Bloomberg: How Three Arrows Capital Collapsed and Triggered a Chain Reaction in the Crypto Industry?

Original Title: “How Three Arrows Capital Blew Up and Set Off a Crypto Contagion”

Written by: Justina Lee & Muyao Shen & Ben Bartenstein, Bloomberg

Translated by: Hu Tao & Binggan, Chain Catcher

Just days before Bitcoin fell below $40,000, two months before Three Arrows Capital's bankruptcy, Su Zhu sat down for an interview in the Bahamas, casually swinging one bare foot beneath his leg. As a legendary investor in the cryptocurrency industry with a decade of experience, his message matched his relaxed demeanor. "When there’s a lot of despair in the market, you can start buying cryptocurrencies," he said expressionlessly in a podcast recording from the FTX exchange. "You don’t have to be governed by the market's despair."

Crypto players like to describe the misspelled term "HODL" as a mantra of never selling, a steely optimism that is evident in them. But Su Zhu is not just a laser-eyed cryptocurrency trader. Together with his classmate Kyle Davies, he runs Three Arrows Capital, one of the largest cryptocurrency hedge funds in the world, managing billions of dollars, although by Wall Street standards, this amount is far from huge. But in the realm of digital assets, it is heavyweight.

Moreover, both Su Zhu and Davies are influential figures in the crypto market, with a combined 610,000 Twitter followers. Three Arrows Capital is a venture investor in some well-known crypto startups, and in some cases, they are both borrowers from large lenders and shareholders in some of those lenders, with Three Arrows Capital even being 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," during which Bitcoin's price fell by about 80%. So when Bitcoin dropped from its peak of over $68,000 this year, with rising interest rates causing investors to flee risk assets quickly, Su Zhu remained optimistic, believing that with borrowed cash, the cryptocurrencies that Three Arrows Capital had bet on would rebound. Instead, the market continued to sink, with dominoes falling one after another until the largest domino, the fund, was overwhelmed. 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.

In the U.S. bankruptcy filing submitted on July 8, the advisors responsible for liquidating the fund stated that Su Zhu and Davies had not cooperated with them, and the two founders were missing. On July 12, Zhu stated on Twitter that the "good faith" efforts to work with the liquidators had been "baited." Su Zhu, Davies, and their lawyers did not respond to requests for comment.

Kyle Davies

It is well known that the rise and fall of Three Arrows Capital is closely related to its transformation into cryptocurrency investments. Starting with speculation on well-known tokens like Bitcoin and Ethereum, it eventually evolved into a mutually dependent relationship. Crypto companies, like banks, offered depositors double-digit yields, while traders borrowed heavily to gain returns. This operating model and the rapid growth of the crypto market drove up cryptocurrency prices and the wealth of Three Arrows Capital; when cryptocurrency prices reversed this year, 3AC collapsed, potentially accelerating the decline. Although the crypto ecosystem created many complex concepts, such as smart contracts, white papers explaining tokens, and discussions about decentralized finance (DeFi), it is still perceived by the public as a simple speculative gambling game, where there will always be more buyers entering the market to push cryptocurrency prices higher.

Subsequently, crypto trading platforms, including BlockFi and Blockchain.com, disclosed their risk exposure to Three Arrows Capital. Canadian-listed Voyager Digital Ltd. went bankrupt after Three Arrows Capital defaulted on a loan worth over $650 million. Many ordinary investors on the Voyager platform and accounts of corporate clients have been frozen, making it unlikely to recover all assets. When the financial market bubble burst, it became clear that almost everyone had lent money to Archegos Capital (Note: Archegos was a South Korean asset management company that lost billions due to a short-selling debacle in 2021), even the long-term capital management of cryptocurrencies.

Cryptocurrencies are praised for their transparent decentralized mechanisms: transaction records are stored in public blockchain databases, and many transactions are governed by open-source software rules. However, for the scale of Three Arrows Capital's funds, borrowing was primarily a matter of relationships, not much different from how typical hedge funds rely on banks. Three Arrows Capital borrowed from large cryptocurrency lenders but did not disclose much financial information. Su Zhu and Davies's social media personas are those of populist billionaires, writing on Twitter, "By the way, only baby boomers trade stocks." But in the crypto market, no one could have predicted that they would make such reckless bets. An executive from a trading firm who wished to remain anonymous stated that they were originally "degens," referring to reckless gamblers in the crypto market.

Both had traditional financial backgrounds before entering cryptocurrency. After graduating from Phillips Academy, an elite boarding school in Massachusetts, and Columbia University, Su Zhu and Davies began their derivatives trading at Credit Suisse Group AG in Tokyo. In 2012, the two friends in their twenties founded their own hedge fund. It was a small operation that exploited pricing discrepancies between emerging market currency derivatives, aiming to earn slight profits while hoping that the money would accumulate over many trades.

As digital assets began to soar in 2016, Su Zhu and Davies saw that the nascent crypto market was filled with the same kind of pricing discrepancies they had profited from in currency contracts. At the peak in 2021, Bitcoin futures traded at a 50% premium to the "spot" price, allowing them to buy tokens themselves. Thus, Three Arrows Capital sold futures and bought spot, a classic strategy on Wall Street that exploited temporary pricing dislocations in the market.

Then came a bigger opportunity. The Grayscale Bitcoin Trust (GBTC) allowed those who could not or did not want to hold Bitcoin directly to buy shares in a fund that invested in it. GBTC is one of the few crypto products regulated by the U.S., so it has its own market and is so popular that its shares have consistently traded at a premium to the value of the Bitcoin it holds.

However, large investors like hedge funds had ways to buy GBTC shares at prices lower than those paid by ordinary traders. Grayscale allowed them to buy shares directly by delivering Bitcoin to the trust. A simple way to make money was to borrow Bitcoin, exchange it for shares, and then sell those shares at a premium. At the end of 2020, Three Arrows Capital was the largest holder of GBTC, with a position valued at $1 billion at that time. But this strategy had a limitation: shares purchased directly from Grayscale were locked for six months.

Starting in early 2021, this limitation became a problem. The price of GBTC slid from a premium to a discount, meaning the share price fell below the Bitcoin spot price, as GBTC faced fiercer competition from similar products. As months passed, the discount grew larger. According to two trading company executives, in early June, TPS Capital, a company that frequently intermediated loans for Three Arrows Capital, tried to persuade other speculators to rush to buy GBTC shares. TPS CEO Timothy Chan stated that Three Arrows Capital proposed the deal and requested a referral. His company was not aware of any financial difficulties at Three Arrows Capital, and in any case, as far as he knew, the company was oblivious to any immediate troubles.

Grayscale's product was one of the simplest trading strategies for Three Arrows Capital. For a time, the cryptocurrency world was filled with strange new arbitrage opportunities that seemed like ways for seasoned investors to collect free money. This assessment seemed particularly true in the hot field known as decentralized finance (DeFi). DeFi sought to build a replica of Wall Street on the blockchain—offering deposits, trading, lending, and insurance functions, but with minimal regulation.

To change the world, DeFi startups needed people to entrust their crypto tokens to them. With savings yields in bank accounts nearly zero and safe bonds yielding less than 2%, DeFi platforms offered depositors double-digit yields in various ways. Like many others, Three Arrows Capital both lent and deposited.

As cryptocurrency prices plummeted, the decline of DeFi was also brutal. The hottest protocol in early 2022 was Anchor Protocol, which offered a 20% interest rate. But to obtain this, you had to hold TerraUSD (UST), a token created by crypto founder Do Kwon, which was linked to another token called Luna. The entire system relied on Luna having value, which was a hopeful future assumed during the best times in the crypto market, where everyone used Kwon's technology to trade tokens and digital art.

For Three Arrows Capital or many other "degens," such a future was not coming fast enough. Davies told The Wall Street Journal that Three Arrows Capital not only earned returns on Anchor but also invested $200 million in Luna in February. At its peak, the total value of Luna and UST was $60 billion. But when Luna's price collapsed, everything vanished.

After that, the collapse continued to spread through cryptocurrencies. Three Arrows Capital also invested in a platform called Lido Finance, trying to earn returns from so-called staking. In short, ETH is needed in the technical process of validating blockchain transactions. If you agree to lock up tokens for the long term to support this activity, you can earn more ETH as a reward in the future. Lido's innovation was that when its depositors locked up ETH, they received another tradable token, stETH. For most of this year, stETH traded at parity with ETH, but after the Luna collapse, as traders rushed to exit, the price fell to a low of 7%.

Three Arrows Capital was one of them. According to data provider Nansen, on June 14, it withdrew over 80,000 stETH (over $84 million) from the DeFi lending protocol Aave through just four transactions and began converting it back to ETH at a lower price. This is a typical sign of a financial crisis: once prices fall far enough, people will desperately sell, even at a loss, which will push prices down further. Nickel Digital crypto fund manager David Fauchier said, "What we saw during this period was everything was a bubble bursting and internal digestion." "This is what happened in 2008. This is a very typical liquidity crunch, with no proactive central bank intervention to do anything."

These transactions can be traced on the public blockchain, according to a former employee who refused to be named, as they were not authorized to speak publicly. However, Su Zhu and Davies obtained funds that ordinary Reddit crypto traders could not access. They borrowed from large digital asset lenders and wealthy holders and reached brokerage agreements with JPMorgan and Bank of America. They secured funding from some decentralized finance projects, with one trading firm accusing Three Arrows Capital of using $1 million of it to meet margin calls.

In at least one case, Three Arrows Capital refused to share details with lenders. In text messages revealed by Hodlnaut, which offers crypto savings accounts, Davies requested to borrow uncollateralized cryptocurrency through TPS in May. After the lender listed its requirements, TPS stated that Three Arrows Capital had not disclosed an audited balance sheet but instead provided a net asset value statement. That value would be self-reported and would not include details of its investments. Hodlnaut claimed that it was possible that the cryptocurrency had already been transferred.

Ryan Watkins, co-founder of crypto hedge fund Pangea Fund Management, stated, "What surprised me most about the collapse of Three Arrows Capital was how they managed to accumulate so much leverage." "It was the lack of transparency that allowed Three Arrows Capital to borrow so much money, which also caused panic throughout the industry because no one knew who was affected and how severely."

In retrospect, Three Arrows Capital had always been a mystery. The fund itself was based in the British Virgin Islands and licensed to manage others' funds in Singapore. But according to Davies, Su Zhu and Davies insisted that the $3 billion fund pool was entirely theirs.

Complicating matters, Three Arrows Capital also deployed two sub-funds: DeFiance Capital for DeFi investments and Starry Night Capital for digital art investments. DeFiance had external investors, and its founders insisted on independent operations, but this structure raised questions. According to an informed source who wished to remain anonymous, given Three Arrows Capital's bankruptcy, it is now considering its legal options. The relationship between Three Arrows Capital and TPS is also under scrutiny. In the industry, TPS is known as the "over-the-counter" desk for Three Arrows Capital, although it is an independent company, Su Zhu and Davies hold shares in it. Last week, TPS issued a statement saying that while the two companies referred business to each other and coordinated loans for Three Arrows Capital, their businesses were entirely different.

On June 30, the Monetary Authority of Singapore condemned Three Arrows Capital for providing false information and exceeding its asset management limits, without imposing fines or other sanctions. Before the collapse, Three Arrows Capital was seeking to move to Dubai, which welcomed the crypto industry. According to informed sources, just two months ago, Su Zhu and Davies were still meeting with some of the world's largest venture capital firms and sovereign wealth funds at a Sequoia Capital conference held in nearby Abu Dhabi. Some said the duo opened an office in an office building in Dubai, although the sign has since been removed, and a spokesperson for the complex said they did not have an office there.

As Three Arrows Capital began to unravel, Su Zhu and Davies met with executives from several cryptocurrency exchanges to discuss the possibility of a bailout. But the outcome was not optimistic, sources said. The cryptocurrency market is now experiencing a typical downturn in the credit cycle, just like the global economy. Unlike the real world, where loans are used for startups or home purchases, the demand for crypto leverage comes almost entirely from speculators. "We all realize that the correlation of cryptocurrencies to the outside world is much higher than it was in the past," said Evgeny Gaevoy, founder of one of the largest cryptocurrency market makers, Wintermute. "Many centralized entities like Three Arrows Capital—they exacerbated the boom of this cycle. They made all the numbers much higher than they should have been."

Former employees said Davies handled most of Three Arrows Capital's external communications, while Su Zhu was the idea person. Su Zhu's main argument was the "super cycle," a long-term price increase driven by a technological revolution that would build a decentralized internet on the blockchain. Su Zhu liked to reference the comprehensive history of empires, depicting a long road to cryptocurrency dominance. Acquaintances of Su Zhu stated that even in private dinners and group chats, the two defended their optimistic crypto beliefs. In May, Davies was still talking about buying Bitcoin and Ethereum on margin, according to someone who knew him at the time but was not authorized to speak with the media.

"Despite their backgrounds as forex traders, I was surprised at how sincerely they seemed to think about this," said Haseeb Qureshi, managing partner at the venture fund Dragonfly Capital. After all, forex traders should be accustomed to bidirectional price fluctuations. "They may have been misled, especially in a market distorted under macro pressure," he said, "but they really believed in these things, and you can see that in their books, right? If you didn't believe this was real, you wouldn't trade like that."

In the future vision of cryptocurrency, such a collapse as Three Arrows Capital should not happen without centralized exchanges. Of course, people might lose money, but everyone's assets would be visible on the blockchain. Reputation would not matter. Bets that failed below lender collateral requirements would be ruthlessly liquidated, and no one would wait for margin calls. Benefiting from these rules, one of the large lending protocols, Aave, managed to survive.

But that future seems far off. The 2022 crypto financial crisis is like all other financial crises: a mad rise in asset prices at first, an excessive trust in the market, followed by a sudden collapse of confidence. In May, Su Zhu called his "super cycle" theory "very wrong." On June 15, he stated on Twitter that he and Davies were "fully committed to solving this issue." By then, Su Zhu had quietly removed tags for protocols like Luna from his Twitter profile. His avatar remained: three upward arrows, accompanied by the words "Only Up."