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 will seek to tie together the issues raised regarding the crypto hedge fund ‘Three Arrows Capital’ (3AC), and the ultimate failure of its Singapore-based investment
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 previously identified there were at least three potential valuations of 3AC’s assets, these were: (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 figure was the lowest valuation, namely
$3 billion. The reason justifying this assumption was that, if the actual valuation of 3AC’s assets had been either
$18 billion or even $10 billion, then notwithstanding the huge losses incurred by 3AC, the firm would likely still have had significant funds with which it could continue its operations.

If 3AC had held either of these large figures, it would still likely have held at least
$1 billion in assets. So, even if 3AC had lost everything apart from $1 billion
(i.e., $1000 million), this amount would still have been enough for it to continue on and rebuild its operations. In practice, nobody would walk away from an investment fund that still held
$1 billion in assets. Therefore, I think the actual valuation would tend to be closer to
$3 billion rather than $10 billion. However, it is possible that crypto start-up investment valuations were increased on paper to make it appear as if the firm was more successful than it actually was at the time.  

The $3 billion valuation also seems to be more consistent with the actions taken by its founders
Kyle Livingston Davies and Su Zhu. That is, it would seem to be the case that once 3AC Singapore’s crypto investment positions went south, then they ghosted their existing trading counterparties instead of servicing their outstanding investment
positions (Strachan 2022). This would tend not only to indicate that the firm’s
liquid trading assets were wiped out by June 2022 (which would have been unlikely if it held
$10 billion in liquid assets), but also that its trading, risk management, and compliance functions were either ineffective, not properly set up, or completely lacking at such time.

In developed financial markets, ghosting existing trading counterparties, no matter the size of losses incurred, is something that is simply not done by financial professionals; rather, it is something that might be done by individuals with a fratboy finance
mentality, insufficient seasoned industry experience, and low emotional intelligence. Based on the information we have gathered and assessed to date, and explaining my reasoning as I go along, I think what potentially may have happened was this.

3AC Singapore’s operations

We saw in Part IV
of this Case Study that investment fund regulatory frameworks have now been highly developed in practice. I provided a specific example of the ‘AIFMD’ (Alternative Investment Fund Managers Directive (Directive
2011/61EU
)) framework that regulates investment funds in the European Union (EU). The regulatory obligations set out therein, included detailed operational requirements pertaining to key areas such as asset valuation; authorisation; capital requirements;
conduct of business standards; delegation; depositaries; marketing; remuneration; reporting; and transparency.

The point made was that when you are setting up and developing an investment fund, there is a huge range of information to draw upon when designing its architecture and creating its operational structure. In addition, efficient fund managers that are aiming
to set up successful investment funds invariably always put in place procedures to make such funds self-sustaining in the long term. This includes setting up effective and independent risk management and compliance functions within the first five years of
a fund’s operations. This goes without question.

The head of compliance should have independent reporting authority, and the investment firm’s audit function should be regularly tested and proven to be effective in practice. All these requirements were set out in the applicable ‘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 functions are tested internally and generally reported on to a supervisory authority and external investors on an annual basis.

The facts would seem to evidence that these functions, all of which were legally mandated by the regulatory framework governing a RFMC, were either not operational or not effective in 3AC Singapore. We know that a RFMC’s only regulatory obligations are to
serve only up to 30 qualified investors and to only manage assets of not more than 250 million Singapore Dollars ($179.78 million), i.e., approximately
$180 million of assets under management (AuM).

Given that 3AC Singapore had not generally opened up to external investors, its only remaining principal regulatory obligation was to ensure that its asset valuation was accurate. This should have been a relatively simple task for an investment fund that
had been operating for five years by August 2018. Yet, according to the MAS, 3AC Singapore had first exceeded its allowable AuM between
July 2020 and September 2020 (MAS
2022
). 3AC Singapore was legally required to ensure its AuM were subject to independent valuation provided by a third-party service provider, or by an in-house fund valuation function that had to be segregated
from its investment management function (MAS
2012 Guidelines
, p. 8
).

An independent auditor was required to periodically check on the precise valuation of 3AC Singapore’s assets and report via the firm’s annual audit (MAS
2012 Guidelines
, p. 9
). As a RFMC, 3AC Singapore was required to notify the MAS
immediately if it beached any licensing or registration requirement, as well as taking immediate steps to rectify the breach (MAS
2012 Guidelines
, p. 10
). All 3AC Singapore’s compliance personnel would have been required to have full knowledge of this mandatory legal requirement.

So, in reality, 3AC Singapore, as a firm that had operated for more than five years, would very likely have known, or have expected, that it had exceeded its authorised AuM threshold in either
June 2020 or July 2020, if not earlier. Yet, despite 3AC Singapore exceeding its authorised threshold between
July 2020 and September 2020, and then again between November 2020
and August 2021 (MAS
2022
), it still failed to notify the MAS imediately. So, clearly this was not a mistake, nor was it an oversight. In fact, all the available evidence indicates that these acts were intentional in nature.

In Part III of this
Case Study, I stated that I believed that the firm had intentionally refrained from notifying MAS in this regard. I believe that the main reasons behind this, were: (1) to stop MAS from looking further into its operations (which the MAS might have decided
to do if notified of a breach of the authorised AuM threshold); and (2) to avoid the firm having to apply 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 had to have changed a huge range of its existing operational, risk management, and compliance practices, as it would have been subject to much more stringent regulatory obligations. Clearly,
this was something that 3AC Singapore wanted to avoid at all costs. Perhaps the real question is why? I think this has something to do with the way that 3AC Singapore was run. In practice, the firm’s risk management functions seem to have been configured and
operated in highly ineffective ways.

3AC Singapore’s investments

Apart from making money, the whole modus operandi behind an investment fund is to effectively manage risk, for example by diversifying its investment strategy in intelligent ways. If an investment fund invests all its AuM in gold, then this investment
exposure to a single asset class creates high concentration risk for the investment fund. If gold markets fall, then the investment fund potentially risks losing all of its investment assets. 3AC operated in crypto investment markets. 3AC Singapore sought
to diversify its investment strategy by investing a proportion of its investments in long-term equity stakes in a range of crypto start-ups.

Although this diversifies risk, it also ties up investment capital, because crypto start-up stakes cannot be liquidated quickly in open markets. So, in 3AC Singapore’s case, if it had invested say
$1.5 billion (50% of its estimated assets) in crypto start-ups, these investments could not be liquidated to service outstanding margin calls on leveraged crypto investments. The likely reason that 3AC Singapore ghosted its trading counterparties was
that it could no longer service outstanding margin calls on its leveraged crypto investments – the firm had run out of money. The firm still held crypto start-up equity investments, but these simply could not be sold in time to service outstanding margin calls
and decentralised finance (DeFi) loans.

The liquidators will therefore likely be able to recover tied-up capital by privately selling the firm’s portfolio of investments in crypto start-ups, but this will take time to find buyers willing to take on such type of illiquid investments at an acceptable
market price. However, it should be noted that if these crypto investments were being accurately valued and reported on, this would have meant that the firm would have had its authorised investment capacity significantly curtailed.

For example, say 3AC Singapore invested $60 million in such crypto investment start-ups, and a few years later this investment had increased in value to
$120 million. That would mean that because its authorised AuM threshold was
$180 million, it only had $60 million of assets remaining that it could officially invest before it breached the AuM threshold, and the firm would have been required to notify the MAS. Any failure to accurately value and report on the asset value
of such investments would not only breach regulatory obligations applicable to a RFMC, but it would also significantly inhibit the overall effectiveness of the firm’s risk management functions.

In Part IV of this
Case Study, we identified the complexity and opaque structures of over-the-counter (OTC) derivatives that were at the centre of the Great Financial Crisis (GFC). We also identified that the use of leverage with OTC derivatives, and their
interconnectedness with other financial services firms, created significant market risks, and could lead to knock-on effects via collateral and margin requirements (OICV-IOSCO
2016
, p. 81
). We saw how these risks were addressed and dealt with via specific clearing and risk mitigation techniques employed, e.g., through the use of high quality, liquid, margin or collateral, and the use of standardised margin or collateral
haircuts.

We also identified that these types of risks could just as easily arise with respect to crypto investments, and that in actuality, crypto investments were seen to present even higher risks than those exhibited by OTC derivatives (Finansinspektionen
2021
). We then listed a range of these crypto asset risks that could arise in practice, and reviewed a range of risk mitigation processes and techniques that could be employed by investment funds to mitigate such crypto investment risks, e.g., as recommended
by The Standards Board for Alternative Investments (SBai).

For example, for 3AC Singapore, it would have meant that the firm employed strict operational due diligence (ODD) requirements relating to key ODD areas such as conflicts of interest; regulatory risk; trade processes; and accurate valuation and asset
verification (SBai 2021, p. 4). 3AC Singapore should have also been using valuation points that were
clearly documented in valuation policies, applied consistently, and documented using time stamps or audit trails (SBai
2021
, p. 5
).

3AC Singapore should also have been using independent parties such as auditors or fund administrators to facilitate the independent valuation and verification of all crypto assets maintained in the fund portfolio (SBai
2021
, p. 5
). 3AC Singapore should have been using high quality, liquid, margin, to support its crypto investments, e.g., high grade government bonds. This would have ensured that its margin positions covered any rapid loss in value of outstanding investment
positions.

Using cryptocurrencies as margin to support other crypto investments is a very bad risk management strategy. This is because if the value of the outstanding investment position falls (e.g., long investment in Bitcoin (BTC)), the market correlation
of cryptocurrencies will likely mean that the value of the posted crypto margin also falls at the same time (e.g., Ethereum (ETH)). The increased risk arises because at the very time that a crypto investment is losing value, its supporting crypto margin
is also losing value, meaning that the value of any additional margin calls will be much higher than would otherwise be the case using high quality (non-crypto) collateral.

If high quality (non-crypto) collateral is used, this will likely retain most of its value in times of market volatility, and so margin risk and investment risk models will remain accurate and risk management strategies will likely remain effective (as these
take into account margin haircuts). If crypto collateral is used, this will no longer be the case, because it will be extremely difficult to predict what the rate of deterioration in value of such crypto collateral will be. What you are essentially doing in
such a case, is backing up a crypto investment (e.g., BTC) with a second crypto investment (e.g., ETH), which may both be quickly losing value in times of high market volatility.

3AC Singapore’s risk management and trading practices

In practice, we know that 3AC Singapore traded with a range 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, to illustrate and explain market developments we will imagine that 3AC
Singapore held just FIVE crypto investment positions at different crypto exchanges, all of which used leveraged trading, e.g., 10:1 leverage ratio. Say 3AC Singapore deposited
$10 million on each crypto investment position which allowed it to control
$100 million in crypto investments at each crypto exchange, i.e., $50 million
funds controlling $500 million in crypto investment positions.

If the crypto markets keep rising, 3AC Singapore keeps making very significant profits and is not required to post additional maintenance margin (MM). However, if crypto markets become highly volatile, or they start to crash, all five crypto investment
positions would not only very quickly lose value, but they will all require more and more MM to be transferred at the same time (otherwise they would have been closed out). Remember, as we noted previously all investment gains are magnified through leveraged
trading, but so too are all investment losses.

If a trading position of $100 million at a crypto exchange loses 5% of its value (i.e.,
$5 million) this represents half (50%) of the $10 million initial margin (IM) deposited. If a trading position loses 10% of its value (i.e.,
$10 million) this represents all (100%) of the IM deposited. If a margin call is set at 80% of IM (i.e.,
$8 million), a crypto exchange will require 3AC Singapore to post additional MM when its trading position falls and only
$8 million in margin remains.

As such, these trading losses will crystallise if 3AC Singapore allows the position to be closed out, for instance because it fails to post additional MM, i.e., total loss of
$50 million IM deposited. When the crypto markets became highly volatile and depressed starting in
May 2022, 3AC Singapore would have been forced to continue to post additional MM on its outstanding positions or face having them closed out resulting in a total loss of their posted IM. This problem would have become extremely acute if 3AC
Singapore was using what I previously referred to as ‘triple leveraged trading’, which I believe 3AC Singapore was using.

This occurs where 3AC Singapore borrows funds via a DeFi intermediary (first leverage), which likely required over-collateralisation of such loans (loan secured by posting more cryptocurrencies as collateral than the value of the loan -
$10 million loan supported by $13 million in value of BTC). It then uses the borrowed funds to trade on a leveraged investment basis (second leverage). However, instead of using just one crypto exchange to trade (more optimal for risk management
purposes), 3AC Singapore then opens up multiple trading accounts across multiple crypto exchanges (third leverage).

This third level of leverage is highly problematic from a risk management perspective. In practice, 3AC Singapore was likely using more than five crypto exchanges, let us say it used the ten crypto exchanges listed above. All these exchanges likely provided
different leverage ratios and stipulated different margin criteria. So, in theory, the risk management function within 3AC Singapore
should have been modifying the firm’s internal investment risk models to reflect this complexity of crypto investments. The risk model parameters
should have been tested to see what would happen to the value of crypto investments and posted crypto margin under different market scenarios, including a range of different extreme but plausible scenarios.

Given the huge market value of such investments, and the extremely high risks of crypto investments, the firm’s risk management function
should have been running stress tests and reverse stress tests on the firm’s investment portfolio. So, we have concentration risk because of investment in one type of crypto asset class. We have significant and extensive market risk because of the huge
volatility and steep decline in cryptocurrency markets that took place from the start of
2022.

We have cryptocurrency correlation risk, because of the negative correlation risk between main established cryptocurrencies. We have margin risk, because of the risk of crypto margin posted quickly deteriorating in value. This was complex to model because
each crypto exchange will likely have stipulated different margin requirements. We have counterparty and default risk because of the range of DeFi loans taken out by 3AC Singapore and the risk of the firm not having sufficient liquidity (e.g., because of unforeseen
margin calls) to service outstanding debt instalments.

We have huge amounts of leverage risk, because of the massive use of triple leveraged trading by the firm. In this instance, 3AC Singapore’s problem becomes extremely acute because it losses are intensely magnified owing to multiple leverage ratios used
across numerous crypto exchanges, combined with the fact that the firm had lost money which was not even its own, this represented borrowed money which it has to repay.

In theory, all these risks were required to be carefully and accurately modelled, represented, and updated in the firm’s internal risk models and risk management practices and policies. However, given what happened to 3AC Singapore, I do not think this happened.
Worse still, this is an area that should have been identified and investigated by the MAS in its investigation of 3AC Singapore that commenced in
June 2021, but it seems to have been completely missed by the MAS.

All these risks would have to have been identified, detailed in depth, and accurately documented and managed if 3AC Singapore would have been required to have registered as a LFMC. All its historic risk management, compliance, and operational functions would
have been subjected to additional intense scrutiny by the MAS. This is why I believe that 3AC Singapore intentionally failed to notify the MAS of its continued breach of its authorised AuM threshold.

To be continued.

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