Apparently the way it works is that if you blow up a big crypto firm, you have to sit in your home in a crypto-friendly jurisdiction giving long rambling interviews about your failures to everyone who wants to chat. Arguably this is an improvement over traditional finance, where if you blow up a financial institution you keep quiet and leave the talking to your lawyers. (“Sam Bankman-Fried Should Shut Up, Bernie Madoff’s Lawyer Says,” is a Bloomberg headline from last week.) Or perhaps it is one more case of us watching in real time as crypto re-learns the lessons of traditional finance. Maybe in six months all the busted crypto leaders will be saying “oh wow we should not have given all those interviews.”
We have talked a lot about Sam Bankman-Fried’s rather unsatisfying Bahamas-based interviews about how he blew up FTX and Alameda Research, and we’ll talk more about them below. But here I want to start with a strangely satisfying interview that Kyle Davies gave to Hugh Hendry about Three Arrows Capital, or 3AC, the crypto trading firm that he ran with Su Zhu and that blew up over the summer. To be fair, as of this writing, I have seen only Part I of this interview, which only glances at the collapse of 3AC, so it is not fully satisfying. But Davies gives an account of the rise of 3AC that is quite useful as just a general story of what happened in crypto over the last few years, and I want to talk about it here.
3AC started as a small proprietary trading firm doing simple arbitrages in foreign-exchange trading. One bank would offer to sell a currency at $1.0001, and another would bid to buy it at $1.0002, and 3AC would buy from one and sell to the other at the same time and make a risk-free profit of a “pip” ($0.0001) or two.
After a while, 3AC got into crypto, because you could make much larger risk-free-ish profits in crypto by buying Bitcoin on one exchange and simultaneously selling it at a higher price on another exchange. This again looks like a real arbitrage — it is the origin story of Bankman-Fried’s Alameda Research too, arbitraging Japanese Bitcoin prices — though it is a stretch to call it “risk-free.” The main risk is that one or both of the crypto exchanges might disappear with your money, which was a common thing for crypto exchanges to do in the early days of crypto, and which has come back in vogue recently.
Another important arbitrage is the Bitcoin spot/futures arbitrage. In the early days of Bitcoin futures, people would pay much more to own Bitcoin futures than they would to own Bitcoin directly. There are various reasons for this — owning Bitcoin directly exposes you to the risk of forgetting your private key, for instance, and is administratively alarming for a lot of traditional financial institutions — but one simple one is that if you want to buy a Bitcoin you have to have $17,000, while if you want to buy a Bitcoin futures contract you can generally put up much less money for the same amount of Bitcoin exposure. The main intuition behind the spot/futures arbitrage was basically that there was a lot of demand for Bitcoin, and it was expensive for crypto investors to get dollars, so a Bitcoin product that required fewer dollars was more attractive than one that required a lot of dollars.
And 3AC did this arbitrage by, basically, being pretty good at borrowing money. You find someone to lend you money at 10% interest, you use the borrowed money to buy Bitcoin, you sell Bitcoin futures at a 30% premium, you collect 20%, etc.
Another important trade is the Grayscale arbitrage, in which a firm like 3AC buys or borrows some Bitcoin, delivers them to Grayscale Investments LLC, and gets back shares of the Grayscale Bitcoin Trust, or GBTC. GBTC — like Bitcoin futures — is a way to own Bitcoin without actually owning Bitcoin, and it was friendly to traditional retail and institutional investors in a way that owning Bitcoin directly, or even owning most futures products, was not. So GBTC consistently traded at a premium to its net asset value for years: One share of GBTC might represent $12 worth of Bitcoin, but would trade at $15. A fund like 3AC could deliver $12 million worth of Bitcoin to Grayscale and get back 1 million shares, with a net asset value of $12 million (equal to what 3AC delivered) but a market value of $15 million, for a free $3 million profit.
This looks like an arbitrage but has a problem, which is that — for securities-law reasons — you don’t get the shares for a year. You can turn your $12 million of Bitcoin into $15 million of Grayscale, but you have to wait a year. This means that it is not a risk-free trade: It is a one-year bet on the Grayscale premium. If you buy (or borrow) $12 million worth of Bitcoin and deliver it to Grayscale for one million shares in a year, and in a year the price of Bitcoin is constant, but now instead of trading at a premium to Bitcoin Grayscale trades at a discount, then you will only get back, say, $10 million from selling your shares, and you will have lost $2 million.
And in fact that happened; GBTC has traded at a discount to spot Bitcoin for much of the last two years.
What could cause this? It could have become less appealing for investors to hold Grayscale, or more appealing for them to hold Bitcoin directly. But another answer, one that Davies emphasizes, is that it became much cheaper for crypto hedge funds to borrow money. This is a trade that offered big profits if you could borrow money, buy Bitcoin, deliver the Bitcoin to Grayscale, and wait a year. If you were early to this trade, you did well. But then everyone noticed it and started doing it, which meant lots of crypto hedge funds were creating lots of new GBTC shares, which meant that the supply of new GBTC shares (created by hedge funds) outstripped the demand (from retail buyers). If you got into the trade when it was relatively quiet and GBTC traded at a premium, and then a year later the trade was crowded and GBTC traded at a discount, you lost a lot of money.
As Grayscale trades got more crowded, 3AC looked into other sorts of arbitrages. The Grayscale trade is risky, but it sort of has the shape of an arbitrage trade; if you squint, it is “buy Bitcoin and sell Bitcoin futures,” only instead of Bitcoin futures it is future delivery of Grayscale shares. But once you’ve done that trade you might squint further and do some trades that are even less arbitrage-y. Davies talks about “discounted Layer 1s.” The trade is:
- Someone is launching some blockchain protocol, some crypto network like Avalanche or Solana that is intended to compete with Ethereum.
- To raise money to build out the ecosystem, they sell tokens to investors.
- For legal reasons, there is a long lockup period on the tokens: If you buy the tokens in the ICO, you can’t sell them for a year or more.
- But you get to buy the tokens at a discount of 40% to 50%.
So there are some tokens that are supposed to be worth $10, that probably have a trading price of $10, though perhaps on small volume and without much history. And you get to buy a lot of them for $6; you just can’t sell them for a year. Davies:
If you believe the market’s going up, if you believe in this protocol, if you believe that they can take those dollars and do marketing or build their platform or hire more people and build value, then it looks like a very attractive trade. And so for us, we found several protocols that we liked, we did very sizeable amounts with them, and that became another source of, you know, something that sat in the middle, where I would have considered it somewhat like an arb kind of trade, like it is a discount, but it’s very directional. It’s not like you’re punting Bitcoin, but it’s somewhere in the middle. …
Over time, people end up doing more and more of this kind of thing, and then by the end, you know, when credit gets squeezed out of the system, there’s a collapse. Basically that’s what happened.
I confess that a certain amount of steam came out my ears when I heard this. Here Davies is describing taking, essentially, equity risk on new crypto protocols. (Worse than equity risk; the token of some new crypto protocol probably has fewer legal rights and cash-flow claims than a share of stock.) He is making multi-year, illiquid, unhedgeable speculative investments in brand-new crypto protocols because he thinks “the market’s going up” and because he hopes that those protocols can hire people and build value. This is a venture capital investment. And he describes it as an arbitrage.
Which, you know, fine, whatever. People are allowed to be wrong; hedge funds are allowed to lose money. But the thing that happened with 3AC is not just that it made a long slow transition from picking up pips in high-frequency foreign exchange trading to making multi-year venture bets on new crypto protocols because it liked the founders. It’s also that it kept the same financing model the whole time. 3AC started out as a proprietary trading firm that made short-term arbitrage-y bets, turned over its capital frequently and had a very high Sharpe ratio, so it was able to borrow a lot of money. It ended up as a firm making long-term unhedgeable illiquid equity bets on crypto protocols with no track records, and was somehow able to borrow even more money. Davies describes his relationship with his lenders, firms — like Voyager or Celsius or BlockFi — that I have described as “crypto shadow banks”:
These firms are under pressure to lend out more and more too. You have to remember that the way they make money is they take these deposits, they lend them out, they earn the spread, but they’re raising equity valuations. And some of these firms are raising at three … one of the firms raised at a $14 billion valuation, others at $3 plus billion valuations. They really want to lend this money out. They can’t afford for it to sit on the books, for one. They don’t want to return it. So their risk management also starts to go down. And, you know, that becomes the whole system, basically.
I think one of the last calls we did someone lent me high nine figures, almost a billion, off a phone call. That was the final one, that was, like, uncollateralized. That’s where the system was. People needed to get dollars out the door. We were a hedge fund, we were paid to take risk.
Were they? One point emphasized in the interview is that 3AC was not really a hedge fund, but a proprietary trading firm; for the most part, it did not take outside money and used its partners’ capital. Nobody was paying 3AC to take risks with their money. Instead, 3AC was paying other people — its lenders — interest to borrow money. Those lenders presumably did not want 3AC to take risks with their money; they wanted to get paid back; they wanted their money to be safe. But they faced competitive pressures to lend a bunch of money to 3AC, so they did.
The story that I want to tell here is that there was an intense demand, within crypto, for “safe assets.” “Safe assets,” in this context, means places to invest your cryptocurrency or stablecoins that earn interest, that feel like bank accounts rather than speculative investments. You might put your dollars into a crypto shadow bank, exchange them for dollar-denominated stablecoins, and earn 8% interest (in dollar-indexed stablecoins) rather than the 0% you’d get at a real bank. Or you might own Bitcoin, and think Bitcoin is pretty safe, and want to earn 8% interest on your Bitcoin. But what you didn’t want is to guess which small-time cryptocurrencies would win or lose; you did not want to make speculative bets on individual cryptocurrencies. You wanted to own normal understandable stuff (dollars, perhaps Bitcoins) and get paid a lot of interest for participating in “crypto.”
Crypto had no sensible way to manufacture this interest. There were not a lot of people borrowing Bitcoin or stablecoins to buy houses or build factories or whatever. Crypto shadow banks could not lend their crypto at 12% interest to stable companies secured by real-world collateral; everything in crypto was new, and financial, and on the blockchain. The best the shadow banks could do was lend their crypto to well-regarded crypto hedge funds secured by crypto collateral, though even that became rarer as lending got more competitive and shadow banks did more unsecured loans.
But at least, the shadow banks thought, they were lending the money to hedge funds who were doing safe trades. They weren’t lending money to firms like 3AC to make wild speculative bets on random cryptocurrencies. They were lending money to 3AC to do “arbitrages.” And then you sit down with Kyle Davies and ask him what kind of arbitrages he did and he’s like “well we’d take four-year lockups on illiquid unhedgeable tokens of brand-new protocols, but we’d get a discount, so it was kind of an arbitrage.” Oops!
In recent months I have often thought, and written, that the crypto industry in 2022 rediscovered the 2008 financial crisis. A quick summary of 2008 is that there was a lot of demand for safe assets, for bonds with AAA ratings. The financial system obligingly manufactured those assets, taking risky assets — mostly subprime mortgages — and packaging and slicing them to achieve AAA ratings. There was so much demand for safe assets that the manufacturing process got sloppy: The subprime mortgages got ever more subprime, the slicing and repackaging got less effective, and ultimately some of the safe assets turned out not to be safe.
Something like that seems to have happened in crypto but there is a critical difference. In crypto, there are no mortgages to speak of. You cannot really start by taking some somewhat risky cash flows and tranching them to make some of the cash flows safer. There are no cash flows. The safe assets in crypto — interest-bearing accounts at Voyager or Celsius or BlockFi or Gemini — are created by making unsecured billion-dollar loans, negotiated in a single phone call, to arbitrage trading firms that are actually just making long-term bets on the marketing abilities of blockchain entrepreneurs. Crypto shadow banks did not manufacture safe assets out of risky investments; they just relabeled the risky investments as safe assets. There were people taking wild speculative risks on brand-new, sentiment-driven crypto projects, and there were people who wanted to invest safely and earn 8%, and they were the same people.