Just weeks after the “implosion” of cryptocurrency exchange FTX, credit services provider BlockFi filed for Chapter 11 protection with the United States Bankruptcy Court for the District of New Jersey, indicating that it is burdened with billions of dollars of estimated liabilities and more than 100,000 creditors.

In the November 28, 2022 filing, BlockFi states it is seeking protection “despite their best efforts to stabilize the enterprise and protect clients,” and that this was a result of the “unprecedented, expedited collapse” of FTX. Hoping to differentiate itself from FTX, BlockFi claims that, because of its “industry-leading protections” and “best-in-class financial services”, they do not face the myriad of issues which are facing FTX. Instead, it is “quite the opposite” and it believes that it is well-positioned for the move forward with business operations, despite 2022 being a “uniquely terrible year.”

Doubling down on the impact of the fall of FTX, BlockFi’s bankruptcy continues to draw scrutiny from the public, and it is unclear how long it will take for crypto sector enthusiasm to rebound (if it ever will).        

FTX’s fall was a product of the same conditions leading to BlockFi’s recent filing. Over the past year, many cryptocurrencies have experienced a decrease in value. BlockFi’s filing included Bitcoin’s “slump” as an example, which dropped 65% in 2022. This drove investor pessimism, causing a significant number of clients to withdraw from BlockFi. 

Several cryptocurrency entities had the same fate as BlockFi and FTX earlier in the year, all of which BlockFi cites as part of the investor pessimism trend. Three Arrows Capital, who was one of BlockFi’s largest borrower clients, was included in the onslaught of collapsing crypto projects when it began liquidation in June of this year. Two other cryptocurrency lenders and competitors of BlockFi, Voyager and Celsius, filed for Chapter 11 protection on July 5, 2022 and July 11, 2022, respectively, which each stimulated an uptick in customer withdrawals from BlockFi’s financial products.

Despite the negative impact of unfavorable market condition and subsequent investor withdrawals, the root cause of BlockFi’s need to seek Chapter 11 protection seems intrinsically linked to its exposure to FTX. In June 2022, when BlockFi required additional capital, it sought to meet that need by way of $400 million of debt financing granted by FTX, which was coupled with an irrevocable and exclusive option to acquire BlockFi. Despite BlockFi’s belief that this financing caused executives and employees to sacrifice “hundreds of millions of dollars” of equity, it was deemed the best and perhaps only way forward. However, BlockFi’s own bankruptcy filing has frozen access to its assets and, as of the date of its filing, BlockFi had $275 million outstanding under the agreement and a pending request for the additional $125 million (submitted just days before FTX’s bankruptcy filing).

Without this additional liquidity, BlockFi paused customer withdrawals and limited platform activity on November 10^th and, in preparation for bankruptcy filing, liquidated digital assets in the amount of $256.5 million (as of the petition date).

Moving forward, BlockFi plans to reemerge and recover a substantial portion of the investments. They have submitted a proposed Plan of Reorganization with the court, which, they believe, will allow them to “emerge as reorganized debtors on the most expedited timetable that is realistic.” They have also stated that they will “fight to maximize client recoveries.” 

If the fall of FTX highlights the need for regulatory infrastructure, the subsequent fall of BlockFi highlights the need for due diligence. Entrepreneurs cannot rely on faith that so-called “established” companies have appropriated internal controls. Third party vendor due diligence must be part of a proactive compliance program and accompanying policies and procedures.

It became clear to anyone who took the time to look that FTX lacked the proper competencies to effect meaningful controls and had fatally inadequate strategies for risk management.

These failings, combined with a lack of proper financial safekeeping and any sort of meaningful conflict of interest policy combined to create a financial catastrophe. If there is any hope for widespread adoption of blockchain and web3 projects, it will rest with the development of meaningful infrastructure, policies, procedures, and controls. Anyone looking to work, build, or play in this space would be well-advised to proactively create systems to mitigate and undercut risk, while simultaneously demanding the same of those with whom they conduct business.