Three Arrows (Right to the Chest)

Last week we noted that Three Arrows Capital (3AC), a prop shop headed by the once-beloved Su Zhu and Kyle Davies, was on the brink of exiting the industry. Well, if you have been following our daily market updates, you know by now that this did indeed happen, and 3AC unleashed chaos of leverage unwinds on its way out the door.

In the past week, we witnessed yet another bout of forced selling, leading to a magnitude of liquidations that rivaled the leverage unwind experienced over a month ago when Luna/UST blew up.

Some Combination of Madoff and Long-Term Capital Management

Now that the dust has settled a bit and the pieces are starting to come together, it appears that the industry was brought to its knees the past two weeks by an old-fashioned Madoff-style Ponzi scheme, wrapped in a trade that was fundamentally similar to the positions that steered Long Term Capital Management off a cliff.

Madoff, in this scenario, is obviously Davies and Zhu, who built an admirable reputation in the space, hailed by many as industry-defining “forward thinkers.” They had many thoughts on technology and finance that our team found helpful, and by all measures, the duo was objectively well-versed on many crypto-related topics. However, the application of their theses manifested itself as downright fraud.

The reputation that preceded them allowed the duo to borrow recklessly from just about every institutional lender in the business. The list of those reeling from the pain wrought by misplaced trust and a lack of due diligence includes high-profile names such as Voyager Digital, Babel Finance, and BlockFi.

At the height of 3AC’s prominence, its AUM was supposedly north of $18 billion. Given the amount of debt we now know was loaned to them, it is uncertain at this point how much actual equity was at risk, and it is likely the pair were simply using borrowed funds to repay interest on loans issued by lenders, while “cooking their books” to show massive returns on capital.

With the magnitude of exposure that companies like Voyager (over $600 million in capital loaned) and BlockFi (also required a quasi-bailout from SBF), it seems that the vast majority of 3AC’s assets were purchased with debt and its collateralization ratio was quite small.

Where Did it Start?

Many factors contributed to this leverage wipeout and the downfall of 3AC – the macro conditions preceded destruction in global asset prices, reducing the collateral value of any cryptoasset, and 3AC was heavily invested in LUNA/UST, which couldn’t have helped the situation, however, we thinkthe downward spiral started with 3AC’s over-leveraged bet on GBTC -0.15% .

As our clients should be well-aware by now, GBTC is a closed-end trust that holds bitcoin but often deviates from NAV largely due to other liquid investment vehicles available on the market.

Below is a Bloomberg screenshot showing 3AC as the largest holder of GBTC as of early June. They were widely known to be early in the GBTC arb trade – the trade that capitalized on harvesting the GBTC’s premium to NAV.

A firm would borrow bitcoin, lock it up in the Grayscale trust, wait until the lockup period on GBTC expired, and sell the GBTC shares at a premium to NAV. This was the hot trade of 2020.

However, as we got further into the bull market, there were fewer buyers of GBTC on the secondary market, thus putting downward force on this premium until it eventually turned to a discount. We have highlighted this trade to many as an excellent long-term bet to achieve a quasi-leveraged long position on bitcoin. Theoretically, purchasing GBTC today, assuming a 30% discount to $20k, would result in a bitcoin price of $14k.

However, the core issue with 3AC’s implementation of this trade is that they were highly leveraged. When the premium-arb trade disappeared, it is likely that they were still locked in GBTC. Instead of exiting at a small loss upon their unlock, they likely doubled down on the trade, expecting the discount to converge to NAV once the spot ETF was approved. To be clear, we think that this trade will eventually pay off for patient investors, but one must be indifferent about their exit horizon. The spot ETF might be approved in two weeks, but it also might not be approved for several years.

Ultimately, as asset prices tumbled, and margin calls were being made, 3AC could no longer hold its daisy chain of leverage together, causing illiquidity issues across the crypto lending space.

The over-leveraged nature of this arb trade is principally similar to the types of trades that were the death knell for Long Term Capital Management (LTCM) – a case study on arbitrage strategies executed with over-leveraged balance sheets.

At a very high level, LTCM was betting on spreads between similar assets to converge. In 1998, the macroeconomic landscape, coupled with competitors actively working against LTCM, caused arbitrage spreads to widen. One of their trades was in emerging market sovereigns, which included Russia. Unexpected to many, Russia defaulted on its sovereign obligations that year, forcing a broad flight to quality across the entire bond market.

This flight to quality both increased arbitrage spreads further and decreased the available liquidity to LTCM, rendering them insolvent. While directionally, the arbitrage bets they placed were “correct,” and most would eventually play out as expected, their over-leveraged nature narrowed the timeline for the trade and left them vulnerable to a liquidity crunch. As most are aware, LTCM would eventually have to be bailed out by the US government.

Where To Now?

We think the industry ultimately emerges from this as a more robust, mature space. We also do not believe it will take as long as people think for the industry to rid itself of bad actors like Zhu and Davies.

It is important to note that throughout the whole ordeal, most DeFi and web3 applications were remarkably performant. The core technology remains sound and the value propositions of crypto remain unchanged. As demonstrated via the venture funding data published by our team every Friday, developers and investors are continuing to invest capital and build through the current bear market.

Most of the issues plaguing the space are simply the result of the human desire to use and abuse leverage and have mostly emanated from centralized market participants. 

Fortunately, this 3AC debacle will instill healthy skepticism in the lending market and usher in a need for more responsible due diligence among centralized market participants in crypto. A benefit of being (mostly) outside of the banking industry is that we get to iterate on things at a much faster pace. Just as traditional markets needed to experience their own credit crisis, Madoff scandal, and LTCM implosion, the crypto industry had to do the same – the only difference being that we get to develop these scars faster and, as challenging as it is to deal with, do not have government bailouts to save us, making this a much more effective learning experience for everyone involved.

Capitulation

Shifting our focus to market observations, we saw a sizeable amount of capitulation this week. As demonstrated below by the entity-adjusted spent output profit ratio (SOPR), which measures the profitability of sellers in the market, many investors flew to liquidity despite being considerably underwater on their position. This level of unprofitable selling had not been witnessed since the depths of the COVID crash in March 2020.

Another metric that gives us confidence that we saw substantive capitulation is entity-adjusted net unrealized profit/loss (NUPL), which is the difference between relative unrealized profit and relative unrealized loss of bitcoin holders. This is a way of viewing the overall profitability of bitcoin investors. The current NUPL level is consistent with the level reached in March 2020 and is conclusively in the “capitulation” zone.

Miner Selling

Below is another representation of the chart above. We can see that miners sold a significant portion of their holdings in May following the fallout from LUNA/UST.

Interestingly, however, we can see that selling pressure from miners has waned in the past couple of weeks as miner positions have increased dramatically. We think this is worth keeping an eye out for as we search for a macro bottom. While there is the possibility that the increase in miner holdings is a function of more efficient miners coming online, it is also possible that we see further selling from these entities who are wagering that we have achieved a macro bottom and thus are holding onto their BTC.

Deep Value

Despite what appears to be significant capitulation, we do think it’s right to remain cautious in the immediate term – we have yet to see any conclusive signs of CPI rolling over and most forecasts point to a recession in Q3.

As demonstrated by the chart below, should inflation not abate, we also have a considerable way to go for interest rates this year. Jay Powell has yet to relent on his position and he may be willing to break the economy in exchange for a marginally lower CPI print.

However, we are conclusively in the long-term investor’s deep value area for bitcoin. Below we see that the entity-adjusted market value-to-realized-value (MVRV) is at a level rarely seen by the network. While this does not mean we will immediately march higher, this chart lends comfort to anyone investing in size at this level.

Strategy

It is still smart to remain cautious and protect your downside in the near term. However, as we have discussed recently, we are approaching the area of deep value for bitcoin (and soon, potentially some other leading cryptoassets). To reiterate our current stance, we maintain that it is wise to reduce exposure to altcoins and hedge long exposure in the immediate term (1-month). However, we are still constructive on cryptoasset prices in 2H. Importantly, we think this is the time for medium and long-term investors (1+ year) to consider allocating to bitcoin more aggressively.