An unprecedented crisis of confidence has occupied the crypto industry for several months.
To measure it, just look at cryptocurrency prices, which are often tied to a platform or project. According to data company CoinGecko, the cryptocurrency market has lost $2 trillion since hitting an all-time high of $3 trillion in early November. Prices for Bitcoin, the king of cryptocurrencies, are down more than two-thirds since hitting an all-time high of $69,044.77 on Nov. 10.
The severity of the crisis deepened earlier this spring with what appeared to be a contained event. In early May, sister coins Luna and UST or TerraUSD collapsed. The crash of the two digital currencies was caused by many investors wanting to liquidate their positions at the same time. At least $55 billion was destroyed in this disaster.
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The collapse of Luna
What may have appeared as an isolated event eventually turned out to be an octopus with multiple ramifications. A month later, crypto lender Celsius Network, which operates like a bank, announced that it was suspending payouts, preventing its customers from accessing their funds. A few days later, Three Arrows Capital or 3AC, a Singapore-based hedge fund, said it was surprised by the loss of Luna, a digital currency in which the company had more than $200 million exposure.
Voyager Digital, another crypto lender, announced that 3AC had defaulted on at least a $630 million loan it had extended to it. Babel Finance, CoinLoan, CoinFlex and other crypto lenders also suspended payouts. BlockFi, one of the big names in the industry, had to turn to young crypto billionaire Sam Bankman-Fried, founder of platform FTX.com, for help. The liquidity crisis spread to other small lenders like Vauld. Crypto exchange Blockchain.com warned its shareholders that it could lose $270 million related to 3AC.
The dominoes began to fall: 3AC was forced into liquidation, Voyager Digital and Celsius Network filed for Chapter 11 bankruptcy. BlockFi has been saved and the future of the others remains uncertain. Your customers don’t know if they can ever get even a small part of their money back.
The link between all of these companies and platforms is 3AC, the hedge fund. Company statements and official documents indicate that a large number of crypto lenders had lent him money. But they don’t seem to have been aware that they were all often hedge fund creditors.
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3AC is an “old-fashioned Madoff-style pyramid scheme”
Three Arrows Capital operated like a Bernie Madoff ponzi scheme in disguise, research firm FSInsight, an independent research firm, said in a recent report. The firm is an “old-fashioned Madoff-style Ponzi scheme” that takes positions similar to those that Long Term Capital Management (LTCM) declined, FSInsight said.
Long Term Capital was a famous hedge fund run by famous Wall Street traders and Nobel Prize-winning economists. The company went under in 1998, forcing the government to intervene to prevent the markets from collapsing.
In the case of Three Arrows, Kyle Davies, 35, and Su Zhu, 35, the founders, acted like Bernie Madoff, according to the research note covering the hedge fund implosion. Davies and Zhu had “exploited their reputation to ruthlessly borrow from almost every institutional lender in the industry,” FSInsight wrote.
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Zhu and Davies likely used “borrowed funds to pay back interest on loans made by lenders while “correcting” their books to generate massive returns on investments,” the note added.
This conclusion raises questions as to whether 3AC’s financial disclosures were true. At its peak, the hedge fund said it had over $18 billion under management. But given the level of exposure crypto lenders had to the hedge fund, it’s likely that most of its assets were bought with debt and its collateralization ratio was quite low, according to Sean Farrell, head of digital assets at FSInsight.
A Ponzi scheme is a fraudulent financial arrangement that consists of paying large returns to existing investors using the capital invested by new investors. This scam thrives on the gullibility of the scammed. It is often only discovered when the funds brought in by the new investors are no longer sufficient to cover the payments to previous investors. This fraudulent scheme was used by former Nasdaq Chairman Bernard Madoff for the largest Ponzi scheme in history.
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“People might call us stupid”
“We were very surprised by the Terra Luna situation,” Davies tried to explain in June.
The two former Credit Suisse traders, who became friends in high school, have been talking ever since. They recently gave a phone interview to Bloomberg News, which was published on July 22nd.
“People might call us stupid. They may call us stupid or delusional. And I will accept that. Maybe,” Zhu told the outlet. “But they’re going to say, you know, that I’ve been siphoning off funds lately where I’ve actually been putting away more of my personal money. That is not true.”
“The whole situation is unfortunate,” Davies told the outlet. “A lot of people have lost a lot of money.”
“What we didn’t realize was that Luna could fall to effective zero in a matter of days and that would trigger a credit crunch across the industry that would put significant pressure on all of our illiquid positions,” Zhu added.
Looking back, the two former Credit Suisse traders say their debacle looks like LTCM’s.
“It was very much like an LTCM moment for us, like a Long Term Capital moment,” Zhu said. “We had different types of trades that we all thought were good, and other people also had those trades,” Zhu said. “And then they kind of all got super devalued, super fast.”
The companies responsible for the liquidation of the hedge fund have complained about the two co-founders’ refusal to cooperate, which they reject.