A look at what went wrong under the hood of one of the most prolific investors in the crypto space — eventually resulting in the declaration of Chapter 15 bankruptcy.
If you’ve been following any crypto — or even mainstream — media outlets, then there is a high chance you’ve heard of Three Arrows Capital (3AC) and how one of the biggest crypto hedge funds filed for Chapter 15 bankruptcy in New York.
The Singapore-based fund, worth an estimated $18 billion in assets under management (AUM) at its peak, has also been reprimanded by the Monetary Authority of Singapore (MAS) after giving false information and managing more AUM than it was allowed.
After the news broke of the fund's insolvency, media covered the apparent abandonment of its offices and reports that its founders were missing — a move that is not that surprising in the crypto world anymore (um, Ruja Ignatova from the OneCoin scam anyone?)
It turns out the founders were laying low, speaking with lawyers and ultimately heading to Dubai — where they had initially planned to move HQ — according to an exclusive interview with Bloomberg.
But hold on, how did this all happen?
The downfall of 3AC caught many in the crypto circle by surprise — founders Zhu Su and Kyle Davies were hailed as some of the smartest in the space, with many loyal followers taking their words, or tweets in this case, as sage advice.
But in a mash-up of poor risk management, leverage and bad investment calls in Terra (read: the full breakdown of the Terra crash), stETH and the Grayscale Bitcoin Trust (GBTC) — 3AC's story eventually spiralled into a series of liquidations, margin calls and ultimately — bankruptcy.
In this article, we attempt to break down, while understanding the basic financial concepts in play, what really happened to the crypto fund. We also explore what ripple effects it had on the wider crypto industry.
Beind the Founders of 3AC
Before we dive in, a quick primer on how 3AC came about.
Zhu and Davies were childhood friends since high school, as well as both Columbia University graduates. After starting out their careers during the 2008 global financial crisis on the trading desks of various investment banks, and a stint as traders at Credit Suisse, the pair left the firm in 2012 to found 3AC.
Initially focused on emerging-market foreign exchanges, the pair then chanced upon cryptocurrencies.
Like most of us here, the two were sold on crypto’s potential, and the fund became crypto-exclusive by 2018. While the fund began with a focus on derivatives trading in Bitcoin and Ethereum, the fund diversified over the years into venture capital, betting big and oftentimes successfully.
Zhu hailed the fund’s investments in Deribit (the options exchange in crypto) along with investments in Layer 1s like Avalanche, Solana and Polkadot during the bear market as some of their best bets.
As a result, the fund’s AUM grew exponentially, reaching an estimated $18 billion at its peak.
3AC was one of the first funds to invest in emerging projects like Aave back in the DeFi summer of 2020. However, it was one of the investments that they made during DeFi summer that caught everyone’s attention — $200 million worth of shares of the Grayscale Bitcoin Trust (GBTC).
The trade would later contribute to the fund’s downfall. Let’s explore it more.
The Grayscale Bitcoin Trust
Grayscale is one of the world’s first digital currency asset managers.
It offers the Grayscale Bitcoin Trust, at that time one of the first few US-regulated institutional products for large players to gain exposure to Bitcoin. Simply put, instead of buying the native asset and storing it, institutions are able to purchase a product that tracks the underlying asset (in this case, Bitcoin).
So why did 3AC buy up so many GBTC shares, eventually becoming the largest holders of GBTC?
The reason was simple: for years after GBTC launched, it traded at a premium (i.e. above its net asset value), as it was the one of the few that offered Bitcoin exposure to institutions. This premium meant that a share of GBTC was trading higher than the value of Bitcoin backing it.
Grayscale allows firms like 3AC to buy shares directly in exchange for Bitcoin. What this also means is it creates an arbitrage opportunity — 3AC can then sell the shares (at a premium) to investors on the market. 3AC accumulated 6.26% of the total shares of GBTC in mid-2020.
However, there’s a catch: GBTC shares have a lock-up period of 6 months.
As more firms entered the so-called “GBTC arbitrage trade,” and competition in the form of crypto exchange-traded funds (ETFs) products from the likes of VanEck, Proshares and Valkyrie hit the market, the premium for GBTC soon flipped into a discount.
To close the widening discount, Grayscale has filed with the U.S. Securities and Exchange Commission (SEC) to convert the Bitcoin Trust to an ETF structure.
However, the discount widened as the SEC continuously rejected Grayscale’s attempt to convert the GBTC investment vehicle to an ETF structure — the latest rejection coming on June 29, 2022.
It was also reported that days before 3AC melted down, it pitched an GBTC arbitrage trade to raise funds before the June SEC decision on its ETF filing, probably in a last-ditch attempt to save the fund.
Accumulating Ethereum and Investing in Terra
In November 2021, at the peak of the bull run, Zhu tweeted that he was abandoning Ethereum “despite supporting it in the past”.
But as it turned out, the fund made a purchase of about $400M worth of Ethereum in December 2021.
According to some, this was typical “psyops” or mind games that Zhu was engaging in — telling the masses one thing, but doing another.
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How was this relevant?
Zhu constantly tweeted about the crypto “supercycle” thesis after the market started dipping post-November 2021. He essentially believed that it was just a dip in the continuation of the bull market. Unsurprisingly, some were sceptical about it being “psyops."
It turns out that he was backing his words — the fund had many long positions open, a major one being Terra. A major reason was the close personal relationship between the 3AC founders and Terra’s founder Do Kwon after he moved to Singapore. However, despire this friendship, 3AC founders were still caught by surprise at the speed of the fall of the algorithmic stablecoin UST and Terra.
Speaking to Bloomberg, Zhu said:
“What we failed to realize was that Luna was capable of falling to effective zero in a matter of days and that this would catalyze a credit squeeze across the industry that would put significant pressure on all of our illiquid positions.”
A seemingly promising layer-one (L1) at the time, the fund had invested about $200M — valued to be about $550M at its peak. After the death spiral and collapse of the Terra ecosystem, that sum was estimated to be — gasp — $500.
The Dominoes Start Falling
The second domino to fall in this case and affect the fund was stETH — a liquid staking derivative for users to trade ETH staked on the Beacon chain.
Lido is one of the leading players in the liquid staking market and currently has about 30% of liquid-staked ETH via its protocol.
Why is stETH considered liquid?
Because you can deposit stETH on Aave to earn/borrow ETH. Or, you can swap your stETH in the Curve’s ETH/stETH pool and get ETH in return.
But here’s the catch: unstaking on Ethereum 2.0 is not available until some time after the Merge. That means, although stETH will eventually be redeemable 1:1 to ETH, holders are essentially locked-in for a pretty long period of time.
But why would this matter?
If a massive amount of stETH is suddenly dumped in the pool, the balance of assets in the pool would skew towards stETH. The selling pressure would cause the value of stETH to drop — causing it to trade at a discount to ETH, although stETH has no hard peg to ETH.
It was reported that during the liquidity crunch following the Terra collapse that two major players withdrew a combined $800M worth of ETH from the pool — Celsius (read: a review of the Celsius halt) and 3AC.
The Terra implosion and resulting selling pressure on stETH caused the coin to trade below the value of 1 Ether. According to Zhu, the market effectively “hunted” for those that are leveraged long stETH, so that they can profit from the liquidations and further decline of stETH.
The stETH to ETH ratio further declined as more stETH was being dumped in the market.
On May 12, according to Nansen, 3AC had removed about $400M worth of liquidity from the stETH/ETH pool of Curve.
Leveraged Long Positions
Leverage is a major component of any financial markets — especially in crypto where volatility, coupled with leverage, can give outsized returns — provided it goes the right way.
After the Terra meltdown and stETH selloff, 3AC’s lenders allowed them to continue trading “as if nothing was wrong,” according to Zhu.
He elaborated that lenders were “comfortable” with 3AC’s financial position after the blowup, although filings later showed that very little collateral was required to obtain such loans. 3AC took out loans from lenders like BlockFi, Genesis, Nexo and Celsius, and leveraged long on all of its positions.
Thanks to the onset of the bear market and falling crypto prices, their loan-to-value (LTV) ratio was consistently increasing — which means a riskier chance of getting margin-called.
A margin call is when your margin falls below the maintenance amount required to keep the leverage that you have taken, causing lenders to sell your assets.
This meant that the fund had to supply more assets to maintain their loan, but their actual liquid funds were much lower than what was needed to pay off for the leveraged positions.
Furthermore, many of their venture investments were not vesting until very late. This essentially meant that 3AC had no funds left to top up collateral in their loans.
The result?
Liquidations of Assets
A court in the British Virgin Islands ordered 3AC to liquidate their assets after they failed to repay loans. The fund itself also filed a case for its own liquidation in a court in the British Virgin Islands.
A liquidation can occur voluntarily or by force, and in this case — you’ve probably guessed it — the forceful conversion of 3AC assets to be paid back to its creditors.
An advisory firm, Teneo has been appointed to manage the liquidations for the hedge fund. Now, it’s their job to look through the balance sheets of the fund and attempt to salvage and distribute the remaining assets fairly amongst 3AC’s creditors.
The Beginning of a Contagion
Court documents revealed that a total of 32 companies lent $3.5 billion to 3AC.
The largest lender is revealed to be Genesis, a crypto brokerage arm of Digital Currency Group (DCG).
Genesis gave the hedge fund a $2.36 billion loan collateralized by their GBTC shares (we know what happened here), Grayscale Ethereum Trust shares, Avalanche and NEAR Protocol.
While Genesis claimed that it had mitigated its exposure, several other lenders affected were not as lucky: Voyager Digital's loan amounted to $1 billion, while Celsius lent around $70 million.
Both of these firms recently declared Chapter 11 bankruptcy, but the real tragedy is the scores of retail investors' funds — and life savings in some cases — that are locked up in these companies.
This kind of credit destruction often leads to what is known as contagion — where a financial crisis spreads from one market to the other.
While in this case the contagion seems limited to crypto for now, the domino effect of other crypto lenders declaring bankruptcy cannot be ignored.
Reflecting on what went wrong, Zhu made it clear that the lenders were aware of the risks involved.
“We’ve never once pitched ourselves as risk-free, like a simple yield.”
When 3AC was doing well, lenders were benefiting immensely too. However, when bad times came and the market went red, 3AC's collapse showed that the risk departments of both the hedge fund and the lenders had made some pretty bad bets.
As a famous saying by legendary investor Warren Buffett goes: "A rising tide floats all boats… only when the tide goes out do you discover who’s been swimming naked."
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