Few days before Bitcoin fell below $40,000 for the first time since March, and two months before his hedge fund went bankrupt, Su Zhu sat down for an interview in the Bahamas. An investor as revered and legendary as they come in the decade-old crypto industry, he had a message that betrayed his relaxed demeanor. “When there’s a lot of despair, you can start buying,” he said to the guys at FTX who were recording for a podcast episode. “You don’t have to follow the despair.”

That kind of steely, stubborn optimism isn’t hard to find in an ecosystem that turned the typo “HODL” into a signature mantra for never selling. Only, Zhu wasn’t just any laser-eyed investor or crypto trader. He was running Three Arrows Capital, one of the largest crypto hedge funds in the world. As the events that followed have shown, like many in the crypto ecosystem, Zhu was landscaping and gardening his yard, while the interior decor in his sitting room was on fire. 

What Was 3AC?

Three Arrows Capital, or 3AC for short, is described by its official website as “a hedge fund established in 2012 and focused on providing superior risk-adjusted returns.” The Singapore-based fund was founded by Su Zhu and Carl Davis, two Columbia university alumni who were roommates while at the university. With $1.2 million in funding, they founded 3AC, and the first 3AC office was located in their living room. At first, they concentrated on trading established emerging currencies. Within three years, the company had more than 30 employees.

However, things didn't start to take off until the founders began experimenting with cryptocurrencies. Su claimed that he first realized the potential of cryptocurrencies in 2017. In an interview with Bloomberg, he said, "By the caliber and energy of young people involved in the space, it became extremely clear to me in late 2017 that crypto was going to follow the dotcom cycle of creative destruction, and then in the end become a paradigm shift across finance, technology, culture, and politics."

In 2018, 3AC became exclusively a crypto focused firm. We all know what happened with the crypto markets over the next two years. With that bull cycle came immense returns and tremendous expansion for 3AC. Within those years, 3AC’s investment strategy was initially focused on trading Bitcoin and Ethereum in the derivatives markets.

However, over the years, 3AC has diversified its investment strategy and explored other opportunities within the ecosystem. The fund began to invest in web3 startups, crypto companies in equity rounds, other funds, and NFTs. Leveraging their standing in the ecosystem, they got into strategic positions and investments at prices that others could only dream of. Little wonder, then, that their AUM was able to swell to over $10 billion. 

Why Is 3AC And Its Founders Making Headlines? 

Amidst falling prices, Three Arrows Capital is causing a stir in the crypto space due to its liquidation — which was itself triggered by 3AC’s inability to pay back loans it owed other crypto investment companies. This in turn has exposed the risky lending behaviour going on behind the scenes with crypto institutions, while simultaneously triggering potential liquidations amongst creditors of 3AC. We will get back to the matter of risky lending behavior, but we must first assess the root cause of 3AC’s collapse. 

LUNA Collapse and falling crypto prices

The collapse of the stablecoin TerraUSD (UST) and Terra token (LUNA), which are now known as USTD and LUNC, was the first indication that Three Arrows Capital was in a difficult position. According to court documents, co-founder Davies claimed that in February 2022, 3AC invested more than $200 million in LUNA tokens. The company's investment effectively lost all of its value when the LUNA ecosystem crashed in May.

The business also held staked Ethereum (stETH) tokens and a stake in the Grayscale Bitcoin Trust (GBTC), both of which witnessed a decline in value amidst the current bear run. The latter is a Bitcoin product for institutions, while the former is a tokenized version of staked Ethereum issued by staking service Lido Finance. In comparison to prices a month ago, their respective values have decreased by 18.4% and 10.8%, respectively.

Three Arrows Capital was unable to meet the margin calls on the cryptocurrency loans it had received from other crypto institutions due to the loss of asset value and falling cryptocurrency prices. To get up to speed, a margin call signifies that the investor's asset value has dropped below the threshold and that additional funds are needed to meet the minimum sum. When a margin call is not fulfilled, the brokerage or exchange will sell the assets in the account in order to meet the threshold.

The company suffered its final setback when cryptocurrency brokerage Voyager Digital revealed that Three Arrows Capital failed to make the required payments on a USD$668M loan consisting of 15,250 BTC tokens, worth USD 318M and USD 350M in USDC stablecoins, and was consequently ordered to liquidate by a British Virgin Islands court. Then, on July 2, Three Arrows Capital declared bankruptcy in order to shield its assets from creditors.

Ever since, the co-founders went briefly into hiding. When they emerged, it was discovered that they misappropriated borrowed funds for frivolities such as a bungalow and a yacht. The drama continues to unfold as the company owes 27 companies $3.5 billion — including a co-founder who has now sued it!  

A cascade of potential liquidations

Voyager Digital was next to declare bankruptcy on July 6 as a result of a loan it gave Three Arrows Capital which it couldn't immediately recover. Genesis, a lender for digital assets, BlockFi and Deribit exchanges, the cryptocurrency services Blockchain.com, and the cryptocurrency savings software Finblox were among organizations that have been hard hit by Three Arrows Capital and its financial recklessness. While Blockchain.com is entangled in other financial problems with Three Arrows Capital, BlockFi is being acquired by FTX. 

KEY TALKING POINTS 

What do we take away from yet another event in the long list of crises we have seen in this remarkable bear market? Here are a few: 

Substance And Utility Have to Match the market Caps If We’re Gonna Make It 

The economist Benjamin Graham, known to some as the pioneer of value investing, once compared the financial markets to a voting machine in the short run and a weighing machine in the long run. While Graham likely would have been a skeptic at best about crypto and its volatility were he alive to see it, his economic theory nevertheless applies to certain aspects therein.

Since the emergence of altcoins, the blockchain space has operated like a voting machine. Many projects have, by and large, been financially unsuccessful, have made little or no impact in real life and have even been detrimental to investors and the space at large. They have, instead, turned crypto and other associated markets into a memelord popularity contest, and their resounding success in that regard can hardly be understated. Sometimes that competition is based on who can promise the best future ‘use case’. Whether that future actually arrives is an entirely different issue.

When that is not the case, the key decider is which founder(s) has enough hype to power through the plethora of questions that genuine, objective users of blockchain technology might have. Often, it is based on who markets themselves best, through well-crafted infographics or token names that would pass for items on the menu of a sushi restaurant. Whatever it is, as the past half-decade has shown, the success of the majority of crypto projects is based on speculation and little else. This is what Graham was referring to as that “voting machine.” 

The million-dollar question thus becomes: Is the crypto market towing the path of the dotcom bubble? Truth be told: the similarities are astounding. Both were built using cutting-edge technologies at the time. Both the internet back then and the blockchain today were designed to provide users with a lot of power. Markets have been fueled by fervent dogmatists and widespread FOMO. 

But more importantly, both have largely disregarded economics' fundamental principles. And this could have negative effects on cryptocurrency, one of the most widely traded assets today. If crypto is indeed on its way to global adoption, then it must begin to prioritize substance and utility over hype. This point is moot when the Terra, Celsius and now, 3AC, collapses are examined. 

Blockchain has enormous promise, at least as much as the internet did in the 1990s. However, it will need to get rid of all the extra weight and reach a fundamentally sound level, just like any emerging sector. Before the industry reaches that point, a lot of startups will continue to fail, a lot of blockchain projects will fail, and a lot of investors who rode the FOMO wave will be severely burnt. 

Blockchain will endure (and overcome) the down times, just as the internet did. However, for now, we can — and should — be grateful for these purges. It is helping our ecosystem mature.

The Recklessness of Institutions Must Be Reigned In With Regulation 

However, one of the most important things that has stuck from this collapse is just how reckless crypto institutions can be. There has been a lot of emphasis about institutional adoption and how it can make the crypto markets more robust. However, in this case, the reckless high leverage activities and interdependence on founders who should know better have brought the market to its knees. The focus should be on building a crypto sector that is decentralized, trustless and antifragile. However, what we continuously see is one that has shown itself to be deceitfully closed source and recklessly takes highly leveraged bets on retail deposits. Admittedly, Three Arrows Capital is a hedge fund - so no one really expects it to be open source — but better risk management, particularly with systematic risk, could be applied by the lending firms.

These debacles mean that the gaze of regulators must now be fixed on the sector. Recent managerial and operational decisions by unregulated crypto institutions reflect a need for greater transparency and regulation in the industry. By doing so, we can ensure that businesses, investors and average users can operate with confidence in the sector, while we can preach true openness and trust to the skeptics. 

Who Is Next? Risks From Uncollateralized Lending Protocols

Two prominent lending platforms that provide institutional crypto loans without collateral are Maple Finance and True Finance. In other words, the two lending protocols enable institutional borrowers to get uncollateralized loans to fund operations and expand their businesses. The loans are given out by lenders who contribute capital to various pools in exchange for interest payments from institutional borrowers and any associated lending bonuses. Loans without collateral are unquestionably riskier than loans with collateral since in the event of default, investors lose everything.

Currently, Maple Finance has loans totaling over US$640 million in its Ethereum Pools and USD 113.9 million in its Solana Pools that are still due. Institutions can borrow from two pools on Solana and five pools on Ethereum. Credit specialists and asset managers, referred to as Pool Delegates, create and oversee Lending Pools. They take part by communicating with potential borrowers, determining their creditworthiness, and negotiating terms before making a loan from their actively managed accounts. 

The creation of a Lending Pool by a Pool Delegate is followed by the provision of Pool Cover to that Lending Pool, which acts as first-loss capital for the Pools and unites their interests with those of Lenders.

During the previous bull run, decentralized lending protocols performed four key roles:

1) Facilitated sophisticated investment techniques and increased capital use 

2) Encouraged institutional involvement 

3) Increased liquidity 

4) Facilitated Speculation 

This unique financial product served as a double-edged tool that nourished and accelerated the industry's growth. On the other hand, by permitting cycled lending, it accelerated inorganic expansion and ultimately led to speculative implosion. An illustration of the trouble with poor risk management and aggressive investing methods is the failure of 3AC. (As seen by its crucial USD 559.6 million loss from investments in Luna and Terra, the speculative component took the shape of highly leveraged investments without risk diversification.)

It is important to pay greater attention to uncollateralized lending companies like Maple and TrueFi as well as their clients as the crypto market remains quiet during the bear market. This is because uncollateralized loans are significantly riskier than collateralized loans, and the industry has already experienced a cascade of liquidity crises.

The financial standing of uncollateralized borrowers and their ability to weather possible liquidity crises require special attention. More institutions will see a decline in the value of their asset base as well as increased shortage of liquidity to cover their liabilities if the market becomes more bearish. They would eventually focus their resources to secure their collateralized loans in order to minimize losses (where they could at least get their collateral back and sell their assets for more liquidity by clearing these debts). The uncollateralized loans would be jeopardized, which would cause lending pool investors to suffer severe losses.

It Is Not Yet Over 

The liquidity crisis will have a big knock-on impact, and the fallout is expected to be characterized by more market collapses and more significant capitulations. As a result, the market's mood will be gauged by whether Amber Group and Wintermute Trading, the two largest borrowers of uncollateralized loans, can make good on their repayment obligations. We could anticipate a cascade of similar liquidity crises if the two show their inability to repay their loans (which may be assumed given they took on more uncollateralized loans in August to cover their previous debts).