Three Arrow Capital (3AC), a Singapore-based crypto hedge fund that at one point managed more than $10 billion in assets, has become one of many crypto firms that have gone bankrupt in this bear market.
However, 3AC’s downfall was not just a market phenomenon. As more and more information surfaced, the collapse looked more like a self-inflicted crisis caused by uncontrolled decision-making.
To put it succinctly, the hedge fund made a series of large directional trades in Grayscale Bitcoin Trust (GBTC), Luna Classic (LUC), and Staked Ether (stETH) and borrowed funds from over 20 major institutions. May’s crypto crash led to a series of spiraling investment meltdowns for the hedge fund. The company went bankrupt and defaults led to massive contagion in crypto.
The first signs of possible insolvency occurred in June with a cryptic tweet from co-founder Zhu Su following the movement of 3AC funds. The crypto market crash led to a sharp drop in the prices of major cryptocurrencies, including Ether (ETH), which led to a series of liquidations for the hedge fund.
The rumors escalated after Zhu deleted all mention of ETH investments, Avalanche (AVAX), LUNC, Solana (FLOOR), quasi-protocol (NEAR), Mina (MINA), decentralized finance (DeFi) and non-fungible tokens (NFT) from his Twitter bio, keeping only a mention of Bitcoin (BTC).
3AC’s series of liquidations had a catastrophic impact on crypto lenders such as BlockFi, Voyager, and Celsius. Many crypto lenders eventually had to declare themselves bankrupt due to their exposure to 3AC.
Sam Callahan, Bitcoin analyst at BTC savings plan provider Swan, told Cointelegraph:
“Using only publicly available information, in my view, 3AC’s failure can really be broken down into two things, 1) poor risk management and 2) unethical and potentially criminal behavior. The first is a classic example of what happens when you use too much leverage and the trade backfires.In this case, 3AC borrowed hundreds of millions of dollars, mostly from crypto-lending platforms. currency, to make arbitrage bets in risky DeFi protocols. Such a risky bet was on Terra. Of course.”
He added that 3AC failed to acknowledge the mistakes, continued to borrow more money and “even allegedly used customer funds to make bets to try and get their money back. This is when 3AC turned into a blatant Ponzi scheme. As general market conditions continued to deteriorate and liquidity dried up, 3AC was exposed as the Ponzi scheme it had become, and the rest is history.
Looking at the timeline of events in 3AC:
- May 11-12: Immediately after Luna’s collapse, multiple lenders ask about Luna’s exposure, 3AC says there’s nothing to worry about.
- May 18: Co-founder Kyle Davies tries to stop loans from being called
- June 3: Increase in interest rates on loans due to market conditions
- June 7: The 3AC team pitches investors on new opportunities to save the company
- June 10-11: Crypto options broker Deribit margin calls 3AC’s account mobyDck
- June 13: Davies tries to get a new loan from Genesis to pay the margin call
- June 16-17: Widely reported 3AC insolvency
3AC possibly deposit for a Chapter 15 bankruptcy on July 1 in a New York court with no known whereabouts of the founders.
Marius Ciubotariu, co-founder of Hubble Protocol, believes that the 3AC lending crisis highlights the resilience of the DeFi ecosystem. He told Cointelegraph:
“The challenges 3AC has faced are not unique to cryptocurrency or financial markets as a whole. Cryptocurrency is currently the only financial market where market dynamics are allowed to play out. The 3AC crisis revealed how resilient DeFi protocols are. For example, Celsius suffered loan losses and was called on margin. Fearing on-chain automated liquidations visible to all, they rushed to pay off their MakerDAO and Compound loans first.
3AC owes creditors $3 billion
3AC’s liquidators have requested a stay of proceedings against the company and access to its Singapore offices in a petition to the High Court of Singapore. Court documents show that 3AC owes approximately $3 billion to its creditors, including 3AC’s main creditor, merchant Genesis Asia Pacific, a subsidiary of Digital Currency Group, lent $2.36 billion.
Among the long list of creditors, Zhu Su also filed a claim for $5 million. In addition to Zhu’s claim, 3AC’s investment manager, ThreeAC Limited, is allegedly manufacturing a $25 million claim. Kyle Davies’ wife, Kelli Kali Chen, is reportedly claiming $65.7 million in debt in the same case in the Eastern Caribbean Supreme Court. A court in the British Virgin Islands ordered the liquidation of 3AC June 27.
I just saw the list of creditors of #3AC and noticed that @zhusu filed a $5 million claim. While on the run, he somehow found the time to diligently and ruthlessly fill out forms to pursue a claim against his own fund. https://t.co/YFfWmYZOoM
—Soldman Gachs ⌐◨-◨ (@DrSoldmanGachs) July 18, 2022
There is speculation that founders Zhu and Kylie used investor funds to make a down payment on a $50 million yacht purchase. However, other reports claimed that Zhu tried to sell his house following the 3AC crisis.
A report by blockchain analytics firm Nansen show that there was active and traceable contagion in the markets. The depeg stETH was triggered partly due to the implosion of TerraUSD Classic (USTC). The report claims that 3AC fell victim to this contagion as it sold its stETH position at the height of the depeg panic, taking a significant haircut.
Jonathan Zeppettini, head of international operations at decentralized autonomous currency platform Decred.org, believes that market conditions played a minimal role in the 3AC saga and only helped prevent more fraud. He told Cointelegraph:
“In reality, they were simply participating in other scams such as Terra and acting as a middleman between dodgy investments and lenders who thought their case was so clean it exempted them from doing their due diligence. Liquidations in cascade caused by the market correction forced the end of the game, however, in reality, their model was always a ticking time bomb and would eventually have imploded no matter what.
Michael Guzik, CEO of institutional lending platform CLST, told Cointelegraph that 3AC has failed to mitigate market risks and the wave of meltdowns, and the underlying liquidity crunch, is a “reminder of the importance of age-old lending/borrowing practices such as leverage and counterparty risk assessment.
3AC operated very opaquely to be the largest crypto hedge fund, and after the collapse it continued to lie to investors about the extent of losses incurred by lenders, fund movements and its directional market exposure .
Centralization and opacity in crypto businesses
The fall of 3AC highlights the fragility of centralized decision-making which can turn into a nightmare during a bear market. The centralization of decision-making in 3AC’s operations only became apparent after the start of the liquidation of its positions.
Zhu and Davies, the founders of the tainted hedge fund, revealed they received a series of death threats after 3AC collapsed, which forced them into hiding. Both founders admitted that overconfidence born out of a multi-year bull market, where lenders saw their values inflate thanks to the funding of companies like theirs, led to a series of bad decisions that should have been avoided.
Joshua Peck, founder and chief investment officer of crypto hedge fund Truecode Capital, told Cointelegraph that what made 3AC’s failure particularly pernicious was its venture capital investment, it often managed cash for its portfolio companies, and it was so well regarded that many other platforms extended substantial credit to it, such as Blockchain.com’s $270 million loan.
The extent of its interdependence with other digital asset companies was unclear until 3AC’s positions began to liquidate during the 2022 cryptocurrency bear market. It quickly became clear that many companies were more exposed to 3AC than commonly thought. Peck told Cointelegraph:
“Our view is that to avoid a total loss in the crypto market, the entire risk profile of cryptocurrency must be managed. Managers with a background in engineering disciplines are more qualified to manage cryptocurrency portfolios because the majority of risks associated with digital assets have more in common with software projects than with financial firms. This was certainly true in the case of Three Arrows Capital.
The fall of 3AC snowballed into a disaster that brought Celsius, Voyager, and a few other crypto credit companies down with them. The extent of damage caused by exposure to 3AC is still unfolding, but it is important to note that the crypto market has managed to outrun Terra and the crypto lending fiasco.