The Lehman Brothers Of Crypto; Three Arrows Capital Explained

Six weeks after Terra collapsed and one week after Celsius suspended withdrawals, investors are now anxiously watching what was once a top crypto hedge fund, Three Arrows Capital, circling the drain and potentially about to bring more companies down with it.

Three Arrows Capital is sitting on what are believed to be billions of dollars worth loans secured by cryptocurrencies. With the market down 56% this year in its worst bear market since 2018, investors believe the collateral no longer supports the loans. Now the fund is on the hook to start paying them back, and everyone is wondering whether it will default. 

As one indicator of this, 3AC may have transferred 30,000 stETH — they have used this to pay off the Aave debt they incurred following liquidations.

stETH is Lido Staked Ethereum. You lock the Ethereum in Lido but receive the stETH token in return, and you’ll be able to swap this stETH 1:1 for ETH once the Merge takes place. However, 

A month ago, 1 ETH could be exchanged for 1.0248 stETH through the Curve protocol, meaning it traded at a 3% discount relative to Ethereum — a very nice boost in capital for an organization who needs it as badly as 3AC does. The stETH price surged as people who had staked it in the Anchor lending protocol, which runs on the all-but-defunct Terra blockchain, rushed to retrieve it. Since then, however, stETH de-pegged from ETH. and is around 6-7% short of the ETH price.

Not surprisingly, this doesn’t help 3AC.

It also doesn’t take the calculation into account that both ETH and stETH dropped in price. They’re down 41% over the last 30 days, according to CoinGecko. Yesterday Three Arrows sold at least $40M worth of staked Ether as part of an apparent liquidation. 

This also doesn’t help 3AC.

Aggressive Leverage

So, how did they get here?

3AC’s strategy was simple: go big, then go bigger. Leverage, then leverage bigger. They seemed unstoppable in their rise during the 2021 bull market, becoming the largest holder of GBTC — then the Fed’s free money faucet turned off and very quickly their luck turned to liquidations.

Here’s why that matters: If 3AC were to become insolvent, it would be catastrophic for the industry due to their roots stretching far and wide — you can think of them like the hedge fund version of Tether; ubiquitous and yet rotten to the core. 

The mastermind of this insanity was co-founder Su Zhu, who has been aggressive in using leverage to maximize his potential investment returns.

Zhu believed in the super cycle and used a ton of leverage to increase their position size.If the firm cannot pay off its positions, it’ll force more liquidations.”  

On June 15, Zhu alluded to the fund’s troubles in a tweet:

“We are in the process of communicating with relevant parties and fully committed to working this out,” he said.

In the meantime, crypto players have been poring over blockchain data and analysis to garner some sense of Three Arrows exposure, and what might happen next.

Getting Margin-Called

On June 15, Danny Yuan, Head of Trading at 8 Blocks Capital, tweeted that Three Arrows removed nearly $1M from his firm’s trading account. Effectively, 3AC stole a million dollars to help cover their debts.

The two companies worked together for 1.5 years, but Yuan explained that when his team tried calling 3AC’s Operations Team about the $1M withdrawal, they ignored their calls.

“What we learned is that they were leveraged long everywhere and were getting margin-called,” Yuan tweeted. “Instead of answering the margin calls, they ghosted everyone. The platforms had no choice but to liquidate their positions, causing the markets to further dump.”

Three Arrows, which is based in Singapore, has become a force in DeFi by backing some of its most important platforms. It’s invested in Solana, Avalanche, Aave and Terra, as well as GameFi names such as Axie Infinity and NFTs. 

Zhu made his name as a crypto bull championing the idea of a “super-cycle” in which Bitcoin would hit $2.5M and become a new form of gold. He believed the digital assets market would sidestep a bearish turn thanks to blockchain innovation.

On May 27, with the market cratering after Terra’s stablecoin, UST, lost its peg, Zhu admitted he was wrong. “Supercycle price thesis regrettably wrong,” he tweeted. “But crypto will still thrive and change the world everyday.”

Inner Workings

Now investors are wondering, and hoping, that Three Arrows survives. If it can’t service its debts that would be a severe blow to a market already struggling to find its footing. Yet it’s hard to get a bead on precisely what’s going on inside the firm.

Just like TradFi hedge funds, Three Arrows doesn’t share much about its inner workings. What is certain is the domino effect of fear it is causing in the marketplace.

When everyone’s rushing for the most liquid thing in the room, the leverage gets unwound and just triggers the next domino.