The bear market has claimed another victim; this time it’s the crypto hedge fund Three Arrows Capital. What led to the collapse of the fund? We summarise the saga in a 5-minute read.

The cryptocurrency market is officially in a bear run and crypto prices are a far cry from its peak just less than a year ago, and the bear market has brought with it a wave of problems that are now being exposed. Terra’s implosion of its USD and LUNA tokens were the first, and now another well-known crypto hedge fund, Three Arrows Capital, is facing liquidation and filing for bankruptcy.

Here’s the TL:DR about who they are, what caused their liquidation, and what this could mean for Singapore’s cryptocurrency industry.

Who is Three Arrows Capital?

Three Arrows Capital is a hedge fund company is based in Singapore. Also known as 3AC, the fund has a large number of cryptocurrency projects under its portfolio. Some of these are popular Layer-1 blockchains like Avalanche, Near Protocol, Polkadot, and Solana; it has also backed a number of decentralised finance (DeFi) projects like lending protocol Aave, decentralised derivatives dYdX exchange, and decentralised exchange Trader Joe.

What are hedge funds? They are essentially pooled investment funds actively managed by hedge fund managers. These funds make use of more complex trading strategies like short selling and derivatives to out-compete the average market returns.

The company was founded in 2012 by Su Zhu and Kyle Davies, both of whom studied at Columbia University in New York and worked at Credit Suisse as derivatives traders.

three arrows capital founder su zhu and kyle davies
Three Arrows Capital founders Su Zhu and Kyle Davies

Why are they making waves on the news?

Three Arrows Capital is causing a stir in the crypto space due to its inability to pay back loans it had borrowed from other crypto investment companies. This in turn has exposed the risky lending behaviour going on behind the scenes with crypto-based institutions while triggering potential liquidations amongst creditors of 3AC.

LUNA Collapse and falling crypto prices

The first sign of trouble for Three Arrows Capital began with the collapse of the stablecoin TerraUSD (UST) and Terra token (LUNA), now known as USTD and LUNC. According to co-founder Davies, 3AC had invested over USD$200M in LUNA tokens back in February 2022. With the crash of the LUNA ecosystem in May, the investment made by the company essentially became worthless overnight.

The company also had a stake in the Grayscale Bitcoin Trust (GBTC) and held staked Ethereum (stETH) tokens, both of which saw their value dip in the current bear run. The first is an institutional bitcoin product, while the second is a tokenised form of staked Ethereum issued by staking solution Lido Finance. Their value have declined by 18.4% and 10.8% respectively compared to prices a month ago at the time of writing.

With the loss of investment value and declining cryptocurrency prices, Three Arrows Capital was unable to meet the margin calls on the crypto loans it had taken from other crypto institutions. To get up to speed, a margin call is a that the investor’s asset value has fallen below the threshold, and more money must be topped up to meet the minimum sum. If the margin call is not fulfilled, the brokerage or exchange will sell the assets in the account to top up and meet the threshold.

The final blow to the company came when cryptocurrency brokerage Voyager Digital announced that Three Arrows Capital did not make the necessary payments on a USD$668M loan consisting of 15,250 BTC tokens worth USD$318M at the time of writing plus USD$350M in USDC stablecoins, and was ordered to liquidate by a court based in the British Virgin islands. Three Arrows Capital then filed for bankruptcy on 2 July to protect its assets from creditors.

A cascade of potential liquidations

As a result of lending a large portion of its funds to Three Arrows Capital which it could not retrieve immediately, Voyager Digital filed for bankruptcy next on 6 July. Other institutions that had expossure to Three Arrow Capital were digital asset lender Genesis, BlockFi exchange, Deribit exchange, cryptocurrency services, and crypto savings app Finblox.

Shining the light on unsafe financial risk management

The fiasco with Three Arrows Capital exposed a bunch of unsafe risk management practices happening amongst cryptocurrency institutions behind the scenes. These include:

Unsafe lending and borrowing behaviour

Voyager Digital had lent the staggering sum of USD$668M to Three Arrows Capital without any collateral. In essence, collaterals are a form of asset that the borrower pledges as security for their loan. If the borrower defaults, then the lender can sell the collateral to recoup some or all of their losses.

This effectively meant that that Voyager Digital was taking a risky bet by lending to 3AC without accepting any form of security, one which did not end well in hindsight. Plus, Voyager Digital’s loan to Three Arrows Capital accounted for around 58% of all loans it made, which made it grossly overexposed as shown in their release here.

It isn’t just Voyager Digital that employs such unsecure strategies too. Crypto derivatives exchange CoinFLEX has also been caught with its pants down when it lent out USD$47M in uncollateralised loan which it has trouble getting back.

DeFi protocols were not spared either. Maple Finance, a peer-to-peer lending protocol, has found itself in hot soup when its crypto institutional lenders, Celsius and Babel Finance, could not repay the uncollateralised loans borrowed from the protocol after losing it to Three Arrows Capital.

Cycled Lending

Another risky behaviour that institutions were engaged in are the use of cycled lending, where Huobi Research identified Three Arrows Capital being guilty of this particular tactic.

In cycled lending, the initial stablecoin loan is first collateralised with assets like Ethereum tokens. The loan is then used to purchase more Ethereum and put it up as collateral. The lender then repeats the process again to increase leverage multiple times. 

What was the response by the Monetary Authority of Singapore?

The Monetary Authority of Singapore (MAS) issued a public reprimand of Three Arrows Capital on 30 June, and promised further investigation on potential breaches that the company may have committed. The reprimand states that the hedge fund:

  • Provided false information by stating 3AC moved fund management to an unrelated offshore entity when the director of 3AC, Su Zhu, was a shareholder of the entity
  • Exceeded its allowable limit of SGD$250M in assets under management, or AUM, and prolonged the breach between July – September 2020 & November 2020 – August 2021
  • Failed to inform MAS of changes in directorships & shareholdings of directors, Su Zhu and Kyle Davies

In addition, Member of Parliament for Bukit Batok SMC Mr Murali Pillai also raised the question of further restrictions on crypto trading in Parliament on 4 July. Senior Minister Mr Tharman Shanmugaratnam answered with the possibility of placing limits on retail participation, and rules on the use of leverage when transacting in cryptocurrencies.

What does this mean for crypto in Singapore?

Singapore has introduced stricter regulations on cryptocurrency trading at the start of 2022. These include restricting advertising of cryptocurrency services in public areas, and introducing the Financial Services and Markets (FSM) Bill which gives MAS the power to issue Prohibition Orders (PO) and regulate local virtual asset service providers (VASP) that provide virtual asset services outside of Singapore.

While the collapse of Three Arrows Capital is more of an institutional issue than retail one, it will undoubtedly invite increased scrutiny from MAS. Other than limits on retail participation and rules on leverage use, we may see a broader rule targeting both institutions and retail trades, or another update to the Payments Services Act and FSM bill may be in the works.

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