Bloomberg: How did Three Arrows crash and wreak havoc on the entire crypto industry?

Just days before Bitcoin fell below $40,000, and two months before Three Arrows went bankrupt, Su Zhu sat down for an interview in the Bahamas, with one bare foot dangling leisurely under his leg. As a legendary investor in the decade-old cryptocurrency industry, his message matched his lighthearted demeanor. “When there’s a lot of desperation in the market, you can start buying cryptocurrencies,” he said with a blank face during a recording of a podcast on the FTX exchange. “You don’t have to be dominated by desperation in the market.”

Crypto players like to describe the misnomer “HODL” as a never-sell mantra, and this steely optimism is all over them. But Su Zhu is more than a laser-eyed cryptocurrency trader. Along with his classmate Kyle Davies, he runs Three Arrows Capital, one of the world’s largest cryptocurrency hedge funds with billions of dollars under management, though far from massive by Wall Street standards. But when it comes to digital assets, it’s heavyweight.

Not only that, but Su Zhu and Davies are both influencers in the crypto market, with a combined 610,000 Twitter followers. Three Arrows is a venture investor in some well-known crypto startups, in some cases both a borrower and a shareholder in some of the big lenders, and even Three Arrows is the parent company of other emerging funds.

Su Zhu first rose to fame at the end of 2018 when he correctly judged the end of the last “crypto winter”, when the price of Bitcoin fell by about 80%. So as Bitcoin fell from its peak of over $68,000 this year, rising interest rates caused investors to flee risky assets quickly, but Su Zhu remained optimistic, betting that the cryptocurrency, which Three Arrows Capital was betting on, would bounce back on borrowed cash. . Instead, the market kept sinking, with dominoes falling one after another until they overwhelmed the fund, the biggest domino. In mid-June, Three Arrows Capital began missing margin calls for its trading positions and declared bankruptcy on July 1 as Bitcoin traded below $20,000.

Bloomberg: How did Three Arrows crash and wreak havoc on the entire crypto industry?

In U.S. bankruptcy filings on July 8, advisors overseeing the liquidation fund said Su Zhu and Davies did not work with them and that the whereabouts of the two founders are unknown. On July 12, Zhu tweeted that the “sincerity” effort to work with the liquidators had “been baited.” Su Zhu and Davies and their lawyers did not respond to requests for comment.

Bloomberg: How did Three Arrows crash and wreak havoc on the entire crypto industry?

Kyle Davies

As we all know, the rise and fall of Three Arrows Capital has a lot to do with its transformation and investment in cryptocurrencies. What started as speculation on some well-known tokens like Bitcoin and Ethereum ended up being an interdependent relationship. Crypto firms act like banks, offering depositors double-digit yields and traders borrowing heavily in return. This operating model and the rapid growth of the crypto market drove up the price of cryptocurrencies and the fortune of Three Arrows Capital; when the price of cryptocurrencies reversed this year, 3AC disintegrated and may even accelerate its decline. Although the crypto ecosystem has created many complex concepts, such as smart contracts, white papers explaining tokens, and about Decentralized Finance (DeFi), etc., it is still regarded by the public as a simple speculative gambling game, that is, there will always be more Many buyers entered the market and pushed the price of the cryptocurrency to continue to rise.

Crypto trading platforms including BlockFi and have since disclosed exposure to Three Arrows. Canadian-listed Voyager Digital Ltd. went bankrupt after Three Arrows Capital defaulted on a loan worth more than $650 million. The accounts of many ordinary investors, corporate clients on the Voyager platform have been frozen, and it is unlikely that they will get all their assets back. When the bubble in the financial markets burst, it was discovered that almost everyone had lent money to Archegos Capital, even cryptocurrency Long Term Capital Management.

Cryptocurrencies are prized for their transparent decentralization: transactions are recorded in a public blockchain database, and many are governed by the rules of open-source software. But for the size of Three Arrows Capital, borrowing is primarily a relationship issue, not too different from the way a typical hedge fund relies on banks. Three Arrows Capital borrows from large cryptocurrency lenders without disclosing much financial information. “Only baby boomers trade stocks, by the way,” tweeted Su Zhu and Davies, whose social media characters are populist billionaires. But in the crypto market, no one could have predicted they would Make such a crazy bet. An executive of a trading company, who asked not to be named, said they turned out to be “degens,” meaning unscrupulous gamblers in the crypto market.

The pair have traditional financial backgrounds before cryptocurrencies. After graduating from elite Massachusetts boarding schools Phillips College and Columbia University, Su Zhu and Davies started their derivatives trading at Credit Suisse Group AG in Tokyo. In 2012, the two 20-something friends started their own hedge fund. It’s a small operation that takes advantage of the price gap between derivatives in emerging market currencies, making tiny profits between the two while hoping the money accumulates over many trades.

As digital assets began to take off in 2016, Su Zhu and Davies saw the nascent crypto market become more rife with the kind of pricing gaps that they profited from currency contracts. At its peak in 2021, Bitcoin futures were trading 50% above the “spot” price to buy the token on its own. So Three Arrows sold futures and bought spot, a classic Wall Street strategy that took advantage of the market’s temporary pricing disconnect.

Then came a bigger opportunity. The Grayscale Bitcoin Trust (G BTC ) allows those who cannot or do not want to hold Bitcoin directly to buy shares in the fund that invests in them. GBTC is one of the few U.S.-regulated crypto products, so it has its own market and is so popular that its stock has been trading above the value of its bitcoin holdings.

However, big investors such as hedge funds have ways to buy GBTC shares at a price lower than what the average trader would pay. Grayscale allows them to buy stocks directly by putting their bitcoins in trust. An easy way to make money is to borrow bitcoin, exchange it for shares, and sell those shares at a premium. At the time of the last filing in late 2020, Three Arrows was the largest holder of GBTC, with a position worth $1 billion at the time. But the strategy has a limitation: Stocks bought directly from Grayscale are locked for six months.

Bloomberg: How did Three Arrows crash and wreak havoc on the entire crypto industry?

This limitation becomes a problem from early 2021. The price of GBTC has slipped from a premium to a discount, that is, the stock price is lower than the spot price of Bitcoin, because GBTC faces more intense competition from the same type of products. The discounts got bigger and bigger as the months passed. In early June, TPS Capital, a firm that often brokers Three Arrows borrowings, tried to persuade other speculators to snap up GBTC shares, according to two trading firm executives. TPS chief executive Timothy Chan said Three Arrows made the deal and asked for references. His firm was unaware of any financial distress at Three Arrows, and in any case, as far as he knew, three Arrows would have fallen on deaf ears.

Grayscale products are one of the simplest trading strategies of Three Arrows Capital. For a while, the cryptocurrency world was filled with strange new arbitrage opportunities that looked like a way for sophisticated investors to collect free money. This assessment seems to be especially true in the hot sector known as decentralized finance (DeFi). DeFi aspires to build a replica of Wall Street on the blockchain — with deposits, trading, lending and insurance, but with minimal regulation.

To change the world, DeFi startups need to get people to entrust their crypto tokens to them. At a time when savings in bank accounts are yielding almost zero and safe bonds are yielding less than 2%, DeFi platforms have delivered double-digit yields for depositors in a variety of ways. Like many others, Three Arrows Capital both lends and deposits.

The decline of DeFi has also been brutal as cryptocurrency prices plummeted. The hottest protocol in early 2022 is Anchor Protocol, which offers a 20% interest rate. But to get that, you have to hold TerraUSD (UST), a token created by a crypto founder called Do Kwon, which in turn is tied to another token called Luna. The entire system counts on Luna for value, a bright future assumed in the best of times in the crypto market, where everyone uses the technology developed by Kwon to trade tokens and digital art.

For Three Arrows Capital or many other “madmen”, such a future cannot come soon enough. Davies told The Wall Street Journal that Three Arrows not only made gains on Anchor, but also invested $200 million in Luna in February. At their peak, the combined value of Luna and UST was $60 billion. But when Luna’s price crashed, it all evaporated.

After that, the crash continued to spread through cryptocurrencies. Three Arrows has also invested in ETH in a platform called Lido Finance, in an attempt to generate income from so-called staking. In short, ETH is needed in the technical process of validating blockchain transactions. If you agree to lock up your tokens for a long time to support this campaign, you can get more ETH as a reward in the future. The innovation of Lido is that when its depositors are locked in ETH, they get another tradable token, stETH. stETH traded flat against ETH for most of the year, but fell to a low of 7% after the Luna crash as traders scrambled to get out.

Bloomberg: How did Three Arrows crash and wreak havoc on the entire crypto industry?

Three Arrows Capital is one of them. According to data provider Nansen, on June 14, it withdrew more than 80,000 stETH (over $84 million) from DeFi lending protocol Aave in just four transactions and began converting it back into ETH at a lower price. This is a classic financial crisis sign: Once prices fall far enough, people sell in desperation, even at a loss, which pushes prices even lower. “What we’ve seen during this period is all bubbles burst and digested internally,” said David Fauchier, a crypto fund manager at Nickel Digital. “That’s what happened in 2008. It was a very typical liquidity crunch, not proactive. Central banks step in and do anything.”

The transactions are trackable on a public blockchain, a former employee told Bloomberg Businessweek who declined to be named because they were not authorized to speak publicly. But Su Zhu and Davies have access to funds that regular Reddit crypto traders cannot. They borrow from large digital asset lenders and wealthy holders, and have brokerage deals with JPMorgan and Bank of America. They secured funding for some decentralized finance projects, and a trading firm accused Three Arrows of using $1 million of that to meet margin calls.

In at least one case, Three Arrows declined to share details with lenders. In a text message revealed by Hodlnaut, who offers crypto savings accounts, Davies asked via TPS in May to borrow cryptocurrencies without collateral. After the lender listed its requirements, TPS said Three Arrows did not disclose an audited balance sheet, but provided a statement of net asset value. The value will be self-declared and will not contain a breakdown of its investments. Hodlnaut said it is possible that the cryptocurrency has been transferred.

“What surprised me most about the collapse of Three Arrows was how they were able to accumulate so much leverage,” said Ryan Watkins, co-founder of crypto hedge fund Pangea Fund Management. “It was the lack of transparency that led Three Arrows to borrow so much. Money, also caused panic across the industry because no one knew who was affected and how badly they were.”

In retrospect, Three Arrows Capital has always been a mystery. The fund itself is located in the British Virgin Islands and is licensed in Singapore to manage the funds of others. But Su Zhu and Davies have maintained that the $3 billion pool is entirely theirs, according to Davies telling The Wall Street Journal.

To complicate matters, Three Arrows Capital has also deployed two sub-funds: DeFiance Capital for DeFi investments and Starry Night Capital for digital art investments. DeFiance has outside investors and its founders insist on operating independently, but this structure makes it questionable. Three Arrows is now considering its legal options in light of its bankruptcy, according to a person familiar with the matter who asked not to be named. Three Arrows’ relationship with TPS has also come under scrutiny. In the industry, TPS is known as Three Arrows Capital’s “over-the-counter” desk, although it is a separate company, with shares held by Su Zhu and Davies. Last week, TPS issued a statement saying that while the two companies referred businesses to each other and coordinated loans for Three Arrows, their businesses were distinct.

On June 30, the Monetary Authority of Singapore condemned Three Arrows for providing false information and exceeding its asset management limit, without imposing fines or other sanctions. Before the collapse, Three Arrows Capital was looking to move to Dubai, which is welcoming the crypto industry. Just two months ago, Su Zhu and Davies met with some of the world’s largest venture capital firms and sovereign wealth funds at a Sequoia Capital conference in neighboring Abu Dhabi, according to people familiar with the matter. Some said the pair had an office in an office building in Dubai, although the signage had been removed, and a spokesman for the complex said they had no office there. 

As Three Arrows began to unravel, Su Zhu and Davies met with executives at several cryptocurrency exchanges to discuss the possibility of a bailout. But the results were not optimistic, the people said. Cryptocurrency markets are now experiencing the typical downturn of a credit cycle, just like the global economy. Unlike the real world, where loans are used to start a business or buy a home, the demand for crypto leverage comes almost entirely from speculators. “We all realize that cryptocurrencies are much more relevant to the outside world than they used to be,” said Evgeny Gaevoy, founder of Wintermute, one of the largest cryptocurrency market makers. “A lot of centralized entities like Three Arrows — they further fuel this cycle of prosperity. They make all the numbers much higher than they should be.”

Davies handled most of Three Arrows’ external communications, and Su Zhu was a thinker, former employees said. Su Zhu’s main argument is a “supercycle,” a long-term price increase driven by a technological revolution that will build a decentralized internet on the blockchain. Su Zhu likes to bring up the full history of the Age of Empires, depicting a long road to cryptocurrency domination. Su Zhu’s acquaintances said the pair defended their optimistic crypto beliefs, even at private dinners and group chats. In May, Davies was still talking about buying bitcoin and ether on margin, said a person who knew him at the time but was not authorized to speak to the media.

“Even though they were FX traders before, I was surprised that they seemed to think so sincerely about it,” said Haseeb Qureshi, managing partner at venture fund Dragonfly Capital. After all, forex traders should be used to prices moving in both directions. “They can be misled, especially in a market like this one that is distorted by macro pressures,” he said, “but they really believe these things, and you can read that in their book, right? If you don’t believe it It’s true, you wouldn’t trade like that.”

In a future cryptocurrency vision, something like the collapse of Three Arrows should not happen without a centralized exchange. Sure, people may lose money, but everyone’s assets will be visible on the blockchain. Reputation will not matter. Lost bets below the lender’s collateral requirements will be liquidated mercilessly and no one will wait for a margin call. One of the big lending protocols, Aave, has survived thanks to these rules.

But that future seems far away. The crypto financial crisis of 2022 is like all other financial crises: a wild rise in asset prices at first, excessive trust in the market, and then a sudden collapse of confidence. In May, Su Zhu called his “supercycle” theory “very wrong.” On June 15, he tweeted that he and Davies were “fully committed to this issue.” By then, Su Zhu had quietly removed the hashtags of protocols like Luna from his Twitter profile. His avatar remains: three upward arrows with the words “only up” attached.

Posted by:CoinYuppie,Reprinted with attribution to:
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