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.
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.
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.
As a result, the fund’s AUM grew exponentially, reaching an estimated $18 billion at its peak.
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.
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.
However, there’s a catch: GBTC shares have a lock-up period of 6 months.
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.
Accumulating Ethereum and Investing in Terra
How was this relevant?
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.”
The Dominoes Start Falling
Why is stETH considered liquid?
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.
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
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.
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.
Liquidations of Assets
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).
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."