An unprecedented crisis of confidence has affected the crypto industry for several months.
To measure it, just consider the prices of cryptocurrencies, which are often attached to a platform or a project. The cryptocurrency market has lost $2 trillion in value since hitting an all-time high of $3 trillion in early November, according to data firm CoinGecko. Prices for bitcoin, the king of cryptocurrencies, are down more than two-thirds since hitting an all-time high of $69,044.77 on November 10.
The severity of the crisis intensified earlier this spring with a seemingly contained event. Early in May, sister coins Luna and UST or TerraUSD collapsed. The fall of the two digital currencies was caused by the fact that many investors wanted to liquidate their positions at the same time. At least $55 billion was wiped out in this disaster.
The Collapse of Luna
What may have appeared as an isolated event finally revealed itself as an octopus with multiple ramifications. A month later, the crypto lender Celsius Network, which operates like a bank, announced that it was suspending withdrawals, thus preventing its customers from having access to their money. A few days later, Three Arrows Capital, or 3AC, a Singapore-based hedge fund, said that it was taken aback by the rout of Luna, a digital currency in which the firm had exposure of more than $200 million.
Voyager Digital, another crypto lender, announced that 3AC had defaulted on a loan of at least $630 million that it had extended to it. Babel Finance, CoinLoan, CoinFlex and other crypto lenders also suspended withdrawals. BlockFi, one of the big names in the sector, was forced to call for help from the young crypto billionaire Sam Bankman-Fried, founder of the platform FTX.com. The liquidity crisis extended 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 for bankruptcy. BlockFi was bailed out and the future of the others remains uncertain. As for their customers, they do not know if they will ever be able to recover even a small part of their money.
The link between all these companies and platforms is 3AC, the hedge fund. It appears from company statements and official documents that a large number of crypto lenders had lent it money. But they seem to have been unaware that they were all often creditors of the hedge fund.
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3AC Is an 'Old-Fashioned Madoff-Style Ponzi Scheme'
Three Arrows Capital was operating like a Bernie Madoff Ponzi scheme in disguise, research firm FSInsight, an independent research firm said in a recent report. The firm was an “old-fashioned Madoff-style Ponzi scheme" that took positions similar to those that sank Long Term Capital Management (LTCM), FSInsight said.
Long Term Capital was a famous hedge fund, which was run by famous Wall Street traders and Nobel Prize-winning economists. The firm went down in 1998, forcing the government to intervene in order to prevent the collapse of the markets.
In case of Three Arrows, Kyle Davies, 35, and Su Zhu, 35, the founders, were operating like Bernie Madoff, says the research note delving into the hedge fund's implosion. Davies and Zhu had "used their reputation to recklessly borrow from just about every institutional lender in the business,” FSInsight wrote.
Zhu and Davies were likely "using borrowed funds to repay interest on loans issued by lenders, while 'cooking their books' to show massive returns on capital,” the note added.
This conclusion suggests questions about whether 3AC's financial disclosures were true. At its peak, the hedge fund said it had over $18 billion under management. But given the amount of exposure that 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 small, according to Sean Farrell, head of digital assets at FSInsight.
A Ponzi scheme is a fraudulent financial arrangement that consists of paying existing investors big returns using the capital invested by new investors. This fraud feeds on the credulity of those cheated. It is often only revealed when the funds brought in by incoming investors are no longer sufficient to cover the payments to earlier investors. This fraudulent system was used by the former Chairman of the Nasdaq Bernard Madoff for the largest Ponzi scheme in history.
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'People May Call Us Stupid'
"The Terra-Luna situation caught us very much off guard,” Davies tried to explain in June.
Since then the two former Credit Suisse traders, who became friends in high school, have been in hiding. They recently gave a phone interview, published on July 22, to Bloomberg News.
“People may call us stupid. They may call us stupid or delusional. And, I’ll accept that. Maybe,” Zhu told the outlet. "But they’re gonna, you know, say that I absconded funds during the last period, where I actually put more of my personal money back in. That’s not true.”
“The whole situation is regrettable,” Davies told the outlet. "Many people lost a lot of money.”
"What we failed to realize was that Luna was capable of falling to effective zero in a matter of days and that this would catalyze a credit squeeze 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 a 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 these trades,” Zhu said. “And then they kind of all got super marked down, super fast.”
The firms responsible for the liquidation of the hedge fund have complained about the refusal to cooperate of the two co-founders, which the latter reject.
