Singapore-based Hodlnaut, a digital-asset lender that used a regulatory license to burnish its reputation, told customers on 8 August it was blocking customer withdrawals.
The company blamed “recent market conditions” and said the move is intended to stabilize liquidity and – important term here – preserve “assets”.
The company didn’t specify what market conditions were problematic – Bitcoin has fallen precipitously this year – but its problems may include the collapse of UST, the algorithmic stablecoin also known as Terra.
It also said it was halting its application to the Monetary Authority of Singapore (MAS) to be a regulated digital payment-token service provider. This ends a short but glorious moment when the company seemed to enjoy being covered with MAS pixie dust.
The combination of reckless business, terminology that deserves scrutiny, and Hodlnaut’s operating under MAS graces make for a toxic outcome – and suggest a better way forward for the industry.
In March, the MAS granted Hodlanut an “in principle” approval to receive a license under Singapore’s Payment Services Act to service local customers. For a crypto company this is a huge endorsement (never mind how provisional). Hodlnaut’s customer inflows subsequently soared.
Unfortunately this endorsement came while the company was allegedly pouring customer funds into risky bets that would blow up just two months later – while it denied to customers it had any such positions.
Hodlnaut’s business was to lend customer funds to other institutions to generate a high return, with its website at different dates promising annualized returns of 5 percent to 14 percent.
Terra goes down
In April, one month after getting the MAS nod, it launched its first exposures to UST, offering 14 percent annualized returns on 180-day fixed deposits that were deployed to Terra. This is a huge return against an asset that is supposed to be stable.
When Terra went down in May, coinciding with a rout in Bitcoin prices, it triggered crises among other crypto entities exposed to its own yield-generating protocol, called Anchor. Anchor had promised annualized returns of up to 20 percent, thus attracting huge inflows via UST from other crypto lenders Blockfi and Celsius, and from hedge funds Digital Voyager and Three Arrows.
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All of which cratered, setting off a chain reaction of freezing customer assets and market chaos.
A measure of calm was restored by the intervention of Sam Bankman-Fried, whose exchange FTX bailed out Blockfi at cutthroat prices. Digital Voyager, which owns another Bankman-Fried business money, refused a similar offer, and Bankman-Fried backed away from bailing out Celsius when he saw the books.
Where was the money?
Since then, with the price of Bitcoin stabilizing, it seemed the worst of “crypto winter” might be over. The Holdnaut crisis, however, is blowing cold.
Another reason for the thaw was that the Hodlnaut team, led by co-founder Juntao Zhu, told the market it had no exposure to Anchor or to UST – as a business. But customers using its token swap program did.
However, recent media reports say Hodlnaut had up to $157 million of client funds stuck in Anchor when the protocol collapsed. The company was pouring money into Anchor to generate the high returns for its customers. Anchor’s own (even higher) promised returns look to have the qualities of a Ponzi scheme.
However, according to screenshots captured by a user in the company’s Discord site who goes by the handle FatMan, the company categorically denied any exposure. FatMan’s conclusion is Hodlnaut lied repeatedly about where it was placing customer monies and the sources of its returns.
Assets versus loans
Part of the problem of trust in companies like Hodlnaut is how customer funds are referred to as “assets”, as in the company is believed to have $500 million of customer “assets under management” – and that its mission is to help users “grow their digital assets”, as Zhu put it in a 2021 interview with crypto website Staking Rewards.
But, as was the case with Celsius and Blockfi, there are no assets – only liabilities. That $500 million figure represents customer deposits, which the company’s terms of service define as unsecured loans. Customers have no special recourse. Whatever remains of the asset side of the company’s ledger has fallen so low that the company is now refusing to return customers’ funds. (Sidenote: how many bad companies can SBF rescue?)
Yet the language used on the company’s website suggests “crypto assets” are being managed for a return. In January, the company said a local auditor, Crowe Singapore, verified the company’s ownership of $106 million worth of crypto assets.
On the website, Zhu said, “With this independent verification exercise, we’re hoping to provide transparency of our assets under management to our users on a period basis.” He said this disclosure was part of the requirements of the PSA under MAS.
What’s not clear is whether those “assets under management” belong to Holdnaut or its customers. Users might be forgiven for believing their deposits were being treated as managed assets.
This lack of clarity, along with allegations of misrepresenting the treatment of customer funds and their sources of return, is firstly a disaster for Holdnaut’s users, who may get very little of their money back, if they get anything at all.
It is secondly a problem for MAS. Holdnaut leveraged its in-principle license while being unclear about vital facts surrounding customer money, even allegedly lying about them. The regulator will have to decide how much of this may be a breach of regulation and how much reflects loopholes in its rules.
On the positive side, this should be a call for regulators and industry participants to rethink traditional financial business models that are being jerry-rigged in the world of decentralized finance.
That can go one of two ways. First is for models that stick more closely to DeFi principles. This means finding ways to get people to think twice before punting on wildly unrealistic promises of returns. For crypto advocates, this means self-custody of assets, enhancing transparency of yield sources and portfolio risks, and building tools to let investors analyze DeFi protocols.
It is to make the space easier for individuals or investment desks to operate without third-party brokers, managers, or custodians. Intermediaries must prove their trustworthiness by adopting DeFi protocols for transactions, and building their own financial products on top. That means foregoing highly leveraged get-rich-quick schemes that are either Ponzis or which rely on lying to customers.
Or, as Juntao Zhu put it to Staking Rewards: “DeFi is the continuity of the Bitcoin revolution that started over 11 years ago. It promises convenience and decentralization without the archaic regulations that traditional finance has.”
Today we have Wall Street reinvented for crypto with no regulation (archaic or otherwise), which means no guardrails, no disclosures, no enforcement. It’s been very lucrative for some insiders but is clearly unsustainable, and hugely unethical.
If DeFi is the way, then it must be true DeFi, which means getting rid of the chokepoints that turn a handful of people into billionaires.
Doesn’t sound very realistic. Most people are in crypto to get rich.
The alternative is regulation.
Regulating digital assets
Hodlnaut and its brethren are shadow banks, taking customer money as unsecured loans and doing what they like with those funds. The unsustainable nature of these get-rich Ponzi schemes almost forces these players to promise unrealistic returns, then misinforming customers about how their money is being treated – all the while benefiting from the perception by customers that their money is considered an asset under management.
But to give DeFi proponents their due, it is true that a lot of compliance is unproductive. DeFi technology does deliver transparency and decentralization offers security at the network level. DeFi boosters say this is good enough to get rid of contractual law-based arrangements (“the code is law”). This is clearly not true, but it could augment regulation.
Crypto is hardly the only place where financial disasters occur. Take last year’s collapse of Archegos, the family office in New York that was wildly overleveraged.
Hodlnaut, Anchor and these other fails are basically Archegos transposed to blockchain-based finance.
The difference is that the tools exist in DeFi to mitigate these risks without having to create onerous teams of compliance people: software, including privacy cryptography and smart contracts, can help. DeFi proponents claim decentralization is better than greedy ol’ TradFi – and maybe it can be! In fact, given crypto trades 24/7, it’s imperative to use technology to bake in the necessary surveillance. It won’t happen without proactive regulation.
The principles of securities regulation are sound, but they aren’t effective when they’re implemented with twentieth-century techniques. MAS inadvertently helped a bad firm look like a good one. The tools exist to ensure market participants look more like their true selves.