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Monday, October 3, 2022
HomeAnalysisCrypto Analysis Case Study - ‘Three Arrows Capital’: PART V

Crypto Analysis Case Study – ‘Three Arrows Capital’: PART V

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By Rodrigo Zepeda, CEO, Storm-7 Consulting

Introduction

In Parts V and VI of this Crypto Analysis Case Study, we are going to search to tie collectively the problems raised concerning the crypto hedge fund ‘Three Arrows Capital’ (3AC), and the final word failure of its Singapore-based funding
fund ‘Three Arrows Capital Pte. Ltd.’ (3AC Singapore). 3AC Singapore was a ‘Registered Fund Management Company’ (RFMC) licenced and supervised by the Monetary Authority of Singapore (MAS).

We beforehand recognized there have been not less than three potential valuations of 3AC’s property, these have been: (1)
$18 billion (£14.9 billion) (June 2022) (Hern and Milmo 2022);
(2) $10 billion (March 2022) (Shen 2022); and (3)
$3 billion (April 2022) (Chipolina and Samson 2022). In
Part II
of this Case Study, we assumed this determine was the bottom valuation, specifically
$3 billion. The motive justifying this assumption was that, if the precise valuation of 3AC’s property had been both
$18 billion and even $10 billion, then however the massive losses incurred by 3AC, the agency would probably nonetheless have had vital funds with which it may proceed its operations.

If 3AC had held both of those massive figures, it could nonetheless probably have held not less than
$1 billion in property. So, even when 3AC had misplaced all the things aside from $1 billion
(i.e., $1000 million), this quantity would nonetheless have been sufficient for it to proceed on and rebuild its operations. In follow, no one would stroll away from an funding fund that also held
$1 billion in property. Therefore, I feel the precise valuation would are typically nearer to
$3 billion reasonably than $10 billion. However, it’s doable that crypto start-up funding valuations have been elevated on paper to make it seem as if the agency was extra profitable than it truly was on the time.  

The $3 billion valuation additionally appears to be extra in step with the actions taken by its founders
Kyle Livingston Davies and Su Zhu. That is, it could appear to be the case that when 3AC Singapore’s crypto funding positions went south, then they ghosted their present buying and selling counterparties as a substitute of servicing their excellent funding
positions (Strachan 2022). This would have a tendency not solely to point that the agency’s
liquid buying and selling property have been worn out by June 2022 (which might have been unlikely if it held
$10 billion in liquid property), but in addition that its buying and selling, threat administration, and compliance features have been both ineffective, not correctly arrange, or fully missing at such time.

In developed monetary markets, ghosting present buying and selling counterparties, regardless of the scale of losses incurred, is one thing that’s merely not accomplished by monetary professionals; reasonably, it’s one thing that is likely to be accomplished by people with a fratboy finance
mentality, inadequate seasoned trade expertise, and low emotional intelligence. Based on the data we’ve gathered and assessed so far, and explaining my reasoning as I’m going alongside, I feel what doubtlessly could have occurred was this.

3AC Singapore’s operations

We noticed in Part IV
of this Case Study that funding fund regulatory frameworks have now been extremely developed in follow. I supplied a selected instance of the ‘AIFMD’ (Alternative Investment Fund Managers Directive (Directive
2011/61EU)) framework that regulates funding funds within the European Union (EU). The regulatory obligations set out therein, included detailed operational necessities pertaining to key areas reminiscent of asset valuation; authorisation; capital necessities;
conduct of enterprise requirements; delegation; depositaries; advertising and marketing; remuneration; reporting; and transparency.

The level made was that if you end up organising and creating an funding fund, there’s a large vary of knowledge to attract upon when designing its structure and creating its operational construction. In addition, environment friendly fund managers which can be aiming
to arrange profitable funding funds invariably all the time put in place procedures to make such funds self-sustaining in the long run. This contains organising efficient and impartial threat administration and compliance features inside the first 5 years of
a fund’s operations. This goes with out query.

The head of compliance ought to have impartial reporting authority, and the funding agency’s audit perform must be frequently examined and confirmed to be efficient in follow. All these necessities have been set out within the relevant ‘Guidelines
on Licensing, Registration and Conduct of Business for Fund Management Companies’ (Guideline No: SFA 04-G05) with an Issue Date of
7 August 2012 (MAS 2012 Guidelines). These features are examined internally and customarily reported on to a supervisory authority and exterior traders on an annual foundation.

The details would appear to proof that these features, all of which have been legally mandated by the regulatory framework governing a RFMC, have been both not operational or not efficient in 3AC Singapore. We know {that a} RFMC’s solely regulatory obligations are to
serve solely as much as 30 certified traders and to solely handle property of no more than 250 million Singapore Dollars ($179.78 million), i.e., roughly
$180 million of property beneath administration (AuM).

Given that 3AC Singapore had not usually opened as much as exterior traders, its solely remaining principal regulatory obligation was to make sure that its asset valuation was correct. This ought to have been a comparatively easy job for an funding fund that
had been working for 5 years by August 2018. Yet, based on the MAS, 3AC Singapore had first exceeded its allowable AuM between
July 2020 and September 2020 (MAS
2022). 3AC Singapore was legally required to make sure its AuM have been topic to impartial valuation supplied by a third-party service supplier, or by an in-house fund valuation perform that needed to be segregated
from its funding administration perform (MAS
2012 Guidelines, p. 8).

An impartial auditor was required to periodically verify on the exact valuation of 3AC Singapore’s property and report by way of the agency’s annual audit (MAS
2012 Guidelines, p. 9). As a RFMC, 3AC Singapore was required to inform the MAS
instantly if it beached any licensing or registration requirement, in addition to taking speedy steps to rectify the breach (MAS
2012 Guidelines, p. 10). All 3AC Singapore’s compliance personnel would have been required to have full data of this obligatory authorized requirement.

So, in actuality, 3AC Singapore, as a agency that had operated for greater than 5 years, would very probably have identified, or have anticipated, that it had exceeded its authorised AuM threshold in both
June 2020 or July 2020, if not earlier. Yet, regardless of 3AC Singapore exceeding its authorised threshold between
July 2020 and September 2020, after which once more between November 2020
and August 2021 (MAS
2022), it nonetheless did not notify the MAS imediately. So, clearly this was not a mistake, nor was it an oversight. In reality, all of the obtainable proof signifies that these acts have been intentional in nature.

In Part III of this
Case Study, I said that I believed that the agency had deliberately shunned notifying MAS on this regard. I consider that the principle causes behind this, have been: (1) to cease MAS from wanting additional into its operations (which the MAS may need determined
to do if notified of a breach of the authorised AuM threshold); and (2) to keep away from the agency having to use for a ‘Capital Markets Services’ (CMS) Licence and register as a ‘Licensed Fund Management Company’ (LFMC).

Registration as a LFMC would have meant that 3AC Singapore would have needed to have modified an enormous vary of its present operational, threat administration, and compliance practices, as it could have been topic to way more stringent regulatory obligations. Clearly,
this was one thing that 3AC Singapore needed to keep away from in any respect prices. Perhaps the actual query is why? I feel this has one thing to do with the way in which that 3AC Singapore was run. In follow, the agency’s threat administration features appear to have been configured and
operated in extremely ineffective methods.

3AC Singapore’s investments

Apart from earning profits, the entire modus operandi behind an funding fund is to successfully handle threat, for instance by diversifying its funding technique in clever methods. If an funding fund invests all its AuM in gold, then this funding
publicity to a single asset class creates excessive focus threat for the funding fund. If gold markets fall, then the funding fund doubtlessly dangers dropping all of its funding property. 3AC operated in crypto funding markets. 3AC Singapore sought
to diversify its funding technique by investing a proportion of its investments in long-term fairness stakes in a spread of crypto start-ups.

Although this diversifies threat, it additionally ties up funding capital, as a result of crypto start-up stakes can’t be liquidated rapidly in open markets. So, in 3AC Singapore’s case, if it had invested say
$1.5 billion (50% of its estimated property) in crypto start-ups, these investments couldn’t be liquidated to service excellent margin calls on leveraged crypto investments. The probably motive that 3AC Singapore ghosted its buying and selling counterparties was
that it may now not service excellent margin calls on its leveraged crypto investments – the agency had run out of cash. The agency nonetheless held crypto start-up fairness investments, however these merely couldn’t be offered in time to service excellent margin calls
and decentralised finance (DeFi) loans.

The liquidators will due to this fact probably have the ability to get better tied-up capital by privately promoting the agency’s portfolio of investments in crypto start-ups, however this can take time to search out consumers keen to tackle such sort of illiquid investments at a suitable
market worth. However, it must be famous that if these crypto investments have been being precisely valued and reported on, this may have meant that the agency would have had its authorised funding capability considerably curtailed.

For instance, say 3AC Singapore invested $60 million in such crypto funding start-ups, and some years later this funding had elevated in worth to
$120 million. That would imply that as a result of its authorised AuM threshold was
$180 million, it solely had $60 million of property remaining that it may formally make investments earlier than it breached the AuM threshold, and the agency would have been required to inform the MAS. Any failure to precisely worth and report on the asset worth
of such investments wouldn’t solely breach regulatory obligations relevant to a RFMC, however it could additionally considerably inhibit the general effectiveness of the agency’s threat administration features.

In Part IV of this
Case Study, we recognized the complexity and opaque buildings of over-the-counter (OTC) derivatives that have been on the centre of the Great Financial Crisis (GFC). We additionally recognized that the usage of leverage with OTC derivatives, and their
interconnectedness with different monetary providers companies, created vital market dangers, and will result in knock-on results by way of collateral and margin necessities (OICV-IOSCO
2016, p. 81). We noticed how these dangers have been addressed and handled by way of particular clearing and threat mitigation strategies employed, e.g., by the usage of prime quality, liquid, margin or collateral, and the usage of standardised margin or collateral
haircuts.

We additionally recognized that these kinds of dangers may simply as simply come up with respect to crypto investments, and that genuinely, crypto investments have been seen to current even greater dangers than these exhibited by OTC derivatives (Finansinspektionen
2021). We then listed a spread of those crypto asset dangers that might come up in follow, and reviewed a spread of threat mitigation processes and strategies that may very well be employed by funding funds to mitigate such crypto funding dangers, e.g., as really helpful
by The Standards Board for Alternative Investments (SBai).

For instance, for 3AC Singapore, it could have meant that the agency employed strict operational due diligence (ODD) necessities regarding key ODD areas reminiscent of conflicts of curiosity; regulatory threat; commerce processes; and correct valuation and asset
verification (SBai 2021, p. 4). 3AC Singapore ought to have additionally been utilizing valuation factors that have been
clearly documented in valuation insurance policies, utilized persistently, and documented utilizing time stamps or audit trails (SBai
2021, p. 5).

3AC Singapore also needs to have been utilizing impartial events reminiscent of auditors or fund directors to facilitate the impartial valuation and verification of all crypto property maintained within the fund portfolio (SBai
2021, p. 5). 3AC Singapore ought to have been utilizing prime quality, liquid, margin, to assist its crypto investments, e.g., excessive grade authorities bonds. This would have ensured that its margin positions coated any speedy loss in worth of excellent funding
positions.

Using cryptocurrencies as margin to assist different crypto investments is a really dangerous threat administration technique. This is as a result of if the worth of the excellent funding place falls (e.g., lengthy funding in Bitcoin (BTC)), the market correlation
of cryptocurrencies will probably imply that the worth of the posted crypto margin additionally falls on the similar time (e.g., Ethereum (ETH)). The elevated threat arises as a result of on the very time {that a} crypto funding is dropping worth, its supporting crypto margin
can also be dropping worth, that means that the worth of any further margin calls might be a lot greater than would in any other case be the case utilizing prime quality (non-crypto) collateral.

If prime quality (non-crypto) collateral is used, this can probably retain most of its worth in instances of market volatility, and so margin threat and funding threat fashions will stay correct and threat administration methods will probably stay efficient (as these
take into consideration margin haircuts). If crypto collateral is used, this can now not be the case, as a result of will probably be extraordinarily troublesome to foretell what the speed of degradation in worth of such crypto collateral might be. What you’re basically doing in
such a case, is backing up a crypto funding (e.g., BTC) with a second crypto funding (e.g., ETH), which can each be rapidly dropping worth in instances of excessive market volatility.

3AC Singapore’s threat administration and buying and selling practices

In follow, we all know that 3AC Singapore traded with a spread of crypto exchanges. These included
inter alia: (1) Aave; (2) Babel Finance; (3) Bitfinex; (4) BitMEX; (5) BlockFi Inc.; (6) Curve; (7) Deribit; (8) FTX; (9) Genesis Trading; and (10) Voyager Digital. Consequently, as an example and clarify market developments we are going to think about that 3AC
Singapore held simply FIVE crypto funding positions at totally different crypto exchanges, all of which used leveraged buying and selling, e.g., 10:1 leverage ratio. Say 3AC Singapore deposited
$10 million on every crypto funding place which allowed it to manage
$100 million in crypto investments at every crypto trade, i.e., $50 million
funds controlling $500 million in crypto funding positions.

If the crypto markets preserve rising, 3AC Singapore retains making very vital income and isn’t required to put up further upkeep margin (MM). However, if crypto markets grow to be extremely unstable, or they begin to crash, all 5 crypto funding
positions wouldn’t solely in a short time lose worth, however they are going to all require increasingly MM to be transferred on the similar time (in any other case they’d have been closed out). Remember, as we famous beforehand all funding positive factors are magnified by leveraged
buying and selling, however so too are all funding losses.

If a buying and selling place of $100 million at a crypto trade loses 5% of its worth (i.e.,
$5 million) this represents half (50%) of the $10 million preliminary margin (IM) deposited. If a buying and selling place loses 10% of its worth (i.e.,
$10 million) this represents all (100%) of the IM deposited. If a margin name is about at 80% of IM (i.e.,
$8 million), a crypto trade would require 3AC Singapore to put up further MM when its buying and selling place falls and solely
$8 million in margin stays.

As such, these buying and selling losses will crystallise if 3AC Singapore permits the place to be closed out, for example as a result of it fails to put up further MM, i.e., whole lack of
$50 million IM deposited. When the crypto markets turned extremely unstable and depressed beginning in
May 2022, 3AC Singapore would have been pressured to proceed to put up further MM on its excellent positions or face having them closed out leading to a complete lack of their posted IM. This drawback would have grow to be extraordinarily acute if 3AC
Singapore was utilizing what I beforehand known as ‘triple leveraged trading’, which I consider 3AC Singapore was utilizing.

This happens the place 3AC Singapore borrows funds by way of a DeFi middleman (first leverage), which probably required over-collateralisation of such loans (mortgage secured by posting extra cryptocurrencies as collateral than the worth of the mortgage –
$10 million mortgage supported by $13 million in worth of BTC). It then makes use of the borrowed funds to commerce on a leveraged funding foundation (second leverage). However, as a substitute of utilizing only one crypto trade to commerce (extra optimum for threat administration
functions), 3AC Singapore then opens up a number of buying and selling accounts throughout a number of crypto exchanges (third leverage).

This third degree of leverage is extremely problematic from a threat administration perspective. In follow, 3AC Singapore was probably utilizing greater than 5 crypto exchanges, allow us to say it used the ten crypto exchanges listed above. All these exchanges probably supplied
totally different leverage ratios and stipulated totally different margin standards. So, in idea, the chance administration perform inside 3AC Singapore
ought to have been modifying the agency’s inner funding threat fashions to mirror this complexity of crypto investments. The threat mannequin parameters
ought to have been examined to see what would occur to the worth of crypto investments and posted crypto margin beneath totally different market situations, together with a spread of various excessive however believable situations.

Given the massive market worth of such investments, and the extraordinarily excessive dangers of crypto investments, the agency’s threat administration perform
ought to have been operating stress checks and reverse stress checks on the agency’s funding portfolio. So, we’ve focus threat due to funding in a single sort of crypto asset class. We have vital and intensive market threat due to the massive
volatility and steep decline in cryptocurrency markets that befell from the beginning of
2022.

We have cryptocurrency correlation threat, due to the destructive correlation threat between primary established cryptocurrencies. We have margin threat, due to the chance of crypto margin posted rapidly deteriorating in worth. This was advanced to mannequin as a result of
every crypto trade will probably have stipulated totally different margin necessities. We have counterparty and default threat due to the vary of DeFi loans taken out by 3AC Singapore and the chance of the agency not having adequate liquidity (e.g., due to unexpected
margin calls) to service excellent debt instalments.

We have large quantities of leverage threat, due to the huge use of triple leveraged buying and selling by the agency. In this occasion, 3AC Singapore’s drawback turns into extraordinarily acute as a result of it losses are intensely magnified owing to a number of leverage ratios used
throughout quite a few crypto exchanges, mixed with the truth that the agency had misplaced cash which was not even its personal, this represented borrowed cash which it has to repay.

In idea, all these dangers have been required to be fastidiously and precisely modelled, represented, and up to date within the agency’s inner threat fashions and threat administration practices and insurance policies. However, given what occurred to 3AC Singapore, I don’t assume this occurred.
Worse nonetheless, that is an space that ought to have been recognized and investigated by the MAS in its investigation of 3AC Singapore that commenced in
June 2021, nevertheless it appears to have been fully missed by the MAS.

All these dangers must have been recognized, detailed in depth, and precisely documented and managed if 3AC Singapore would have been required to have registered as a LFMC. All its historic threat administration, compliance, and operational features would
have been subjected to further intense scrutiny by the MAS. This is why I consider that 3AC Singapore deliberately did not notify the MAS of its continued breach of its authorised AuM threshold.

To be continued.

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