditors’ Committee (a cost-sharing device) or if a Committee is even possible given that the professional fees issue applies to the Committee professionals as well.
Let’s say this second scenario holds. If so, the issuer will be able to get DIP financing, and the DIP financing will be secured with a first priority lien over all assets, including the reserves. So that DIP financing jumps ahead of all of the stablecoin holders. But it’s worse. Although the DIP financing is not from the professionals, it will inevitably have a “carve out” for professionals fees, meaning that part of the proceeds of the sale of the DIP lenders’ collateral will be earmarked to cover the professionals’ fees. Because of the GENIUS Act gives stablecoin holders’ claims payment priority, I would expect to see extremely large carveouts to to ensure that the professionals do in fact get paid first, as they have to in any working insolvency system.
C. “First” Means “Fifth”
As a practical matter, this means that the payment stablecoin holders do not come first. They come fifth. First will be the repo and margin claims that aren’t even subject to the automatic stay. Second will be the DIP lenders, and they charge a pretty penny for their funding. Third will come the professionals, piggybacking on the DIP lenders through the carve-out. Those fees can be immense. FTX is at around $1 billion, and while that’s unusual, hundreds of millions is not so extraordinary any more. Fourth will be any pre-petition setoff claims (assuming they are “adequately protected” from the DIP loan). And only after all of these folks will come the payment stablecoin holders.
That’s a deep dive into bankruptcy priority, but I hope it shows how naïve stablecoin holders are if they think they’re sitting first in line for payment if an issuer goes belly up. They aren’t. They’re going to be getting a real haircut.
2. Timing of Payments
The GENIUS Act also tries to give some comfort to stablecoin investors by indicating that they will get paid for their coins very shortly after the bankruptcy commences; they won’t face an interminably long lock-up like we’ve seen in exchange bankruptcies. Again, GENIUS comes up short. The relevant provision provides that:
(5) with respect to the redemption of payment stablecoins held by a person, if the court finds, subject to the motion and attestation of the permitted payment stablecoin issuer, which shall be filed on the petition date or as soon as practicable thereafter, there are payment stablecoin reserves available for distribution on a ratable basis to similarly situated payment stablecoin holders, provided that the court shall use best efforts to enter a final order to begin distributions under this paragraph not later than 14 days after the date of the required hearing.
As an initial matter, I don’t know what the “attestation” reference is about–there is nothing in the Bankruptcy Code or Federal Rules of Bankruptcy Procedure of which I am aware that requires an attestation, and the GENIUS Act’s only other mention of an attestation has no relevance here. What is more interesting, however, is that this provision appears to permit only the stablecoin issuer to file the motion for a distribution. If it doesn’t file the motion, no one else can.
But let’s focus on the real issue, the timing. The timing is not 14 days from the bankruptcy filing. It is 14 days “after the date of the required hearing.” That would be a hearing on the motion for a distribution. Let’s imagine that motion were filed on the first day of the bankruptcy (it won’t be). Normally a motion in bankruptcy requires 7 days notice of the hearing. Let’s assume that the court has nothing else going on and can schedule the motion hearing immediately. So the hearing is on day 7 of the bankruptcy. Let’s also assume that the judge rules from the bench at that hearing. In that best of all possible worlds scenario, the funds get distributed pretty fast. But that’s not how it’s going to work.
First, the DIP lender will almost surely require that the issuer agree not to file a motion for a distribution to stablecoin holders absent the DIP lender’s consent. The DIP lender won’t grant that consent until it and all of the professionals have been paid, which won’t happen until the end of the case.
Second, if it’s a Chapter 7 case, the trustee won’t file any such motion for the issuer until the trustee figures out how he is going to get himself and his professionals paid. That won’t happen for a while because the trustee won’t have had any time to prep.
Third, in any situation, there’s another drafting problem: the GENIUS Act neglected to define “holder” of a stablecoin. The term “holding” or “holder” is not defined in the GENIUS Act. Most crypto is custodied in exchange-controlled wallets, rather than in self-custody arrangements. Is the exchange the holder or the exchange customer? This matters in terms who has a claim in the bankruptcy, which affects who gets paid and potentially who can vote or have standing to object. This issue will have to be resolved before the estate can make any distributions—it will have to know if it is paying the cash to the exchanges for forward distribution to their customers or to the customers directly.
Finally, despite the urging of the GENIUS Act, no court is going to want to move too fast on this–once the money flows out, it can’t be clawed back with any ease. All of that suggests that there will likely be at least a couple of months, and possibly much longer, before funds go out to the stablecoin holders…assuming that there are any left after the various secured claims are satisfied.
Conclusion
Bottom line here: stablecoin investors should not expect a smooth ride in an issuer bankruptcy. They sit fifth in the order for repayment and won’t get their money back even in part any time soon. Once they understand that, it will have an upstream effect: stablecoins will be much more likely to run, which is itself a self-fulfilling prophecy, as issuers will have to liquidate harder-to-value assets to convince investors that they have certain asset value.
Is there a lesson here? I think so. It’s that you can’t really recreate the equivalent of bank money without the backing of the state via deposit insurance.