Chocolate Finance: Understanding the Underlying

Before this happened, there were some of us who warned against investing in Choco, not just because of the cryptobro name, but because instant withdrawals at superior rates sounded too good to be true. Even now, many clearly do not understand how Choco really works.

Let’s start with Choco’s fundamental value proposition. To compete in a market with so many other established players, all offering access to money market funds (MMFs) with very low fees, Choco had to be able to give you something more. They decided to do this with a) the promise of instant withdrawals below $20k and b) a higher guaranteed rate.

So, while Endowus offers 2.8% to 3.1% p.a., Choco offers 3.3% p.a. on the first $20k. And whereas Endowus takes 1-2 business days to process a withdrawal, Choco promises instant withdrawals.

Problem 1: Must generate 3.3% p.a.

This creates two problems for Choco. First, it must generate this 3.3% yield. It can’t do so with MMFs since these do not produce 3.3% p.a. So, what does Choco do? Choco invests in short-term bond funds with slightly higher yields. The trade-off is that these bond funds are exposed to greater risks on two fronts: changes in interest rates (interest rate risk) and potential defaults (credit risk).

Here’s the list of underlying funds and their average duration.

– Dimensional Short-Term Investment Grade SGD Fund (DSF) —> 0.81 years

– UOBAM United SGD Fund (USF) —> 1.52 years

– Fullerton Short Term interest rate SGD Fund (FST) —> 1.6 years

– LionGlobal Short Duration Bond SGD Fund (LGF) —> 1.79 years

– Nikko AM Shenton Short Term Bond Fund (NST) —> 1.15 years

And here’s how duration works. With a duration of 1 year, a 1% rise in interest rates would likely lead to a 1% decline in value. So, for LGF, a 1% rise in interest rates could cause you to lose around 1.79% in value. If interest rates rise by 2%, you could lose as much as 3.58% in value. Of course, most of these funds will recover their value within a year, but you would still have some volatility within that year.

As for credit risk, the funds are rated A or A-, which is actually quite safe, but not entirely immune to some volatility as well.

So, the need to generate 3.3% yield means Choco must use underlying funds that suffer from greater volatility than MMFs.

Problem 2: Must offer instant withdrawals

The second problem is that Choco must offer instant withdrawals even though its underlying funds suffer from some volatility.

Choco solves this by a) reserving the right to delay withdrawals and b) absorbing resulting losses. Neither solution is really sustainable in the long run.

The moment Choco delays withdrawals, for whatever reason, more and more people will start withdrawing, which is essentially what happens with most bank runs, and is precisely what is happening now. Although Choco’s initial delay in processing withdrawals was actually caused by a legitimate banking issue with DBS, what really matters in this case is perception and sentiment rather than facts. And the perception now is that Choco’s promise of instant withdrawals is worthless. Moving forward, it is unclear how Choco will be able to attract new deposits given that its essential value proposition has collapsed and any claim to offer instant withdrawals must now face the reality that they may, at their sole discretion, delay withdrawals.

Panic begets panic

Once this happens, and if Choco is no longer able to attract new deposits, it then becomes a question of if, not when, Choco will run out of investor funds. The moment it runs out, Choco will no longer be able to absorb losses resulting from the mismatch between the underlying funds’ NAV and its promised rates. These losses must then shift onto the customers, particularly the “bagholders” who withdraw later than the rest.

Upon realising this, everyone is likely to try to withdraw from Choco, worsening the situation even further, and making this a self-fulfilling prophecy.

Sad to say this, but the only thing you should do right now if you have funds invested in Choco is to withdraw it before you become the bagholder or before your funds end up being frozen for even longer than 10 days as Choco enters liquidation. Whatever 0.2% additional gains you are getting from Choco is not quite worth the risks involved here. The optimal decision from an individual standpoint, given that everyone is likely to think the same way, is simply to withdraw as soon as you can. Of course, like in all crypto pump and dumps, there will be those who try to dissuade you and say that this is "fud".

I should add that this comment by one of Choco’s backers does not exactly inspire confidence. Qin En from Saison Capital: “All funds are parked in money market funds”. No they are not, but this is quite a revealing comment — you can’t really trust what they say. Saying that Choco is founded by the same founder of Singlife, which has no shortage of ILPs, does not help either.

Edit: I have made another post adding more analysis on how customers might potentially suffer capital losses even in spite of custodied accounts. See: https://www.reddit.com/r/singaporefi/comments/1ja6yw6/chocolate_finance_all_the_downside_none_of_the/