Cryptocurrencies should have taught traditional financiers a thing or two about how to survive collapse and crisis. Still, it seems that we are merely repeating history. Notably, the messy hedge-fund insult caught up in Roger Lowenstein’s 2000-published book, When Geniuses Fail: The Rise and Fall of Long-Term Capital Management.
Trading firm Three Arrows Capital is now in trouble, following the $60 billion stablecoin collapse of Terra and Luna and the freezing of withdrawals on crypto-lending platform Celsius. The fund is liquidating its holdings amid rapidly falling prices, and an ominous tweet from co-founder Zhu Su about “communication with relevant parties” is fueling fears of something potentially more deadly.
A look at Three Arrows’ past crypto bets on the likes of Luna and Axi Infinity, as well as bitcoin and ether — leaves little doubt that “communication” probably isn’t the fun kind of thing. The fund, estimated to manage $10 billion in assets in March, combined Zhu’s derivatives expertise with a kind of resounding belief in a broader crypto “supercycle” that he recently believed to be wrong.
The wave of forced selling is still ripping through the crypto markets, showing how complex and lending-driven this market has become. Margin calls of traditional finance take a more brutal form in the cryptosphere when smart contracts automatically liquidate positions in quick succession. The current focus is on exposure to Ether staked at Three Arrows, a token designed to earn interest while Ethereum upgrades its network, which is buckling under heavy selling pressure.
But it also shows that the lessons of history have been ignored. This is hardly the first boom-and-bust cycle in bitcoin or the broader crypto market; This year’s 65% drop in the Bloomberg Galaxy Crypto Index is similar to the crash seen in early 2018. Still, hedge funds set up to deliver market-beating returns from crypto assets are visceral. According to industry database NielsenHage, the average projected return for those providing daily data was -24% in April, -32% in May and -28% in June. A large number of managers have “simply stopped trading”, with the stock falling from 510 in January to 325.
The risk of a generalized crypto recession, the kind that underpinned token-picking strategies in 2018, doesn’t seem high on their radar. Strategies designed to take advantage of inefficiencies between exchanges that could bring in 6%-10% returns have been juxtaposed by funds using DeFi lending platforms that offer attractive rates – which are proving volatile. Huh. As one hedge funder tells me, it’s like picking up a BMW instead of pennies in front of a steam-roller. The end result still involves being squishy.
According to PwC, with over 40% of crypto funds using borrowing and lending strategies, the current turmoil feels like a ruse-bridge rather than a confirmation of trading smarts. The winners are probably the ones who got their money out in good time. Mike Novogratz believes that two-thirds of crypto funds are likely to fail. Short-sellers appear to be in short supply.
Three Arrows’ Zhu probably spoke to many investors earlier this year, when he said the lesson of 2018’s slide was to be bullish and not give in to “disappointment.” Pays people who spend their days breeding virtual pets that have been battered by hype and a $620 million hack. His justification appears to be wrapped in futurism rather than risk management: his “Bible” is James Dale Davidson’s 1997 book The Sovereign Individual, some of the social upheavals of the Internet age.
Maybe Zhu should have read when genius failed. As Novogratz observes, what’s happening in crypto is the 1998 blowout of Long-Term Capital Management, a hedge fund filled with very smart people, including a pair of Nobel laureates who Works in sophisticated arbitrage strategies juiced by derivatives. When the unthinkable happened and losses piled up, banks called up their loans and eventually took over the firm.
The silver lining is that the bank has little involvement in the crypto downturn. Given the risk of spreading to a real US economy already battered by rising inflation and weak economic growth, it is probably the same.
But that doesn’t change the fact that the actual deficit is being borne by the money and punters who are least able to afford it. Whatever be the case with Three Arrows, the lesson of 2022—that crypto prices can go down and go down for months—should not be forgotten like in 2018. © Bloomberg
Lionel Laurent is a Bloomberg Opinion columnist covering digital currencies, the European Union and France.