In the exciting world of cryptocurrencies, Zhu Su and Kyle Davies were big names. They founded Three Arrows Capital in 2012, and at its peak, the hedge fund had $18 billion in assets. However, things took a nasty turn when Luna's algorithmic stablecoin, UST, crashed, and 3AC's poor risk management led to margin calls and ultimately, its liquidation.
The whereabouts of Su and Davies remains a mystery as their creditors hunt for $3.5 billion. Join us as we dive deeper into what happened to 3AC and the valuable lessons crypto investors can learn from this debacle. Brace yourself for a cautionary tale of greed, recklessness, and the dangers of high leverage.
A Brief History
Kyle Davies and Su Zhu were classmates at Phillips Academy and then studied at Columbia University before working for Credit Suisse. They started Three Arrows Capital in late 2012 with $1.2 million, focusing on emerging market currency trading. Soon after, they shifted their focus to Bitcoin and other cryptocurrency assets.
The fund began backing high-profile crypto projects, including Aave, Avalanche, Luna, BlockFi, Ethereum, Polkadot, and Solana. And according to a January 2021 SEC filing, it also owned nearly 40 million units of the Grayscale Bitcoin Trust (GBTC) at the end of 2020. The fund also had a high profile on Twitter, with Zhu having more than 500,000 followers.
In March 2022, Nansen reckoned that 3AC managed about $10 billion in cryptocurrency assets, although its visible assets may have come from uncollateralized borrowing on various lending platforms. Regardless, the hedge fund was one of the best-known names in the crypto space and influenced a significant portion of the market.
3AC's Downfall - What Happened to Three Arrows Capital?
At the height of its success, Three Arrows Capital managed a staggering $18 billion in cryptocurrency assets, solidifying its position as one of the top firms in the industry. This impressive feat was made possible by the fund's early investments in successful projects like Ethereum (ETH) and Avalanche (AVAX).
However, despite its success, poor risk management, reckless dealings with business partners, and a strong desire for profit ultimately led to the fund's downfall. The trouble began with the collapse of LUNA and its algorithmic stablecoin UST, in which 3AC held a significant position worth approximately $560 million at its peak. The fund had used high leverage via counterparty funds to build this position, which it had put in the Anchor Protocol without the knowledge of the counterparties.
The first rumors of a 3AC margin call surfaced after Zhu Su, one of the fund's co-founders, deleted his social media presence and disappeared from the public eye. Reports later revealed that 3AC had deposited $245 million in ETH on the lending platform Aave, using it as collateral to borrow $189 million in USDC and USDT, resulting in a loan-to-value ratio of just 77%. The fund was unable to repay the loan or increase its collateral, and the situation only continued to worsen from there.
3AC Liquidation and Scandal
A court in the British Virgin Islands ordered the liquidation of 3AC, overseen by Teneo, and the fund filed for Chapter 15 bankruptcy to protect its U.S. assets from creditors in early July 2022. Since the default, Zhu and Davies have made some public comments on Twitter, but court papers suggest they have not cooperated with the liquidation process.
According to the company's bankruptcy filings, 3AC owes $3.5 billion to 27 companies, including $2.3 billion to Genesis Global Trading. The filings also accuse the two founders of using company funds to make a downpayment on a new $50 million yacht and two Good Class Bungalows in Singapore for $35 million and $21 million.
For his part, Zhu Su argued in a July 12, 2022, Twitter post that 3AC's good faith to cooperate with liquidators was met with baiting. Su also pointed out that the liquidators failed to exercise StarkWare's token purchase offer, causing the company to lose substantial value and impacting its assets available to liquidate.
Impact on Other Firms
Three Arrows Capital's default continues to send shockwaves through the crypto ecosystem. Blockchain.com, a crypto exchange, had made $270 million in loans to 3AC and Voyager Digital filed for Chapter 11 bankruptcy after 3AC couldn't repay a $670 million loan. Meanwhile, Genesis, BlockFi, BitMEX, and FTX are all facing losses from 3AC.
Aside from those directly impacted by 3AC, the hedge fund's demise has led to tighter underwriting standards and less credit throughout the industry. As a result, many significant funds and investors pull capital out of liquidity pools, contributing to the market's steep decline and sparking concerns over other businesses.
Thus far, Blockchain.com's CEO indicated that the exchange remains liquid and solvent, but Voyager Digital made similar promises before it filed for bankruptcy. In the end, the actual damage caused by 3AC's overleveraged positions may not be apparent for several months as liquidators work through what's available.
Lessons for Investors
The failure of Three Arrows Capital is reminiscent of thousands of similar stories across conventional finance. From the 1929 crash to the 2008 financial crisis, excessive leverage quickly turned modest market corrections into devastating crashes. And these crashes almost always catch investors by surprise, given the preceding market strength.
Investors should remember that leverage is a double-edged sword. While leveraged funds deliver superior returns during bull markets, these gains can disappear overnight during a market crash. Moreover, highly-leveraged markets also open the door to systemic shocks since a single event triggering selling can lead to a chain of margin calls.
In addition, investors should remember from what happened to 3AC is that diversification is often the best way to mitigate these risks. For example, investing across non-correlated asset classes can minimize the risk of any single market crash impacting your entire portfolio. That's even true within the crypto space, where different types of tokens have different dynamics.
The Bottom Line
Three Arrows Capital became the latest casualty of the crypto winter when it filed for bankruptcy in mid-2022. With the failure of Luna and leveraged positions in cryptocurrencies causing tremendous losses, the move shouldn't come as a surprise. But ultimately, these losses could spark concern among mainstream investors over the long term.
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Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
