Legal questions hang over Poloniex, the cryptocurrency exchange, after a price crash in a little known alt coin forced the firm to liquidate the positions of traders on the platform.

What happened

On May 26, altcoin $CLAM collapsed more than two thirds of its value during the day, resulting in the margin lending pool incurring a more than $13 million USD loss in today's price of bitcoin. Now, Poloniex is tapping into 1,800 BTC from the principal of active BTC margin loans to cover the loss to the lending pool. In margin trading, exchanges and traders can lend crypto at an interest rate for borrowers to trade, hopefully at a gain. Users have to pay back what they are lent. When a borrower is unable to pay back the loan, they default, losing money they didn’t have to begin with.

Some trading CLAM, a coin with low liquidity, began to default on their loans as the value of the coin dropped, making them unable to pay since their assets were now worth far less than when they borrowed.

Worse, many of those who defaulted had used CLAM for collateral on the loans, the amount put up to safeguard against an extreme loss for the lender, like a deposit. Since the coin had reached such a low value, that collateral became nearly worthless as well. While Poloniex said it is uncommon for traders to use CLAM as collateral, non U.S. traders can do so with any asset available for lending.

The number of defaults left the lending pool with 1,800 BTC unrepaid by borrowers. To mitigate the loss, Poloniex “socialized” it among BTC margin traders. The exchange took 16.202% from the principal of all currently active BTC loans even those that weren’t active at the time of the crash.

While only affecting 0.4% of Poloniex users, this still incurred the ire of some BTC margin traders. But more than that, it raised questions about how losses can be sustained by crypto exchanges.

Can they do that?

Poloniex said it spread the loss among BTC lenders because the exchange pools loan on margin to mitigate risk.

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"Because all BTC loans on Poloniex are lent in a common pool that is shared across all markets and borrowers, but we want to emphasize that we are pursuing defaulted borrowers to get them to repay the BTC they owe to lenders and exploring other ways to defray losses," said a company spokesperson. "As we recover funds, we will return them to affected lenders."

The legality of the practice was questioned by sources, including Silver, but it's unclear what that means for the crypto economy since there hasn’t been a public case interpreting the problem. That could change if Poloniex’s U.S. based BTC lenders decide to take legal action, and legal sources say they probably will.

“Any crypto exchange that socializes losses is begging for a lawsuit,” said David Silver, an attorney specializing in securities law.

A former crypto exchange executive said it depends on how one defines "legal," since lending is state-regulated unless you have a federal license.

To be clear, the firm said it only offers margin lending and borrowing to non-US customers.

The firm said it is “exploring other ways to help defray margin lender losses, and, as we recover funds, will return them to affected lenders."

The Block did not find a clear term in Poloniex’s terms of service indicating a precedent for socializing a loss, and Poloniex did not directly respond to the question in an email interview, but said the 16% figure was proportional to the amount of losses in the lending pool. Regardless, Silver said it would be unlikely for a court to allow an exchange to socialize a loss even with a term of service stated.

“I highly doubt any court would allow that to stand,” he said.

Stephen Palley, another attorney with Anderson Kill, disagreed with Silver, saying he didn't necessarily think Poloniex breached their terms of service.

"Now maybe you could blame them for listing an asset with a thin order-book like clam," he said.

Still, one anonymous source in capital markets consulting, told The Block Poloniex should have had more controls in place to monitor the liquidity of the asset, giving warning calls to traders if necessary.

"If there was a liquidity squeeze on this type of asset they should have had better risk management controls," said the source.

Other steps taken

In response to the crash, Poloniex did more than give its BTC lending pool a haircut. All defaulted accounts have been frozen until the loans are repaid.

"Margin lending and borrowing are only available to non-US customers, we are pursuing the defaulted borrowers to get them to repay the BTC they owe to lenders," said a company spokesperson.

It removed BTS, CLAM, FCT and MAID citing a lack of liquidity in these markets. A liquidity problem led to the CLAM crash, since traders couldn’t liquidate their positions fast enough to get out from under the falling value. Poloniex said it would continue to monitor the coins and could reinstate them in the future.

The exchange has also added additional layers to monitor markets so it can disable problematic assets. It also plans to add more market protections to prevent price slippage and over-concentration, including the NICE/Actimize tool which was implemented on June 1.

Update: This post has been edited to attribute claims of the legality of Poloniex’s actions to Silver and other sources. We also added commentary from Stephen Palley, an attorney with Anderson Kill.