Crypto lending service Cred announces bankruptcy

In a statement released by the company, it said it had “commenced a voluntary Chapter 11 case in the United States Bankruptcy Court for the District of Delaware to explore strategic alternatives, including, without limitation, the restructuring of its balance sheet or the sale of its business as a going concern, in a court-supervised process. The Cred technology platform has serviced customers in over 100 countries and Cred intends to use the Chapter 11 process in its attempt to maximize the value of its platform for its creditors.”

Cred was founded in 2018 by former PayPal employees Daniel Schatt and Lu Hua. The company estimates it has assets to the value of $50-100 million and estimated liabilities between $100-500 million.

The bankruptcy news confirms the worst fears of the company’s users who were told in an announcement on October 28 that the platform would be suspending deposits and withdrawals for two weeks.

The company tweeted that “We deeply regret causing so much concern as we assess the business impact connected with a recent fraudulent incident. Cred is cooperating with law enforcement authorities to investigate the incident.”

Cred said none of its systems, accounts, or user data was compromised in the “fraudulent incident,” but it has not provided any new information or updates on any platform since October 30.

Shortly before the announcement, the crypto wallet provider Uphold ended its partnership with Cred. It has since published a statement on its website. The statement says “In breach of its contractual and fiduciary responsibilities, Cred failed to inform Uphold about the issue until Uphold contacted the firm on Friday, October 23rd, having been approached that day by a journalist investigating potential issues at Cred.

As a result, Uphold plans to sue Cred LLC, the corporate entity, its affiliates, as well as Cred’s founders for fraud, breach of contract, and reputational damage. Any proceeds Uphold receives from these actions will first be distributed among Uphold customers who have lost money at Cred. Uphold will fund the costs of this litigation.”

New reporting by Bloomberg alleges that infighting and a failed Bitcoin hedging strategy are behind the firm’s downfall.

Bloomberg reports that in March, the company sought to set up a new entity called Cred Capital to oversee crypto asset management. Former Chief Capital Officer James Alexander then attempted to make himself the sole director and gave Cred Capital’s voting shares to an unnamed outside investor who never put money into the company.

Bloomberg said that Alexander failed to use a 300 Bitcoin loan from company founder Hua to set up new hedging strategies and instead took some of the proceeds to pay off vendors who helped form Cred Capital. Alexander was fired in June, when the company learned he’d moved Bitcoin worth about $3 million to a private wallet and refused to return it.

Cred has filed papers in a California court against Alexander. The court filing states “A material loss connected with the onboarding of a fraudulent asset manager by former Chief Capital Officer, James Alexander, and his misappropriation of certain Debtors’ digital assets severely impaired the Debtors balance sheet.”

It’s understood that the events mentioned above in the court filing refer to the “fraudulent incident” described by Cred in its tweet on October 28.

With withdrawals now indefinitely suspended as the Chapter 11 process begins, Cred users face an uncertain wait to learn whether they will receive some, all, or none of their assets.

While the circumstances are very different, Cred users are in the same position as OKEx users, who are also unable to withdraw their assets due to OKEx founder Mingxing ‘Star’ Xu being detained by Chinese authorities. Mingxing is understood to be a private key signatory of the OKEx cold wallets.

Not your keys, not your coins

Events at Cred and OKEx are a timely reminder that in crypto, it is important to understand the idea behind the “not your keys, not your coins” mantra. Put simply, any crypto assets that are left on an exchange, or with a lending service such as Cred, are very vulnerable to theft, hack, or loss.

This point was eloquently made by Caitlin Long, Founder/CEO at Avanti Bank & Trust, and an appointee to the Wyoming Blockchain Select Committee. Long, a Bitcoiner, and Bitcoin advocate commented on Twitter, “This is what can happen to a fractional-reserve Bitcoin

Lender, as there is no lender-of-last-resort for BTC. Get ready for more news like this to come out. There’s ZERO transparency or counterparty credit risk analysis available for BTC lenders. Rehypothecation and BTC don’t mix.”

Long said that one of the trends to note with the collapse of Bitcoin intermediaries such as Cred, is that they usually blame a hack or similar event initially, but it is ultimately revealed that they were actually running a fractional reserve for a long time. Financial institutions can stay liquid long after they’re insolvent.

Long urged Bitcoiners to not blindly accept the “we were hacked” excuse, stating that it’s an easy scapegoat that hurts Bitcoin.

Rehypothecation is what happens when a lender takes the collateral from an original loan and uses it as collateral for a new debt. This process increases liquidity in the market while also increasing uncertainty. The more assets that are re-used in this way, the less clear it becomes who owns the asset and who has the rights to payment if someone in the chain defaults.

Rehypothecation is common practice in Wall Street but is seen as controversial in Bitcoin. According to Long, uncovered exposures can build gradually in the traditional financial system, mostly owing to the commingling and rehypothecation of securities. This can take many forms, including securities lending, repurchase agreements, derivatives and prime brokerage. But the end effect is the same, uncovered, fractionally-reserved exposures build within the system slowly and mostly undetectably.

When something goes wrong, that can lead to a chain reaction of negative events. If there was, or is a shortage of Bitcoin, as Warren Buffet likes to say “when the tide goes out you see who’s swimming naked.”

Another subtle point of concern about the rehypothecation of Bitcoin is that the owner of an asset that’s being rehypothecated is losing out because the practice suppresses the market price of the asset. This is due to real buying demand being satisfied with an artificial supply.

BlockFi, a crypto lending platform that offers a similar service to Cred, takes the other side of this argument and advocates for Bitcoin Rehypothecation on its website.

How can we help Bitcoin and blockchain technology win market share?, asks BlockFi. “We can develop scalable, trustworthy lending systems to support the growth of the asset class. As part of that journey, we will need to use rehypothecation,” it says.

One concern is that rehypothecation creates more than 21M Bitcoin. BlockFi counters this and says “In our view, without a major change to the implementation of Bitcoin, you can’t create more than 21M Bitcoin. This is a technological reality of the Bitcoin blockchain. Even if you are worried about margin trading or rehypothecation enabling this, platforms that enable margin and up to 100X leverage have already existed for some time, including during the 2017 bull run.”

Blockfi then cites 5 key points regarding rehypothecation in traditional markets and how this capability is unique with Bitcoin.

Summarized, the points are:

1. Securities rehypothecation generally lowers the cost for consumer access to products.
2. Rehypothecation promotes market liquidity and price discovery by enabling market participants to express a multitude of views.
3. With Bitcoin, settlement isn’t instant but we do have a settlement layer that is much faster when compared to traditional markets.
4. Rehypothecation was not responsible for the financial crisis.
5. Our goal as an industry is to compete with the traditional financial system. In order to do that, we will need to use existing tools from the traditional financial system and leverage the blockchain to improve them.

Ultimately, holders of Bitcoin and other crypto assets will need to make their own decision as to whether they endorse the philosophy behind the “not your keys, not your coins” mantra. There is perhaps some peace of mind in having your private keys secured by oneself. On the other hand, some investors would prefer the laborious task of private key management to be handled by a trusted third party such as a professional custodian. And that’s okay too. Some others, crypto asset holders in need of a fiat loan, or keen to earn interest on their assets, will be tempted by services such as Block Fi. There is no right or wrong answer in crypto, just another series of trade-offs and risks in an ever-growing hall of mirrors.