Crypto Analysis Case Study - ‘Three Arrows Capital’: PART II

By Rodrigo Zepeda, CEO, Storm-7 Consulting

Introduction

In Part I of this Crypto Analysis Case Study, we identified the co-founders of the crypto hedge fund ‘Three Arrows Capital’ (3AC), namely Kyle Livingston Davies and Su Zhu, their background, the legal entities through which 3AC operated, and an overview of the types of crypto investments the firm made. In Part II of this Case Study, we will put together events that may have directly and indirectly contributed to the collapse of the crypto hedge fund. Because of the complexity of these events, we will cover analysis of these events and how they impacted 3AC in Part V of this Case Study. 

Identifying the 3AC Window of Analysis

In November 2021, the price of Bitcoin (BTC) had surged to a new high of $68,000 (£50,000), and analysts were predicting that it would rise further in 2021 and beyond (Kollewe 2021). Instead, crypto market capitalisation plummeted from $2.3 trillion (£1.71 trillion) to $1.6 trillion (£1.18 trillion) in the space of the first three weeks of January 2022, i.e., a decline of 30% (Wang 2022). The value of Bitcoin fell by 28% and the value of Ether (ETH) fell by 40% (Wang 2022). This extreme volatility precipitated a negative crypto cycle that continued throughout the first quarter of 2022.

On 29 April 2022, the ‘Registered Fund Management Company’ (RFMC) of 3AC situated in Singapore, ‘Three Arrows Capital Ptd. Ltd.’ (3AC Singapore), notified the Monetary Authority of Singapore (MAS) of its intent to cease fund management activity with effect from 6 May 2022 (MAS 2022). The question is, did this notification at such time indicate that 3AC was already in trouble and/or potentially thinking about winding down its operations? I believe the answer is ‘No’.

The ‘FTX/SALT Crypto Bahamas’ was a crypto conference that took place in Nassau, Bahamas from 26 to 29 April 2022. 3AC co-founder Mr Zhu was in attendance at the event. On 28 April 2022, it was reported that Mr Zhu had confirmed at the event that 3AC had decided to move its headquarters in Singapore to Dubai, United Arab Emirates (Wang 2022; Ossinger 2022). It was further noted:

“The planned move comes as Three Arrows Capital organizes its first-ever fund that would take capital from external investors, according to sources familiar with the matter." (Wang 2022).

So, at this time (i.e., April 2022), 3AC was not only planning to re-locate its headquarters from Singapore to Dubai, but it was also planning to set up a new investment fund based on external investment for the first time. Whilst theoretically, such a fund might be set up with a minimum of $100 million, it would likely necessitate at least $250 million to attract sufficient investment interest from external investors. Consequently, it seems highly unlikely that 3AC was planning both these new moves, which would require significant financial expenditure and considerable time and effort, at the same time as it was suffering from massive financial difficulties and/or financial losses.

If this analysis is correct, it would mean that 3AC operations instead actually fell apart across a very short time frame, namely from May 2022 to June 2022. It would seem to be the case that a series of events and decisions contributed to the ultimate collapse of 3AC in June 2022. It did not come down to a single mistake made by the firm. In Part I of this Case Study, we identified there were at least three potential valuations of the firm’s assets, namely $18 billion (£14.9 billion), $10 billion, and just over $3 billion (Chipolina and Samson 2022; Hern and Milmo 2022; Shen 2022). For present purposes, we will assume the lowest valuation, i.e., $3 billion which is $3,000 million in April 2022. [I will explain why in Part V of this Case Study.]

The Percentage of Private Equity Crypto Investments held by 3AC

In Part I of this Case Study, we identified that 3AC had taken a range of venture capital (VC) equity stakes in crypto technology start-up firms, which covered areas such as GameFi, Base Layer, blockchain scaling solutions, decentralised finance (DeFI) applications, non-fungible tokens (NFTs), and crypto trading platforms. For present purposes, the importance of these types of investments lies in their theoretical valuations and lack of liquidity.

Equity stakes in a crypto business may have a high theoretical (paper) value, but they may feature a significant lack of liquidity, i.e., the stake may not be capable of being readily sold on open market, or 3AC may have been precluded from selling the investment stake for a fixed period of time, e.g., 3 to 5 years. So, for example, if 3AC held $2,500 million in crypto business equity stakes, it would feature a high accounting (paper) valuation in terms of assets held or invested in, but it would have a comparatively lower investment capacity, i.e., it had only $500 million remaining that could be invested.

This is an important point for readers to understand, as they may think why did 3AC get into trouble if it held around $3 billion in assets. Holding a VC investment in a new crypto technology company may be highly profitable in the long run, as 3AC might invest $1 million and then later sell its VC investment for $15 million five years later. The problem is that 3AC may be tied-in for a pre-determined long-term investment period. The larger the proportion of VC investments held by 3AC, the lower the amount of readily available funds it would have to employ for crypto trading and investment purposes, or to deploy in cases of emergency.

Leveraged Trading

3AC employed leveraged trading which very likely contributed to its downfall. There are three types of leverage which 3AC may have used. First, 3AC may have used loans, for example by taking out a market loan at a low fixed interest rate, e.g., $10 million at a fixed daily simple interest rate of 3%. The loans may not have been sourced through traditional banks and financial intermediaries, but rather through DeFi lenders such as online lending platforms.

If 3AC used the loaned monies and invested in high return crypto investments (e.g., 23% equivalent interest rate), it would have been able to both service the loan interest repayments and gain significant profits. Historically, this type of trading may have been extremely attractive within certain crypto investments that provided a high return on investment (ROI), e.g., of 100% or more. For example, the one-year ROI from October 2020 calculated for Bitcoin was 401%, for Ethereum it was 919%, for Cardano it was 2045%, for Solana it was 6,499%, and for Terra/LUNA it was 14,119% (Phemex 2021). Second, 3AC could also employ leverage through margin trading.

For example, if a crypto trading exchange (CTE) (e.g., a centralised exchange (CEX) such as Binance, BitMEX, Blockchain.com, FTX, Gemini, Kraken) offered 3AC a leverage ratio of 10:1, this would mean 3AC would need to deposit $10,000 in its crypto trading account to enter into a trade of $100,000. So, if 3AC deposited $1 million of the money it loaned previously, it would be able to enter into a trade of $10 million, and if it deposited all $10 million, it would be able to enter into a trade of $100 million.

This would represent double leveraged trading, i.e., through the loan (first) and then through the margin (second). Margin trading requires a margin threshold, referred to as maintenance margin (MM), for trades to be established, e.g., 50% of the initial margin (IM). If a MM level is breached this will trigger a close out of the trading position. If IM is set at $1 million (to maintain a $10 million trade using 10:1 leverage), a MM of 50% would amount to $500,000. So, if the funds in 3AC’s trading account fell to $500,000, its trading position would be closed out by the CTE.

To prevent this from happening, the CTE would make a margin call (e.g., at 80% of IM = $800,000) which would require 3AC to top up its trading account to prevent its trading position from being closed out. In this way, crypto investments using margin trading can be extremely profitable if crypto investments keep rising (profits on $10 million using only $1 million of 3AC’s funds). However, whilst margin trading can magnify gains, they can also massively magnify losses. So, to keep a position open, 3AC might be required to keep on adding margin if a crypto investment continued to fall in value (if 3AC believed that the crypto investment would soon turn around and increase in value).

To maximise crypto trading even more, 3AC likely carried out what I will refer to as triple leveraged trading. This is margin trading spread out across multiple CTEs, thereby leveraging different leverage ratios (e.g., 10:1, 20:1, 100:1), IM and MM requirements, and trading limits offered by different CTEs. Therefore, to leverage its trading capacity even more, 3AC would likely have opened up crypto trading positions across multiple CTEs. Whilst this can maximise potential crypto trading gains, it can also make crypto trading operations particularly complex and challenging (as multiple margin calls may be continually requested at different levels and different times during times of market volatility).

12 MAY 2022: The Collapse of TerraUSD and LUNA

Just prior to its collapse, the algorithmic stablecoin ‘TerraUSD’ (UST), which was stabilised via its sister token Terra (LUNA), was valued at around $18 billion (Sandor and Genç 2022). From 7 May to 11 May 2022 UST experienced severe capital flight, signalling a huge loss in confidence in the Terra blockchain protocol, which ultimately led to the collapse of the UST stablecoin and the LUNA token (Kessler and Young 2022). On 12 May 2022, LUNA experienced a 96% fall in value resulting in a trading price of less than 10 cents (Sandor and Genç 2022).

The collapse of TerraUSD and LUNA ultimately played a central role in the collapse of 3AC. The ‘Luna Foundation Guard’ (LFG) was launched in January 2022 to improve the sustainability of its stablecoins, and to expand the Terra ecosystem (Wright 2022). The launch included a $1 billion LUNA token sale (Wright 2022). It was reported by Mr Davies that 3AC had initially purchased around $200 million in LUNA tokens (Bourgi 2022).  

However, in June 2022 it was alleged by a whistleblower from the Terra Community Forum that 3AC had purchased 10.9 million locked LUNA, originally valued at close to $560 million ($559.6 million), but whose value at the time of disclosure (14 June 2022) had fallen to $670.45 (Bourgi 2022). So, there are at least three potential scenarios that arise for 3AC. First, 3AC only lost its initial $200 million investment, second, 3AC lost $560 million which represented an accumulated LUNA investment ($200 million + $360 million), or third, 3AC lost $760 million which represented a cumulative LUNA investment ($200 million + $560 million).

The Cryptocurrency Crash

The ‘First Wave’ in May 2022

The combined collapse of TerraUSD and LUNA resulted in a loss of around $40 billion in investments in the stablecoin framework (Jha 2022), which thereafter precipitated a general fall in the value of both Bitcoin and Ether in the crypto markets. These are cryptocurrencies which 3AC was known to have invested significantly in. In the second week of May 2022, it was stated that Ether had lost more than 30% of its value, and that more than $300 billion in value had been wiped out by the ensuing first wave crash in cryptocurrency prices (Yaffe-Bellany, Griffith, and Livni 2022; Chambers 2022). Indeed, the media reported that the melt down in cryptocurrencies had essentially sparked a perfect storm of fear and panic in the crypto markets (Yaffe-Bellany, Griffith, and Livni 2022).

On 20 May 2022, it was calculated that, year-to-date, the value of Bitcoin was down 36.9%; Ethereum was down 46.3%; Ripple (XRP) was down 48.7%; Cardano (ADA) was down 61.4%; and Solana (SOL) was down 70.0% (Warner 2022). This meant that not only had 3AC taken a large financial hit with the losses incurred through its Terra/LUNA investments, but its investments in its crypto portfolio were also likely very quickly losing value. This was highly problematic for three reasons. First, the firm’s standard (non-leveraged) crypto investments and cryptocurrencies held in accounts were losing value.

For example, in theory a 20% weighted average loss (WAL) in cryptocurrency values in May 2022, would mean that 3AC’s $3,000 million value decreased to $2,400 million in one month. If this 20% WAL continued in June 2022, it would mean that 3AC’s $2,400 million value decreased to $1,920 million, i.e., a combined 8-week loss of $1,080 million. A 30% WAL would leave $1,470 million and a 40% WAL would leave $1,080 million of assets remaining. This is why concentration risk across a single investment class can become so problematic in times of high market stress.

Second, its leveraged crypto investments very likely triggered a range of margin calls for additional funds to be added to its crypto trading accounts, and third, the value of its crypto collateral posted would likely also have deteriorated in value. This meant that 3AC was likely forced to repay a range of outstanding loans and margin calls within a very short space of time. For example, it was noted that 3AC’s fire sale of Lido Staked Ethereum (stETH) commenced in May 2022 straight after the collapse of Terra’s UST stablecoin. In June 2022 3AC liquidated all its holdings of stETH, e.g., by 17 June 2022 it had liquidated 27.15 million of its stETH holdings, valued in Tether stablecoin (USDT) (14,118 to 13.5 million USDT; 7,000 to 6.86 million USDT; 7,118 to 6.79 million USDT) (Singh 2022).

The ‘Second Wave’ in June 2022

On 17 June 2022, the crypto lending and trading services firm, Babel Finance, announced that it was temporarily suspending redemptions and withdrawals due to unusual liquidity pressures (Babel Finance 2022). Withdrawal limits were also imposed by competitor firms Finblox (crypto yield generator), Celsius Network (Celsius) (crypto lending platform), and CoinFLEX (crypto exchange) (Nagarajan (June) 2022; Wagner 2022; Yang 2022). The suspension of all transfers, swaps, and withdrawals announced by Celsius on 12 June 2022 was highly significant.

This was because not only did it affect around $12 billion in crypto assets held by users on its platform, but it also indicated the high prevailing level of market volatility, along with the perceived risk of contagion and systemic risk operating within the crypto markets at such time (Barrett 2022). It fuelled rumours that the platform had become deeply insolvent, and in fact, amidst mounting liquidity issues throughout June 2022, Celsius did indeed file for Chapter 11 bankruptcy protection in the US Bankruptcy Court for the Southern District of New York on 13 July 2022 (Napolitano 2022). According to a report published by the crypto analytics firm ‘Nansen’, 3AC was a victim of trackable contagion that arose in the crypto markets at such time (Locke 2022).

3AC’s Failure to meet Loan Payments and Margin Calls

On 16 June 2022 it was reported that the crypto lending platform ‘BlockFi Inc.’ (BlockFi), had exercised its best business judgment and liquidated the position of a large client (referred to as 3AC) because it had failed to meet earlier margin calls (Nelson 2022; Shubber and Oliver 2022; Yang and Miller 2022). On 17 June 2022, Genesis Trading publicly noted that it had sold and/or hedged all liquid collateral held by it on behalf of a large counterparty (later confirmed to be 3AC) who had failed to meet a margin call made earlier in the week (Bellusci 2022; Nagarajan (July) 2022; Alpher 2022).

On that same day it was reported that FTX, Deribit, and BitMEX had all liquidated trading positions held by 3AC owing to 3AC failing to meet margin calls, with BitMEX reported to have been owed around $6 million (Khatri 2022; Malwa 2022). It was reported that 3AC’s trading positions held at Bitfinex had been closed at a loss (Khatri 2022). Deribit later claimed that 3AC had failed to repay $80.13 million (1,300 Bitcoin + 15,000 Ether together valued at $42 million loaned in March 2020 + $37.1 million in negative asset values) still owed to the crypto exchange, and so it had terminated its outstanding lending agreement with 3AC on 15 June 2022, owing to breach of the minimum account balance requirement on 11 June 2022 (Chipolina 2022).

At this time 3AC publicly noted that it had hired legal and financial advisers and was looking at different options that might be available to it, including the possibility of asset sales and some form of a rescue or bail-out (Malwa 2022; NG 2022; Reuters 2022; Yang and Miller 2022). However, it was also identified that 3AC had failed to pay $270 million to Blockchain.com, which was owed this sum in cryptocurrency and United States (US) dollar denominated loans (Allison 2022). The crypto broker firm ‘Voyager Digital, LLC’ (Voyager) had also previously notified 3AC that it required a repayment of $25 million US Dollar Coin (USDC) by 24 June 2022 (Ge Huang 2022).

However, this demand was later amended to instead require 3AC to repay all loans outstanding by 27 June 2022, i.e., acceleration of all existing debt (Ge Huang 2022). When 3AC later failed to repay loans totalling just over $670 million (one loan worth $350 million (valued in USDC) and one loan worth $323 million (valued as 15,250 Bitcoin)), Voyager served a loan default notice on 3AC (Hedgeweek 2022). It was Deribit and Blockchain.com that were among 3AC’s creditors that sought to push for the liquidation of 3AC (Crawley 2022; Thomas 2022). The order for liquidation of 3AC was made by the Supreme Court (High Court) in the British Virgin Islands on 27 June 2022.

To be continued.