“The worst for Three Arrows Capital has already happened.” How the fund’s problems will affect the crypto market

After a series of position liquidations totaling $400 million, one of the largest hedge funds in the cryptosphere, Three Arrows Capital (3AC), is heading toward total insolvency. Experts polled by GetBlock Magazine believe that this could trigger a domino effect that would cause the collapse of other major players and the crypto market as a whole.

3AC's forced position closures come amid a fall in the capitalization of the crypto market - from more than $3 trillion in November 2021 to $859 billion in June 2022. On June 18, bitcoin fell below $20 000 for the first time since 2020, and the drop in most altcoins from their peaks in some cases was as much as 90%.

3AC is one of the largest and most active players in the crypto industry, having invested in many leading lending and trading platforms. 3AC had $10 billion in assets under management in March 2022, according to analyst service Nansen.

When the first rumors of insolvency surfaced, 3AC co-founder Zhu Su kept silent for some time. After apparently growing social media unrest, he tweeted that the fund was “in the process of communicating with relevant parties” and was "fully committed to working this out.”

Millions in debts and silence

Cryptocurrency broker BlockFi was one of the first to publicly announce that it liquidated some of Three Arrows Capital's positions. BlockFi CEO Zac Prince confirmed this on his Twitter account on Thursday, June 17:

“BlockFi can confirm that we exercised our best business judgment recently with a large client that failed to meet its obligations on an overcollateralized margin loan. We fully accelerated the loan and fully liquidated or hedged all the associated collateral.”

BlockFi can confirm that we exercised our best business judgment recently with a large client that failed to meet its obligations on an overcollateralized margin loan. We fully accelerated the loan and fully liquidated or hedged all the associated collateral.— Zac Prince (@BlockFiZac) June 16, 2022

Three Arrows made a strategic investment in BlockFi in 2020, after which it borrowed bitcoins from the platform, but failed to cope with the margin call. According to a Financial Times source, the liquidation of the fund's positions may have been consensual.

Other major lenders to 3AC have also begun making statements. For example, investment platform Finblox, which offers up to 90% annual returns on deposits in cryptocurrency, has cut withdrawal limits by two-thirds, linking the decision to the the situation around Three Arrows, the company's investor.

IMPORTANT UPDATE FROM FINBLOX! pic.twitter.com/VjclRMMiSe— Finblox (@finblox) June 16, 2022

Representatives of the cryptocurrency derivatives exchange Deribit noted that its parent company had a small number of potentially problematic accounts in arrears. Deribit added that the non-payment of these loans will not affect the company's work and the safety of users' funds.

Even in the event that none of this debt is repaid to us, we will remain financially healthy and operations will not be impacted. We can confirm all customer funds are safe and the full insurance fund will remain intact as is. Any potential losses will be covered by Deribit.— Deribit (@DeribitExchange) June 16, 2022

The CEO of the 8 Blocks Capital trading fund, Danny Yuan, also spoke publicly about the problems that arose from his company's partnership with 3AC. According to Yuan, fund representatives took $1 million from 8 Blocks' account without warning to cover the margin call. Yuan and other representatives of Three Arrows' creditors noted that the fund ignored any attempts to contact about what was going on. The head of Genesis, another major 3AC lender, Michael Moro tweeted on Friday, June 17, that his company “carefully and thoughtfully mitigated [its] losses with a large counterparty who failed to meet a margin call to us earlier this week.”

3/Genesis can confirm that we carefully and thoughtfully mitigated our losses with a large counterparty who failed to meet a margin call to us earlier this week. No client funds are impacted. We sold and/or hedged all of the liquid collateral on hand to minimize any downside.— Michael Moro (@michaelmoro) June 17, 2022

On Wednesday, June 22, shares of cryptocurrency broker Voyager Digital fell more than 60% after the company publicly announced that it had loaned Three Arrows 15 250 BTC and $350 million in USDC stablecoins. Voyager made a $25 million repayment request and then demanded that the entire balance be paid off by June 27. At the time of publication, none of those amounts had been paid, and 3AC's failure to repay the debt within the designated period would constitute a default.

“Such a precedent [liquidation of positions] is not as bad as the possible bankruptcy of 3AC,” according to Nikita Zuborev, senior analyst at the BestChange.ru aggregator. Further developments will depend on the actions of fund managers, as they also managed the finances of many projects that they themselves financed.

“So far the market has relatively stabilized, and there is good reason to believe that the worst for Three Arrows has already happened,” the analyst says, “If it turns out that in an attempt to stabilize the fund they squandered the funds of their principals, an additional scandal could destroy the fund both reputationally and physically through the withdrawal of the remaining liquidity by investors. If that happens, the market will see a series of liquidations and another de-linking of synthetic assets like the one that took place in the stETH/ETH pair.”

The “supercycle” didn't work out

The Three Arrows fund, run by Zhu Su and co-founder Kyle Davies, was known for its consistently bullish attitude toward the crypto market. Su had always broadcast the idea of a “supercycle,” in which the growing spread of cryptocurrencies among the masses should inevitably lead to a prolonged rise in bitcoin and the tokens of other crypto projects without significant pullbacks and going into a bearish period. However, in May of this year, Su admitted that the strong market decline played against his idea, but even so, he wrote on Twitter that “crypto will still thrive and change the world every day.”

Supercycle price thesis was regrettably wrong, but crypto will still thrive and change the world every day— Zhu Su 🔺 (@zhusu) May 27, 2022

A large share of the 3AC portfolio was held by the LUNA token, which acted as collateral for TerraUSD (UST) algorithmic stablecoin. Both cryptocurrencies plummeted to zero in May, which became a trigger for a further decline of the entire market. In addition to Terra, the fund invested in numerous crypto projects, including Avalanche, Solana and P2E game Axie Infinity.

Keep an eye on these assets. These are 3AC’s primary holdings. They’ll presumably look to dump during upcoming unlocks. pic.twitter.com/ozXP8HcdXe— Miles Deutscher (@milesdeutscher) June 16, 2022

The $245 million in Ethereum that 3AC invested in the Aave protocol was used to collateralize a loan of another $189 million in USDC and USDT stablecoins. Because the tokens were blocked by the protocol, 3AC was unable to add the collateral needed to repay the debt. This also triggered a cascade of liquidations. The rapidly falling market clearly demonstrated the fund's excessive use of leverage. 3AC held only long positions. To secure loans, the fund also sold 30 000 stETH, at the same time Su removed from its Twitter profile description the entire list of cryptocurrencies in which 3AC invested.

Three Arrows was also the largest holder of GBTC shares owned by Barry Silbert's Grayscale Bitcoin Trust. The trust's shares are currently trading at a 30 percent discount to the bitcoin price after the U.S. Securities and Exchange Commission (SEC) denied Grayscale's registration of the trust as an ETF (exchange-traded fund). Until early 2021, GBTC shares, on the other hand, traded at a markup. This gave arbitrage opportunities to their owners, who could make deposits in loaned bitcoins to Grayscale in exchange for GBTC shares and then sell them on the open market. However, Grayscale does not allow the shares to be converted back into bitcoin.

According to a 3AC report filed with the SEC last year, the fund had about 39 million GBTC shares equivalent to $1,2 billion at the end of 2020.

Who benefits from liquidations

According to the co-founder and former head of the crypto exchange BitMEX Arthur Hayes, the forced closure of positions of major players will put further pressure on the bitcoin exchange rate. On June 20, he drew attention to the sale of 24 500 BTC by the Purpose Bitcoin ETF (BTCC), and noted that after falling 20% over the weekend, the market began to recover on low trading volumes.

1/ BTCC - Purpose ETF puked 24,500 $BTC into the North American Friday close. I'm not sure how they execute redemptions but that's a lot of physical BTC to sell in a small time frame. pic.twitter.com/BY7foKdPjY— Arthur Hayes (@CryptoHayes) June 19, 2022

According to Hayes, given the weak risk management of cryptocurrency lenders and overly generous loan terms, we should expect that the next players will also be forced to sell BTC and ETH.

According to Cryptorg trading platform CEO Andrey Podolyan, those large funds that invest in the DeFi sector are most at risk right now. DeFi mechanisms allow you to re-mortgage your assets several times, gaining leverage. This works well both during normal market behavior and during periods of strong volatility, the expert noted.

“But when there is a prolonged relentless decline, these leverages begin to play a bad role with their owners. After all, when there's a big drop in the exchange rate, the risk of liquidation of the entire re-mortgaged portfolio grows. In order not to lose all capital, funds are forced to sell cryptocurrency on the market, thus, such sales lead to an even greater acceleration [of the decline],” Podolyan explained.

“If the market follows a negative scenario, the whales can only reinforce this trend and further push the market lower in order to trigger a cascade of panic sales and liquidations,” Nikita Zuborev notes. “They benefit from this because of their longer-term planning than that of the average private investor. They are willing to sell some of their assets so they can increase their positions at much lower prices at the height of the panic,” he added.

“The rate drop below $20 000 was bought up by some whale or group of whales who bought up about 100 000 bitcoins,” Andrey Podolyan said, “But now we should pay attention to the US stock market. If it continues to decline, bitcoin will go back to testing the lows. Correspondingly, it will affect funds and we'll see significant liquidations when BTC goes to $17 000.”