The explosion of 3AC – LTCM without the Nobel Prize economists

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Benjamin Dean is a director of digital assets at an investment firm WisdomTree in Europe.

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A deleveraging process is underway in the digital asset industry. The events of the past few months serve as a helpful demonstration of how digital (or “crypto”) assets are merging with traditional finance – for better or for worse. The liquidation of Capital of the Three Arrows (3AC), alongside the increasingly apparent exposures of its lending counterparties, shed light on the relatively new crypto lending industry.

At the same time, these events also demonstrated the strengths of decentralized finance (DeFi) applications, which still work well, and provide transparency and auditability that is so often absent from the traditional financial system.

DeFi versus CeFi

To begin with, it is important to establish what is and is not “decentralized finance”. Here is a succinct definition: “Decentralized finance (DeFi) offers financial instruments without the use of financial intermediaries such as brokerages, exchanges or banks by using smart contracts on a blockchain.”

According to the WisdomTree digital asset taxonomy, the DeFi segment of the digital asset ecosystem represents less than 1% of the ecosystem’s overall market capitalization.

The segment includes a set of decentralized applications (dapps) that run on one or more layer 1 smart contract networks (e.g. Ethereum, Polygon, etc.). These dapps provide financial services or instruments such as trading, lending or derivatives. Examples include Aave, Compound and SushiSwap.

The key element of the DeFi definition is at the end. The implication of “using smart contracts on a blockchain” is that one can audit holdings at any time, due to the transparent nature of distributed ledgers (“blockchains”) and open source smart contract code . The rules of the contract are very clear. Those who use these DeFi applications do so in possession of their public/private key pair, which means that they own their assets and decide when and how these assets can and are used.

DeFi contrasts with what some call centralized finance (CeFi) or traditional finance (TradFi). Historically these two areas were separate. In recent years, however, the lines have blurred.

An example of this is the emergence of the centralized crypto lending industry. The industry can be broadly divided into crypto lending companies (e.g. BlockFi, Celsius, Babel Finance), intermediaries connecting lenders with borrowers (e.g. Genesis) and the borrowers themselves. These borrowers were often hedge funds, which in some cases took leveraged positions in various digital assets. Three Arrows Capital (3AC) is one such hedge fund.

If not taking leveraged long positions in digital assets, borrowers could also invest their holdings in DeFi applications to take advantage of the sometimes high returns offered. Much of this lending activity involved tokens pegged to the US dollar (“stablecoins”), which is another example of the blurring of crypto and traditional financial rails.

With these concepts in mind, it is possible to better understand what is happening now.

Let the deleveraging begin

To understand current events, it is useful to begin with the collapse of Terraform Labis UST/LUNA. At the start of April 2022, the LUNA cryptocurrency was valued at the equivalent of approximately $41 billion. As of mid-May, he was worth less than $300 million. The maximum outstanding amount of USTs exceeded USD 18 billion on May 7, 2022. As of July 1, 2022, one UST was trading at 4 cents on the dollar.

Think of the UST/LUNA collapse as a depth charge. Now those who were exposed to the explosion are floating on the surface of the water.

The first to show public signs of tremor was crypto lender Celsius when it suspended withdrawals, citing “extreme market conditions.” Next was crypto lender BlockFi, which began to downsize before revealing that it was one of several companies involved in liquidating positions owned by hedge fund 3AC.

It is at this point that the interdependence of different crypto lenders with 3AC (and each other) becomes apparent. So far, 3AC is believed to have had over $200 million in LUNA exposure – and that’s the start. crypto broker digital travel revealed in public filings that 3AC was unable to meet payments on a loan of 15,250 BTC, worth approximately $305 million, and $350 million in coins (USDC). Market maker and lender, Genesis, is believed to have hundreds of millions of dollars of exposure to 3AC.

At present, a number of buyout and bailout efforts have been initiated but not concluded. Crypto Exchange, FTX, is one of the main parties. Crypto Investment Company, Morgan Creek Digital, is another. Time will tell how this will unfold.

If this story sounds familiar to you, it’s because you’re thinking of Long-term capital management (LTCM) – minus Nobel Prize-winning economists (or a government bailout).

The result of taking large leveraged long positions in markets as volatile as digital assets is hardly surprising. It should be noted that the lack of transparency around the leveraged positions of hedge funds, such as 3AC, and the level of collateralisation of positions from lenders such as BlockFi or Celsius, contrasts with transparency and auditability as defined by DeFi explained at the top of this note.

In the coming months, expect digital asset prices to remain subdued. The forced liquidation of digital asset positions brings additional supply in markets that have been characterized by risk aversion sentiment since January 2022.

Even networks or dapps that have nothing to do with liquidated positions and insolvencies, and continue to function well (eg Aave and Compound), are susceptible to collateral damage.

Also expect more insolvent parties to emerge, especially as trading volume dries up on smaller crypto exchanges.

The path to responsible DeFi

The good news is that the liquidation and bankruptcy of these entities have not yet had any significant contagion impacts on the traditional financial system. However, as the lines between crypto systems and traditional financial systems continue to blur, it’s hard to imagine regulators not taking a closer look at activities in and around the digital asset ecosystem. .

What is likely to emerge will be a more “responsible” DeFi, spurred by a stricter set of regulatory and oversight requirements in industrialized economies.

This trend was already apparent with the Executive Order on Ensuring Responsible Development of Digital Assets in the United States and with soon-to-be-adopted Crypto Asset Markets (MiCAs) in the EU. It will continue to accelerate in the near future. »

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Learn more:
– 3 reasons why 3 Arrows Capital failed, according to its founders
– Coinbase on its exposure to Celsius, 3AC, Voyager and Terra

– Crypto Turmoil Latest: 3AC Creditors List Revealed and Celsius Tells Creditors to “Go Long” on Crypto
– Today in Crypto Turmoil: Woes Deepen, Legal and Reimbursement Developments from Celsius, 3AC, Voyager Digital, and More

– FTX and Ledn Compete for Struggling BlockFi – Reports
– BlockFi Obtains $250M Line of Credit from Bankman-Fried’s FTX

– Coinbase refutes claims it lists securities as SEC launches investigation
— Prosecutors raid home of Terra co-founder Daniel Shin as Do Kwon returns to Twitter

– Ethereum merger date proposed for September, liquidator arrives for 3AC
– 7 DeFi risks you should be aware of according to CoinShares