Considering the Implications of Cred’s Bankruptcy for the Cryptoasset Lending Sector

  • Commentary
  • November 30, 2020

On November 7th, the cryptoasset lending company, Cred Inc. filed for Chapter 11 bankruptcy in the state of Delaware, having accumulated $136 million of liabilities while holding just $67.8 million in assets. While the exact reasons for the bankruptcy are still not fully known, we can surmise four main factors based on admissions from Cred, as well as statements, reported in the press, from persons associated with the firm:

  • Factor 1 – Having raised $26.4 million in Ether in a May 2018 ICO, the firm did not sell the ETH until late 2018, once its price had decreased significantly, resulting in substantial losses.
  • Factor 2 – The original filing posits that an external manager associated with Cred committed fraud with 800 BTC held by the firm. Ex-employees speaking to reporters claim that these assets were invested in the manager’s cryptoasset derivatives firm, Quantacoin, and the manager subsequently cut all communications with Cred, and seemingly still holds or disposed of the BTC.
  • Factor 3 – Ex-employees went on the record to say that Cred had provided a Chinese lender with a $39 million credit line which the lender could not pay back in full.
  • Factor 4 – Finally, Cred also engaged in multiple cryptoasset derivative trades, losing over $14 million in the process.

Cred’s demise has unsurprisingly focused greater attention on the broader blockchain lending sector, specifically the risk these companies incur to generate returns for their customers as well the transparency, or lack thereof, that permeates the industry. Unlike DeFi lending protocols, where assets and liabilities all exist publicly on-chain and their movements can be tracked in real-time, lenders (i.e. consumers) to so-called CeFi lending businesses enjoy no such oversight, and are instead reliant on the competent management and ethics of the company.

Notably, some providers have made meaningful attempts to increase their practices’ auditability and transparency. For instance, Celsius has been working with the blockchain platform Horizen to see if zero-knowledge proofs could be used to provide solvency attestations related to Celsius’ asset holdings and transaction data; Nexo has stated that it is collaborating with Chainlink to provide information on how the company manages customers’ assets, although any specifics beyond this are lacking. While these are encouraging early signs from parts of the sector, there is no doubt that substantially more could be done at large. Specifically, companies could leverage existing cryptographic primitives, which are already used in blockchain protocols, to provide robust audits and with less reliance on third-party auditors.

The proposed use of these primitives in such a context has a relatively long history, tracing back to 2014, when the Bitcoin Core developer, Gregory Maxwell proposed the concept of Proof of Reserve, a series of steps based on Merkle proofs that would allow exchanges to prove they had sufficient assets to cover the balances of all their customers, or, in other words prove, they were not undercollateralized or operating on a fractional reserve basis. In March of that year, Kraken was the first to use a system, based in part on Maxwell’s original design. Although proof systems based on Merkle proofs can certainly augment the trust which consumers have with exchanges and lenders, they do come with several limitations, most notably a significant lack of privacy for the parties involved.

Alternatively, audit proofs can also be conducted with zero-knowledge proofs (ZKPs), which by and large offer substantially greater privacy guarantees. The idea of applying ZKPs in this context originated with a 2015 paper by Dagher, Bunz, Bonneau, Clark & Boneh in which the authors presented a proof of solvency protocol, termed ‘Provisions’ based on Pedersen commitments and zero-knowledge proofs that would allow an exchange, which could also theoretically be a lender, to issue proofs without revealing any of its addresses, assets, liabilities, or customer data. Unfortunately, to-date there have few examples of any companies, lenders, exchanges, or otherwise, using ZKP-based solvency proofs. 

Given the substantial advances in recent years related to the functionality, performance, and accessibility of ZKPs, it is arguably increasingly untenable for cryptoasset-related companies to ignore or be unaware of their application. With the news of Cred’s bankruptcy, it would be welcome to see lending firms leverage the cryptography which underpins the technology upon which its value derives to provide consumers with far greater transparency than is currently the case and without the need for onerous regulatory burdens.