Last week saw the collapse of Three Arrows Capital, a fund that had over ten billion dollars in AUM at one point but was reduced to a debtor with several counterparties knocking on the door. How did all this happen? Could this spread to other crypto funds and companies, and what does this mean for the future of crypto? That’s all covered today. Let’s see what caused the Three Arrows Capitals bubble to deflate.
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What Was 3AC?
Before we can dive into what happened, we need a bit of background about the fund. Three Arrows Capital, or 3AC for short, was founded back in 2012 by Su Zhu and Kyle Davies. They were old school classmates and had worked in a number of traditional fire roles in Asia. They started 3AC with 1.2 million dollars in capital. Their first office was in their living room. Their initial focus was on trading traditional emerging currencies. The firm grew to over 30 employees within three years, but it wasn’t until the founders started dabbling in crypto that things started to pivot.
Su Zhu stated that in 2017 he became aware of crypto’s potential. In this Bloomberg interview, he said, ‘in late 2017, it became extremely clear to me just from the calibre and energy of young people involved in the space that crypto was going to follow the dot-com cycle of creative destruction and then eventually become a paradigm shift across finance, technology, culture and politics’.
Then, in 2018, 3AC became almost exclusively a crypto-focused firm. Su called the bottom of that bear market when bitcoin was at close to $3,800. We all know what happened over the next two years, and with that bull cycle came immense returns and wealth for 3AC.
3AC’s investment strategy was initially focused on trading bitcoin and ethereum in the derivatives markets. According to that Bloomberg interview, derivatives are still the company’s bread and butter, but over the years the fund has greatly diversified its investment strategy. The fund started investing in crypto companies in equity rounds, one of which Defi, other funds, gaming and NFTs. Now when you take a look at an overview of its portfolio, it’s pretty damn solid given that Su and Kyle were such well-known figures in the space. You can be sure that they got in on a lot of these projects in seed or strategic rounds, i.e., at prices that us mortals could only have dreamed of.
It’s no wonder then that their AUM was able to swell to over 10 billion. According to the founders, they never took on external capital, which can only mean that this was their own money.
Speaking of the founders, they were quite popular in the crypto community and were active on crypto twitter. They regularly posted about their market moves and theses and weren’t averse to the occasional post either. Many on cryptotwitter thought that their public statements were a form of psychological operations, or psyops.
Words intended to mislead retail investors to trade the opposite way. This was particularly evident last year when Su claimed he was quitting ethereum as it had abandoned its community. However, it transpired that about a month later, 3AC bought over 150 000 ETH, according to Nansen analytics.
Okay, so that’s a bit of background, but how did a star in the crypto space fall so quickly? Well, like anything in life, it starts with one really bad bet, and that bet was Terra.
Unless you’ve been living under a rock the past few weeks, you’ll have heard of the Terra Luna and UST collapses. One of the methods that Terra wanted to use to shore up the UST peg was the Luna Foundation Guard, or LFG.
The LFG raised over one billion dollars in bitcoin, which was exchanged for one billion dollars in LUNA coins. Jump crypto, Defiance capital, and 3AC were among those who purchased Luna. 3AC purchased 10.9 million locked Luna due to vesting, which cost 3AC a pretty penny, more than $500 million. 3AC was a big proponent of terror and worked closely with the LFG in order to accumulate more of that bitcoin. Of course, we all know what happened to Terra. The death spiral in UST led to a collapse in the value of Luna, which was minted into infinity. Want to guess what that lunar position over at 3AC is worth now? About $670 yikes.
I should also point out that the actions of the LFG in the wake of the collapse had massive implications for the broader crypto market. That’s because in order to defend the peg, over three billion dollars of bitcoin had to be sold, which naturally drove down BTC’s price. 3AC took their leave and appeared to have moved on from the saga.
According to a recent Wall Street Journal post, Kyle Davies said that they initially managed to handle the lunar hit, but the market conditions post-Terra only made things worse. This all coincided with a toxic macro environment and piss-poor crypto sentiment.
However, it appears as if two trades in particular may have sunk 3AC. It was well known that 3AC was the largest holder of Greyscale’s bitcoin trust, or GBTC shares. For those who don’t know, the Greyscale Bitcoin trust is an investment vehicle. That was one of the first structured institutional products for Bitcoin. It allowed institutional investors to get exposure to bitcoin without having to buy and store the spot equivalent.
For years, this has traded at a premium because it was one of the only ways for these large players to do so. This premium proved lucrative for those firms like 3AC that could make an arbitrage on it. This premium proved lucrative for those firms. However, with the launch of all those ETF products we saw over the past year, this greyscale premium became a discount, and over the past few months, that discount has continued to widen.
Knowing that the ETFs would eat their lunch last year, Greyscale began actively filing to convert its bitcoin trust into an ETF. However, the Sec has consistently denied the application. This is due to many factors, which I won’t go into here.
3AC was of the view that this grayscale discount would immediately reverse itself the moment an ETF was approved. The thinking was that if it was an ETF, its net asset value should track the price of bitcoin much more closely. This is something that Su tweeted about last year. It was a great opportunity for those people who missed the rally in the weeks after the Terra collapsed.
3AC focused a lot of its attention on the GBTC arbitrage. In early June, for example, they were pitching the idea to numerous investors looking to take on external capital.
According to the piece from the block, 3AC’s investment management arm, TPS Capital, was asking for a 20 management fee on this arbitrage trade. According to the article, 3AC was pitching the trade on the 7th of June, a few days before rumors of insolvency started to surface. No one knows how many people chose to invest in 3AC’s Grayscale pitch, but given that this came after the very public Terra implosion, one can assume that they would have had a pretty icy reception when they pitched it.
Either way, the continued widening of the GBTC discount over the past few weeks could only have worsened not only 3AC’s own position in GBTC but also those of the clients who may have invested in the trade. We don’t know exactly when 3AAC closed out of their GBTC. As of the 17th of June, Bloomberg updated its GBTC holdings tracker and 3AC was no longer listed as a holder. Perhaps they were forced to liquidate all their GBTC as a result of a cascade of margin calls and liquidations. Maybe it was caused by another bad trade, a trade that could be verified on chain and one that also went badly for other players in the space. This was the long bet that 3AC took on tokenized staked ETH or stETH.
Basically, despite the fact that stETH was not designed to be pegged to eth, there were many who thought that it shouldn’t diverge from parity. It is, after all, a token that generates yield and will be redeemable for ETH when the network transitions to proof-of-stake, which is scheduled to take place sometime…
But the point here is that there were many who thought holding stETH was a no-brainer, including Su. He tweeted on the 12th of June that stETH has a great deal of functionality and therefore should be considered as an attractive part of an ETH demon portfolio.
Unfortunately for the holders, stETH began to fall in price relative to ETH. This led large players in the space, such as Alameda Research, to convert their stETH into ETH equity in curve pools. This precipitated further falls in the price of stETH. This drained the curve pool of its heath, thereby making it imbalanced.
But it wasn’t just Alameda that was dumping. 3AC was also exiting its positions only two days after Su’s bullish tweet on Saturday. They converted over 22 000 stETH into ETH. Oh, and I’ll also mention that this collapse in the price of ETH could also be a part of the reason why Celsius ran into liquidity issues.
It wasn’t too long after Celsius announced that it was stopping withdrawals that the rumors of the 3AC collapse started coming through. This thread on Twitter was one of the first to emerge. It noted that neither Su nor Kyle had tweeted for days. Su had deleted his Instagram account and announced that they were abandoning their stETH positions.
On top of that, it pointed to some Bitfinex leaderboard numbers, which showed how big their losses were, but in the days that followed, we learned just how exposed they were and how interconnected most of the crypto space has become.
Once it was clear that 3AC was in trouble, stories began to surface of just how much leverage it had been taking on since the Luna collapse. This was with borrowed funds from many of the biggest lenders out there as 3AC’s capital position continued to worsen. It appears that they leveraged their risk in order to make some money back. This had the impact of compounding their losses and digging an even bigger hole for themselves.
Not only that, but according to some, the founders completely ghosted most counterparties and even members of their own team. In the days that followed, reports started to emerge of just what the 3AC team was up to. What many thought was a fund that was well risk managed with acceptable hedges, was more of a degenerate farm betting more than its own money. That’s because, according to numerous sources from projects they invested in, 3AC offered what are called treasury management services. Essentially, the projects would hand over the funds that they’d raised to 3AC, which would help the project teams generate yields on those funds. Who knows what exactly they were doing with those funds and how they were generating that yield?
The projects that did give 3AC money to manage have recently been unable to contact the 3AC team. These claims of 3AC managing project treasuries led many of those that had taken investment from them to issue statements. The latter included the likes of Avalanche, DYDX, and others, but the broader concern with the collapse of 3AC was not whose money they lost but who they were exposed to.
The attention of the market turned to who else was exposed to 3AC. Apparently, the company had taken out massive loans from many crypto lenders in the space. Not only that, but they had trading accounts at numerous exchanges that were also on the verge of being liquidated.
When the rumor mill began to turn, some of these lenders were required to make public statements about their actions. This was at a particularly sensitive time for them given that, only a few days previously, Celsius had halted withdrawals, an action that sent shock waves through the lending sector.
BlockFi and Genesis were two of the firms that attempted to clear the air. They both mentioned that they had liquidated the collateral of a trading partner. They didn’t name any names, of course. In the case of Genesis, they said that they did take a loss, but it was contained and they would be taking legal action. It was also reported that Bitmex had a three-ac trading account that was five million dollars in debt and which they had closed out. They said it didn’t impact their other accounts and that they would also be pursuing legal action. The report stated that they also had some trading accounts that were underwater, but they also managed to keep things contained and there was no risk to any of their users’ accounts.
However, one lending platform that did appear to have suffered from the 3AC fallout was Finblox with 3AC, which invested in Finblox. It was offering people returns of up to 90% on their crypto. What could possibly have gone wrong anyways?
Last week, Finblox had to limit withdrawals on its platform to a thousand dollars a day. This was presumably to stem the leak from the flood of withdrawal requests. Still, speculation continued to swirl around who else had exposure to 3AC and who had loaned them crypto. Of course, it was now clear that these counterparties would not get their money back and would have to take an L, of course.
Then there’s also the question of what happens to those projects that 3AC has invested in. They were pretty active in seed or strategic rounds for some of the most high-profile raises of the past three years. Given that these were earlier rounds, that means a lot of the tokens are most likely locked into investing contracts. This then raises the prospect of 3AC’s allocations being dumped the moment they hit the unlock, especially if those tokens are reclaimed in a bankruptcy. It’s not a pretty picture now.
The prospect of asset sales and disposals was made even more likely when the founders eventually broke their silence. And they said that they are considering asset sales as well as the prospect of being taken over by another firm. Whether they can really get themselves out of a hole that is speculated to be over one billion dollars deep is anyone’s guess.
That’s most of what we know so far about the 3AC saga. I’m sure there’s going to be a lot more coming out in the days, weeks, and months ahead. So what does this mean for Three Arrows Capital? Well, it’s in a tight spot, and that’s putting it mildly. The company has a deep, deep hole to dig itself out of, and any firm that’s looking to acquire 3AC will have to also take on all the debt it has accumulated. It’ll also be hard for 3AC to recover through asset sales given crypto prices right now.
The broader question is what this could mean for the wider crypto space. Well, it’s worth pointing out that this happened in a very public way and at about the same time as the Celsius saga began to unfold. It was also less than a month after the Terra implosion. This means the gaze of regulators is now fixed on the sector. You can bet your bottom Satoshi that they are sharpening their pencils to start bringing the crypto industry to healing.
To be honest, I think a bit of regulation may be needed in this space. As long as it’s common sense and doesn’t stifle innovation, then it could help to foster strong organic adoption. There should be more transparency around what these funds are exposed to and what products they’re investing in.
However, there should also be clear rules around leverage and fund VRA. In the future, such rules could allow for more transparency and hence less uncertainty around counterparty exposure.
However, one of the most important things that stuck out to me from this collapse is just how reckless institutions can be. We always harp on about institutional adoption and how it can make the crypto markets more mature. However, in this case, their high leverage and interdependence have brought the market to its knees. We should have known that this was a likely outcome. We saw it in the great financial crisis of 2008 as big players recklessly bet on housing bonds. However, in this case, we are not going to see a taxpayer-funded bailout. To be honest, that’s a good thing. Doing so would make us no different from the traditional fire sharks.
Furthermore, when you reward failure, you create a moral hazard. This was a painful lesson for the crypto space, but it was an important one. It’ll make us a lot more resilient and a lot more prepared for the next bull market, whenever that may come.
What do you think of the 3AC saga and how do you see it playing out?
[This article is a transcription of a video made by Coin Bureau ]
Original video: https://youtu.be/gg6p1GF01Gc ]