By now you’ve probably heard of the collapse of the multi-billion-dollar VC firm Three Arrows Capital (3AC). For a fund that once held over $10 billion under management, nobody predicted its demise to happen so quickly. In this piece, we will break down what went wrong for 3AC and discuss its effect on the entire crypto market.
What Is 3AC?
Founded in 2012 by high school classmates Su Zhu and Kyle Davies, 3AC started small with around $1 million in capital as they worked out of an apartment together in San Francisco. Since that time, they grew to manage billions of dollars, but how did they get there?
For starters, they only managed their own money, rather than the money of others. This would make them more of a trading firm than a VC, as VCs manage the capital of other investors. 3AC was able to dominate trading in the bull and bear cycle, making lots of money by trading Bitcoin and Ethereum derivatives. In addition to becoming successful with trading, 3AC was also able to correctly predict the end of crypto winter around 2019, with Zhu predicting a quick growth curve the second the market flipped from bear to bull. Combine successful trading and timing the bottom, and 3AC profited tremendously.
In addition to their Bitcoin and Ethereum trades, 3AC was also able to gain access to some incredible cryptocurrency project seed rounds. Seed rounds are funding periods that are only accessible by the wealthiest investors, and often lead to buying assets at insanely cheap prices before the public has a chance to buy. The tradeoff with seed rounds is that investments are locked for periods of time (also known as vesting schedules). These vesting schedules are set up to help prevent quick selloffs from these investors who hold a large number of tokens. For example, a company may buy 1000 tokens at the price of $1, but by the time the token is available for public trading, the token is trading at $25. This would be an instant x25, where many would be tempted to sell. Vesting schedules would force this company to only be available to sell a portion of their 1000 tokens over periods of time rather than all at once (more on this later). By investing a multitude of seed rounds, 3AC was now additionally making insane money on these ground floor investments. As the community saw the success of 3AC, many investors started to feel comfortable giving them money to invest (turning them into a VC), while exchanges felt comfortable loaning out large sums of money.
What Went Wrong?
Many tend to see past success as a predictor of future success. Unfortunately for 3AC and those connected to them, that is not the case. 3AC experienced a storm of events that turned the once flourishing firm into a firm on the brink of insolvency.
The first of many blows can be traced back to the Luna Foundation. 3AC participated in a token purchase of Luna to help fund the Luna Foundation Guard who would then go on to buy Bitcoin with the money. This reserve was created to defend the peg of UST. As things played out, Luna and UST entered the dreaded “death spiral". 3AC had approximately $560 million invested in Luna, most of which was locked as part of the agreement with LFG. This forced 3AC to helplessly watch their investment crumble to less than $1000. Regardless of how big a company is, turning that sum of money into vapor will hurt business operations by also forcing the company to have much less cash on hand. Being illiquid poses a risk!
In addition to the Luna catastrophe, 3AC was also involved in another investment that would hurt them tremendously. In 2020 and 2021, 3AC was the largest holder of GBTC (Grayscale Bitcoin Trust). This trust held a large amount of Bitcoin, and it was largely considered the best option for institutions and the older generation to gain exposure to BTC in their 401ks and IRAs. When Grayscale was the main way for big money funds to gain exposure to BTC, GBTC traded at a high premium. This means that the value of the GBTC stock price was trading at a market capitalization that was higher than the market capitalization of the physical Bitcoin held by Grayscale. For example, GBTC could hold 100 bitcoins at $5. The value of the BTC on hand is $500. If GBTC was trading at a premium, the market cap of GBTC could be trading at $600, even though it only held $500. Once other BTC exposure alternatives rose, the GBTC premium fell because institutions could gain exposure through other trusts that offered lower management fees. This eventually flipped the premium to a discount. Here is why this caused a problem for 3AC.
Three Arrows Capital was partaking in a GBTC arbitrage trade. Arbitrage is the buying of an asset at a price, and then selling that same asset for a higher price. With Grayscale, they allow institutional investors to buy GBTC shares at a price directly correlated to the value of the physical bitcoin it held, even if GBTC was trading at a premium. Institutions would then have a 6-month lock-up period of their shares. Once the period ended, they were able to sell their shares at the premium that retail investors were paying.
For example, the price of the physical Bitcoin held by GBTC could correlate to GBTC being worth a “true” value of $20 a share. If Grayscale was trading at a 25% premium, the GBTC price on the open market would be $25 a share. Groups like 3AC could then buy a share for $20, wait 6 months, and then sell for $25. By repeating this process over and over they made a great deal of easy money. The problem is if the premium collapsed and flipped to a discount, the price on the open market would be less than $20. This meant the arbitrage trade was no longer feasible because all the shares bought at $20 could not be sold at a higher value. With the easy money pipeline running dry, 3AC was now in even more trouble. Surprisingly, only days prior to rumors of a collapse, 3AC was rumored to be pitching the idea of a new GBTC trade to potential investors in hopes that GBTC switched to a spot ETF. What may be even more surprising is as things stand now, 3AC no longer owns any GBTC. Could this be forced liquidation to pay off debt? Only time will tell.
On top of the Luna collapse and GBTC arbitrage ending, 3AC traded with leverage. Leverage rarely ends well for most, 3AC included. On top of using leverage, most positions were long (bets that prices will go up). In a bear market, leveraged longs are the fastest way to lose money. To use this level of leverage, 3AC borrowed money from some big lenders. An example of one of their loans is from the popular company known as Voyager. Voyager lent out 15,250 BTC and 350 million USDC, a value of approximately $660 million.
As of today, Voyager has been unable to contact 3AC to pay more collateral, and if requests are not met by June 27th, Voyager will be forced to liquidate the loan and seize what it can. Unfortunately for Voyager, they are not guaranteed a full return and could take a big loss. 3AC has taken loans out in varying sizes from other lenders like BlockFi, Genesis Trading, Bitmex, and Finblox. By most accounts, 3AC was getting liquidated left and right, often ghosting the lenders when they tried to get in contact.
What is the effect?
With the implosion of 3AC, there will be a lot to be learned for the future of the crypto market. Lessons were learned from previous monumental moments in crypto history, and the last few months will be a teaching moment for many. The first effect seen from 3AC is the ripple effect on those with close ties to the firm. These lenders either took on big losses or are still trying to recoup losses. With these large crypto entities paying the price of 3AC, they have fallen under financial stress and are in talks with bailouts from exchanges like FTX. Whenever bailouts are being discussed, it shows how bearish the market truly is.
With the cascading effect of 3AC liquidations, it is expected to see a large amount of sell pressure enter the markets. As mentioned earlier, projects allowed 3AC to become a ground-floor investor, with many of 3AC’s assets being locked in vesting schedules. With 3AC currently in a deep hole, it would not be surprising to see these assets sold the second they become unlocked. Also, if 3AC is unable to repay its debts, it could be expected to have those assets seized. Here are some of the assets 3AC invested in that are now intertwined in the whole situation.
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