From $10 billion to zero: How a crypto hedge fund collapsed and took many investors with it

As of March, Three Arrows Capital was managing approximately $10 billion in assets, making it one of the largest crypto hedge funds in the world.

Today, the company, also known as 3AC, is directed to bankruptcy court after falling cryptocurrency prices and a particularly risky trading strategy combined to wipe out its assets and render it unable to repay lenders.

The chain of pain may have only just begun. 3AC had a long list of counterparties or companies whose money was invested in the company’s ability to at least stay afloat. With the crypto market down over $1 trillion since April, driven by the fall of bitcoins and etherealinvestors with concentrated bets on companies like 3AC suffer the consequences.

Crypto Exchange Blockchain.com would face a $270 million hit on loans to 3AC. Meanwhile, digital asset brokerage Voyager Digital filed for Chapter 11 bankruptcy protection after 3AC failed to repay the approximately $670 million had borrowed from the company. US-based crypto lenders Genesis and BlockFi, crypto derivatives platform BitMEX and FTX crypto exchange also suffer losses.

“Credit is being destroyed and withdrawn, underwriting standards are tightened, creditworthiness is being tested, so everyone is withdrawing liquidity from crypto lenders,” said Nic Carter, a partner at Castle Island Ventureswhich focuses on blockchain investments.

Three Arrows’ strategy involved borrowing money from the industry as a whole, then turning around and investing that capital in other, often fledgling, crypto projects. The company had been around for a decade, which helped give founders Zhu Su and Kyle Davies some credibility in an industry populated by newbies. Zhu also co-hosted a popular podcast on cryptos.

“3AC was supposed to be the adult in the room,” said Nik Bhatia, professor of finance and business economics at the University of Southern California.

Court documents reviewed by CNBC show that attorneys representing 3AC’s creditors say Zhu and Davies have yet to begin cooperating with them “in a meaningful way.” The filing also alleges the liquidation process has not begun, meaning there is no money to repay the company’s lenders.

Zhu and Davies did not immediately respond to requests for comment.

Three Arrows Capital’s downfall can be attributed to the May collapse of terraUSD (UST), which had been one of the most popular USD-pegged stablecoin projects.

The stability of the UST relied on a complex set of codes, with very little cash to back the arrangement, despite the promise that it would retain its value regardless of the volatility of the broader crypto market. Investors were enticed – on an accompanying lending platform called Anchor – with a 20% annual return on their UST holdings, a rate that many analysts have deemed unsustainable.

“The correction in risky assets coupled with lower liquidity exposed projects that promised high and unsustainable APRs, leading to their collapse, such as UST,” said Alkesh Shah, global crypto and digital asset strategist at Bank of America.

The panic selling associated with the fall of UST and its sister luna cost investors $60 billion.

“The collapse of terraUSD and luna is ground zero,” said Bhatia of USC, which last year published a book on digital currencies called “Layered Money.” He described the collapse as the first domino to fall in a “nightmarish long chain of leverage and fraud”.

3AC told the Wall Street Journal he had invested $200 million in luna. Other industry reports said the fund’s exposure was around $560 million. Whatever the loss, that investment became virtually worthless when the stablecoin project lack.

The implosion of the UST has shaken confidence in the sector and accelerated the fall of cryptocurrencies already underway as part of a broader withdrawal of risk.

3AC’s lenders asked for some of their money in a flood of margin calls, but the money wasn’t there. Many of the company’s counterparties were, in turn, unable to meet the demands of their investors, including retail holders who were promised annual returns of 20%.

“Not only did they not cover anything, but they also evaporated billions of creditor funds,” Bhatia said.

Blockchain.com CEO Peter Smith said last week in a letter to shareholders seen by CoinDesk, that his company’s exchange “remains liquid, solvent and our customers will not be impacted”. But investors have heard this kind of sentiment before – Voyager said the same days before filing for bankruptcy.

Bhatia said the stunt hits any market player with high exposure to deteriorating assets and liquidity crunch. And crypto comes with so few consumer protections that retail investors have no idea what they will end up owning.

Voyager Digital customers recently received an email stating that it would take some time before they could access the crypto held in their accounts. CEO Stephen Ehrlich said on Twitter that after the company went through bankruptcy proceedings, customers with crypto in their account would potentially receive a shopping bag of sorts.

This could include a combination of the crypto they held, common stock in the revamped Voyager, Voyager tokens, and any proceeds they can get from 3AC. Voyager investors told CNBC they don’t see much reason for optimism.

LOOK: Voyager Digital Files For Bankruptcy Amid Crypto Lenders Solvency Crisis