Three Arrow Capital (3AC), a Singapore-based cryptocurrency hedge fund that at one point managed over $10 billion in assets, was one of the many crypto firms that went bust in this bear market.

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However, the drop in 3AC was not purely a market phenomenon. As more information became available, the crash looked more like a self-inflicted crisis, caused by an out-of-control decision-making process.

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In short, the hedge fund ran a series of large directional trades with Grayscale Bitcoin Trust (GBTC), Luna Classic (LUNC) and Staked Ether (stETH) and borrowed funds from over 20 major institutions. The crypto crash in May led to a series of spiral investment hedge fund collapses. The firm went bankrupt, and loan defaults led to massive crypto-infection.

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The first hints of possible insolvency emerged in June with a cryptic tweet from co-founder Zhu Su following the movement of 3AC funds. The collapse of the cryptocurrency market led to a sharp drop in the prices of major cryptocurrencies, including Ether (ETH), which led to a series of hedge fund liquidations.

3AC exchanged roughly $500 million worth of bitcoin (BTC) with the Luna Foundation Guard for the fiat equivalent of LUNC just a few weeks before the Terra explosion.

Rumors intensified after Zhu removed all mention of investments in ETH, Avalanche (AVAX), LUNC, Solana (SOL), Near Protocol (NEAR), Mina (MINA), decentralized finance (DeFi) and non-fungible tokens from his account ( NFT). A Twitter biography that only mentions Bitcoin (BTC).

The series of 3AC liquidations has had a disastrous impact on crypto lenders like BlockFi, Voyager and Celsius. Many crypto lenders ended up having to file for bankruptcy due to the impact of 3AC.

Sam Callahan, bitcoin analyst at Swan, a provider of BTC savings plans, told Cryptooshala:

“Using only publicly available information, in my opinion, the failure of 3AC 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 on you. In this case, 3AC borrowed hundreds of millions of dollars, mostly from cryptocurrency lending platforms, to arbitrage bets on risky DeFi protocols. One such risky bet was Terra. Of course.”

He added that 3AC didn’t admit mistakes, borrowed more money, and “allegedly even used customer funds to place bets to try and get their money back. This was the moment when 3AC turned into a more egregious Ponzi scheme. As overall market conditions continued to worsen and liquidity dried up, 3AC was exposed as the Ponzi scheme it became, and the rest is history.”

Looking at the timeline of events in 3AC:

  • May 11–12: Immediately after the collapse of Luna, several creditors ask about the insecurity of Luna, 3AC says there is nothing to worry about.
  • May 18: Co-founder Kyle Davis tries to prevent loan recalls
  • June 3: Increase in interest rates on loans due to market conditions
  • June 7: The 3AC team tells investors about new opportunities to save the company
  • June 10–11: Crypto options broker Deribit margins with 3AC mobyDck account
  • June 13: Davis is trying to get a new loan from Genesis to pay a margin call
  • June 16–17: Bankruptcy of 3AC received wide publicity

3AC in the end filed filed for Chapter 15 bankruptcy July 1 in New York court, whereabouts of founders unknown.

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Marius Ciubotariu, co-founder of the Hubble Protocol, believes that the 3AC credit crunch highlights the resilience of the DeFi ecosystem. He told Cryptooshala:

“The challenges faced by 3AC are not unique to cryptocurrencies or financial markets in general. Cryptocurrency is currently the only financial market where market dynamics are allowed. The 3AC crisis has shown how resilient DeFi protocols really are. For example, Celsius suffered losses on loans and received a margin call. Fearing automatic online liquidations that are visible to everyone, they rushed to pay off their MakerDAO and Compound loans first.”

3AC owes $3 billion to creditors

3AC’s liquidators have requested a suspension of legal proceedings against the business and access to its Singaporean offices in a petition to the Singapore High Court. Court documents show that 3AC owes about $3 billion to creditors, of which 3AC’s largest creditor, trader Genesis Asia Pacific, a subsidiary of Digital Currency Group, lent $2.36 billion.

Among the long list of creditors, Zhu Su also filed a $5 million lawsuit. It is reported that in addition to Zhu’s statement, investment manager 3AC ThreeAC Limited manufacturing lawsuit for $25 million. Kyle Davis’ wife, Kelly Kali Chen, is reportedly seeking $65.7 million in debt in the same Eastern Caribbean Supreme Court lawsuit. On June 27, a court in the British Virgin Islands issued a decision to liquidate 3AC.

There is speculation that founders Zhu and Kylie used investor funds to make a down payment on a $50 million yacht. However, other reports claimed that Zhu tried to sell his home after the 3AC crisis.

Nansen blockchain analytics company report showed that there was an active and traceable infection in the markets. The stETH depeg was partly caused by the collapse of the TerraUSD Classic (USTC). The report claimed that 3AC fell victim to this contagion, as it sold its stETH position at the height of the depeg panic, going down a lot.

Jonathan Zeppettini, head of international operations at decentralized autonomous currency platform, believes that market conditions played a minimal role in the 3AC saga and only helped prevent further fraud. He told Cryptooshala:

“They were really just participating in other scams like Terra and acting as intermediaries between dubious investments and lenders who thought their reputation was so unblemished that it exempted them from having to do their due diligence. Cascading liquidations triggered by a market correction ended the game. However, in reality, their model has always been a ticking time bomb and would have exploded in the end, no matter what.”

Michael Guzik, CEO of institutional lending platform CLST, told Cryptooshala that 3AC has failed to mitigate market risks, and the wave of crashes and liquidity crunch underlying it all are “a reminder of the importance of age-old lending/borrowing practices like leverage.” and counterparty risk assessment”.

3AC was very opaque as the largest cryptocurrency hedge fund, and after the crash came, it continued to lie to investors about the extent of creditor losses, the flow of funds, and its directional market impact.

Centralization and opacity in crypto firms

The fall of 3AC highlights the fragility of centralized decision-making, which can turn into a nightmare during a bear market. The centralization of the decision-making process in the activities of 3AC became known only after its positions began to be liquidated.

Zhu and Davis, the founders of the tainted hedge fund, said they received a series of death threats after the collapse of 3AC, forcing them to go into hiding. The two founders acknowledged that overconfidence, born from a years-long bull market in which lenders saw their value rise thanks to financial firms like them, led to a number of bad decisions that should have been avoided.

Joshua Peck, founder and chief investment officer of crypto hedge fund Truecode Capital, explained to Cryptooshala that 3AC’s failure is particularly detrimental, as is her venture investing, she often managed the treasury of her portfolio companies, plus she was held in such respect that many other platforms have provided significant loans to them, such as $270 million in loans.

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The full extent of its interdependence with other digital asset companies was unclear until 3AC’s positions began to be liquidated during the cryptocurrency bear market in 2022. It quickly became apparent that many firms were more affected by the 3AC than generally thought. Peck told Cryptooshala:

“We believe that in order to avoid a complete loss in the crypto market, the entire risk profile of cryptocurrencies must be managed. Managers with backgrounds in engineering disciplines are more qualified to manage cryptocurrency portfolios because most of the risks associated with digital assets have more to do with software projects than with financial firms. This is certainly true in the case of Three Arrows Capital.”

The fall of 3AC turned into a disaster that killed Celsius, Voyager and several other cryptocurrency lending companies. The extent of the damage caused by the impact of 3AC is still being revealed, but it is important to note that the crypto market has managed to overcome Terra and the crypto lending fiasco.