How Hedge Fund Three Arrows Capital Was Crypto’s Long-Term Asset Management

Many crypto enthusiasts blame the collapse of Three Arrows Capital (3AC) for this year’s crypto winter, and not just because the crypto hedge fund has dragged other crypto-related firms down with it. When the hedge fund collapsed, forced selling swept across the crypto markets as fear took hold.

However, what happened to the crypto market in the wake of 3AC’s collapse may feel familiar to those who have been in the financial market for a couple of decades. A crypto hedge fund manager draws parallels between Three Arrows Capital’s downfall and the collapse of Long-Term Capital Management in 1998.

The best time to allocate to crypto?

During his 30-year career, CK Zheng of crypto hedge fund ZX Squared has experienced many stressful situations, including this year’s crypto winter. However, his playbook is quite similar to what he did during the dotcom bubble or the Great Financial Crisis.

He believes that what some investors see as problems can present opportunities for others. In a recent interview with ValueWalk, Zheng says the worst is when people panic, but such scenarios provide the best investment time frames.

“I then remember Lehman [Brothers] went bankrupt,” says Zheng. “My friends dumped their stocks to get out of risky assets, but that’s actually the best entry point to allocate to that asset class. For me, that’s how I see it today.”

Similarly, he believes 3AC’s collapse offers opportunities in the same way as LTCLTC
M’s fall did in the late 1990s.

How Three Arrows was similar to long-term capital management

CK believes many people blamed the implosion of Three Arrows Capital, a $10 billion crypto hedge fund, for some of the turmoil in the crypto market. However, he also recalled the collapse of Long-Term Capital Management, adding that what happened to Three Arrows Capital was similar.

LTCM collapsed in 1998, receiving a $3.6 billion bailout from 14 banks engineered by the Federal Reserve. CK notes that many investors got out of the financial markets at the time, but then, as now, he feels that a stress point has been an excellent entry point.

“We don’t want to catch a falling knife, but when the market stabilizes, we will be able to manage risk and reward,” he explained. “This is a fascinating time for many investors.”

How leverage was the downfall of 3AC and LTCM

According to Zheng, both Three Arrows and LTCM were highly leveraged hedge funds. He added that the minds behind LTCM were “geniuses” – including two Nobel laureates on the team. But even though the hedge fund had some of the financial industry’s brightest minds backing it, it was still leveraged 25 to one.

As a result, when the Asian financial crisis occurred in 1997 and Russia defaulted in 1998, LTCM’s conversion trade became problematic due to its high leverage. The Fed stepped in and convinced more than a dozen Wall Street firms to coordinate and liquidate the hedge fund’s assets.

Similarly, Zheng believes that Three Arrows Capital was heavily leveraged. In fact, 3AC was known for its use of leverage, although it is unclear how much the crypto hedge fund was leveraged due to the relatively opaque nature of the crypto market. He also notes that LTCM’s problem stemmed from conversion trades, including swaps. However, 3AC’s influence was based on Greyscale BitcoinBTC
Trust, staked ether and others.

When Terra broke the pin

He adds that 3AC was also exposed to LunaLUNA
and its algorithmic stablecoin, Terra, which now trades as Terra Classic after breaking its peg to the US dollar in May and subsequently collapsing. Zheng notes that algorithmic stablecoins are a new innovation that could work, in theory, if all goes well.

But when a market dislocation hit, Terra fell apart — another situation that Zheng likened to the Great Financial Crisis. When the housing market went under, it basically wiped out the subprime housing market. Likewise, CK states that stablecoin was not stable, just as AAA-rated collateralized debt obligations (CDO) based on the subprime mortgage market were not.

“When you have all these things together, you start to pump the bubble,” he explained. “When the bubble bursts, the things you don’t see in normal times are revealed … and that’s how it plays out … Basically, the question is do we know how it’s going to stop. Have they washed out all the influence yet or not? We’re still living through the process, still digging out… So we’ll see how that plays out, but I’m sure after a period of stress the market will stabilize.”

Regulation of the crypto market

When asked about regulation in the crypto space, Zheng says he personally believes regulation is “absolutely required” in the digital space, just as it is in any asset class. However, he also believes that the crypto regulation should be different from the regulations for other types of technology.

“If we talk about finance, we’re talking about people’s assets and savings,” states the fund manager. “I think regulation is absolutely necessary so that innovation can sustain itself for a long time, and that may be when the initial phase was OK, but this cycle clearly constitutes many types of regulation that are [sic] missing. Unfortunately, for some platforms, the promise to investors is 10% to 15% to 18% returns. It’s absurd without the disclosure of the risk they’re taking.”

Of course, a $10 billion hedge fund like 3AC affects the entire $3 trillion crypto industry. As a result, Zheng believes it is clear that some form of regulation is necessary, allowing regulators to step in to ensure that it remains an asset class to protect in the long term.

However, he sees every crisis as an opportunity for regulators to do a deep dive and study why things happened that way and how we can get smarter without killing an innovation that benefits society.

Regulation as a catalyst?

The fund manager sees catalysts for the crypto market in the future, especially next year, although he believes some may come earlier. Regulation can be a potential catalyst, especially for some institutional investors because regulations can enable them to invest in the crypto market.

On the other hand, some institutional investors are worried that regulations will kill their investments, so they want more clarity around cryptocurrencies. Zheng observes many institutional investors who bought bitcoin when it was around $60,000 because they were afraid of missing the train.

He believes that many of these investors are still positive about the digitization process. Zheng also sees the current situation as unique because we are still in the cryptocurrency adoption stage.

“I think as the adoption becomes more and more mature, I think the correlation with the stock market will drop significantly,” he said. “It may be years away, but I say when people see that cryptocurrency has become a unique asset class, the correlation between cryptocurrency and stocks will eventually fall.”

Zheng believes it will be the final phase of bitcoin adoption because bitcoin will be universally accepted as gold is today. However, he believes that is still at least 10 or 20 years away. As a result, he sees a lot of room to buy into bitcoin and EtherETH
eum in the next decade and see how that asset class gradually becomes a unique asset class.

No free lunch

At the end of the day, CK feels it is important for investors to realize that there is no free lunch, including in cryptocurrency. He has found that many people think crypto provides quick, easy money, but he thinks that is very wrong.

“It’s really a risk/reward game, and I just feel sorry for uneducated people who aren’t financially savvy,” Zheng opines. “People got burned in this asset class. I think the biggest part is that education is very helpful to this industry. I wish people had more education. I think it’s a fascinating asset class, but you really have to be careful.”

Michelle Jones contributed to this report.