Crypto Analysis Case Study – ‘Three Arrows Capital’: PART VI (Rodrigo Zepeda)

By Rodrigo Zepeda, CEO, Storm-7 Consulting

Role of the Monetary Authority of Singapore

In June 2021 the Monetary Authority of Singapore (MAS) commenced an investigation into the Singapore-based investment fund ‘Three Arrows Capital Pte. Ltd.’ (3AC Singapore) (MAS
2022). On the face of it this consisted of a one-year investigation which culminated in a mere warning being published on
30 June 2022 (MAS
2022). As I explained and reasoned in Part IV of this
Case Study relating to ‘Three Arrows Capital’ (3AC), I believe that if the MAS had properly carried out its duty of supervisory capacity vis-à-vis the adequate, prudent, and timely supervision of 3AC Singapore, it should have required 3AC
Singapore to register as a ‘Licensed Fund Management Company’ (LFMC), as opposed to its existing status as a ‘Registered Fund Management Company’ (RFMC).

I believe that this would have imposed on 3AC Singapore a legal obligation to adhere to a broad range of much stricter regulatory requirements which would have significantly bolstered the firm’s existing operational, risk management, compliance, and capital
obligations. This in turn may have potentially prevented the firm’s collapse, or at the very least, significantly reduced the extent of financial damage incurred. Consequently, I believe that the failure in its duty of supervisory capacity by the MAS therefore
also ultimately contributed to the collapse of 3AC Singapore.

Crypto market events in 2022

In Part II of this
Case Study we identified three main market events. These were: (1) the collapse of ‘TerraUSD’ (UST) and its sister token Terra (LUNA) on
12 May 2022; (2) the cryptocurrency crash (via the ‘First Wave’ in May 2022 and the ‘Second Wave’ in
June 2022); and (3) 3AC’s failure to meet its loan payments and margin calls in
June 2022. I think it was a combination of these three main market events that ultimately led to the collapse of 3AC Singapore.

However, to be clear, it was the pre-existing structural and operational weaknesses and failures exhibited by 3AC Singapore at that time, that allowed these events to lead to its collapse. As we noted in
Part II, it was a series of events and decisions that contributed to 3AC Singapore’s collapse in
June 2022, and not simply one single mistake made by the firm. In summary, these weaknesses and failures were previously identified in relation to widespread failures in risk management; compliance failures; asset valuation failures; investment risk
failures; and highly excessive over-leveraging.  

On the face of it, 3AC Singapore broke many different operational rules. It seemed to operate ineffective and lacklustre risk management models, practices, and policies. It exposed itself to massive concentration risk by investing across a single asset class
(cryptocurrencies). The margin practices it adopted were not conservative in nature, nor did they reflect safe risk management practices, despite the fact that crypto investments posed higher risks than highly risky, complex, and opaque over-the-counter (OTC)
derivatives investments.

The most important point of all, was that the triple leveraged trading that it carried out represented a massive risk for the firm, that in all likelihood could not have been justified based on established risk management practices. The collapse of TerraUSDand
LUNA and the First Wave of the Cryptocurrency Crash in May 2022 extensively depressed crypto markets. The decisions made by 3AC Singapore during this first event very likely sealed the firm’s ultimate fate. The crypto analytics firm ‘Nansen’ carried
out a highly detailed on-chain forensics analysis of the events surrounding the collapse of TerraUSD and LUNA (Nansen 2022).

It was found that during the initial Terra collapse from 7 May 2022 to
16 May 2022, the main liquidity pool on Curve lost more than half of its ‘total value locked’ (TVL), and 3AC Singapore and Celsius Network LLC (Celsius) together withdrew nearly
$800 million from the Lido Staked Ethereum (stETH) and Ethereum (ETH) Curve liquidity pool (3AC Singapore withdrew approximately
$400 million of liquidity) (Nansen 2022). It was stated that
‘These transactions had a strong negative impact on the liquidity of the pool and the vulnerability of the peg’
(Nansen 2022).

So, at that point, the crypto markets had exhibited high volatility throughout
2022, and the value of cryptocurrencies was steadily declining month by month. For instance, in the week of
9 May 2022 to 16 May 2022 the price of ETH had significantly declined and was down 29% (Nansen 2022). This
likely significantly negatively impacted 3AC Singapore’s crypto investments. From
9 May 2022 to 12 May 2022, the TVL of the stETH/ETH Curve pool had contracted by more than 50% (from
$4.08 billion to $1.91 billion) (Nansen 2022). Nansen (2022)
further noted that ‘the implosion of UST was a major contributor to increasing risk-off sentiment among market participants’.

This was a crucial point in time for 3AC Singapore. If 3AC Singapore had conservatively calibrated its investment risk models it should have realised that the market risks that had accrued at this point were too great. During this initial phase (9 May
2022 to 16 May 2022), other large crypto investment players that held leveraged stETH/ETH positions clearly sought to unwind their existing positions (Nansen
2022). These large players made the right investment play at this point in time.

3AC Singapore should have been one of those players looking to de-risk its investments, but instead, despite withdrawing some liquidity, 3AC was actually not among the large stETH sellers during that period, and in fact kept the majority of its stETH
investment (Nansen 2022). This was completely the wrong move. By the time that 3AC Singapore started panicking on
13 June 2022 it was too late, and it was caught up in the rapid decline of stETH and crypto market contagion. For instance, Nansen (2022)
concluded:

‘3AC however, appears to be a victim of the contagion. A case of being in the wrong place at the wrong time… 3AC’s lack of sound risk management coupled with excessive leverage was simply a ticking time bomb that was set off by the stETH “de-peg”.’

I would tend to concur with Nansen’s analysis. It was estimated that 3AC Singapore had lost approximately
$500 million in the aftermath of the collapse (Roth 2022). We identified above
that the price of ETH had declined by 29% in just one week in May 2022. We also saw in
Part II of this
Case Study that a 20% weighted average loss (WAL) in cryptocurrency values in
May 2022, would mean 3AC’s $3,000 million value would decrease to
$2,400 million. If this 20% WAL continued in June 2022 3AC’s $2,400 million
value would decrease to $1,920 million.

So, we can now see why 3AC Singapore’s estimated $3 billion in assets seemed to rapidly dissipate throughout
May 2022 and June 2022. Let’s say 3AC Singapore held $1 billion
in illiquid crypto start-up investments, which would leave it with $2 billion
in assets it could invest. If these had been invested in crypto assets and cryptocurrencies, the estimated 20% WAL across
May 2022 and June 2022 would have decreased the value from $2,000 million
to $1,600 million in May 2022, and down to $1,280 million
by June 2022. If we deduct the estimated $500 million loss from the stETH/ETH collapse, only
$780 million remains.

Granted, these are not the actual figures, but the point is that by running different scenario analyses like this, we are then able to roughly approximate how losses of such magnitude were incurred. These losses would have been much larger if the actual
WAL experienced by 3AC Singapore were found to be greater, e.g., between 20%-50%. Overall, 3AC Singapore experiences massive losses because of the combined collapse of TerraUSD and LUNA. Then we have the onset of the Second Wave of the Cryptocurrency Crash
in June 2022 which massively negatively impacted cryptocurrency markets. This then in turn massively negatively impacts 3AC Singapore’s existing crypto investment positions spread across a range of crypto exchanges.

As a result, 3AC Singapore fails to meet continuing margin calls and ultimately loan instalment repayments on its existing decentralised finance (DeFi) loans. We will refer back to the
FIVE theoretical leveraged crypto investment positions adopted by the firm set out in
Part V of this
Case Study. At first, at the beginning of June 2022, 3AC Singapore may have believed that its five crypto investment positions would turn around. As such, it would have been required to post additional maintenance margin (MM) to each crypto
exchange in order to maintain its open positions, despite incurring significant investment trading losses.

At this point in time, the crypto markets have experienced the First Wave of the Cryptocurrency Crash, but it is not yet
13 June 2022 when 3AC Singapore seems to have first started to panic. Increasing amounts of MM would have been required as each position lost more value. Say each position lost value which required 3AC Singapore to post additional MM of
$10 million for each open position, the firm would then have posted a total of
$100 million in investment funds (5 x $10 million IM + 5 x $10 million
MM). When its crypto investment positions were closed out 3AC Singapore would have lost all of its initial investment funds, i.e.,
$100 million.

We provided the example of five crypto investment positions. However, in reality, 3AC Singapore was likely operating at least
TEN investment positions across different identified crypto exchanges. It is also likely that at least some of these exchanges offered the firm higher leverage ratios such as 1:50, 1:75, or 1:100. This would have meant that its losses across these higher
leverage platforms were even worse than as illustrated using the 1:10 leverage ratio. If 3AC Singapore had not been using such excessive leverage, if it had employed strong margining practices, and if it had relied on sound risk management models and policies,
it would have been able to close out its positions effectively. It would have lost a great deal of money, but it would not have failed and collapsed.

In practice, at some point in June 2022, 3AC Singapore realised that its positions would not be turning around in the short-term, or it had run out of funds with which to post any additional MM required, or both. This likely occurred during the third
week of June 2022, i.e., 13 June 2022 to 19 June 2022. Because it had insufficient funds remaining, it was unable to repay outstanding DeFi loan instalments which led to loan default and acceleration of the full amount of loans outstanding.
For example, the crypto broker firm ‘Voyager Digital, LLC’ (Voyager) had notified 3AC that it required a repayment of a
$25 million US Dollar Coin (USDC) loan instalment by 24 June 2022
(Ge Huang 2022;
PRNewswire 2022).

The entire amount of existing debt outstanding at such time was over $670 million
($350 million (USDC value) loan + $323 million (BTC value) loan). Therefore, it was obviously in 3AC Singapore’s interests for it to have repaid such loan instalment, which would have then prevented this loan from entering default and being
accelerated (the firm would then have been able to pay the loan off over a longer period of time). Yet, 3AC Singapore was unable to repay
$25 million, or chose not to repay, and so Voyager accelerated the entire amount of the loan amount which was then due by
27 June 2022.

BitMEX reported that it was owed around $6 million by 3AC Singapore (Khatri 2022;
Malwa 2022). Deribit claimed 3AC Singapore owed it
$80.13 million (Chipolina 2022).
Blockchain.com was owed $270 million by 3AC Singapore (Allison 2022).
These loans alone totalled approximately $1,026.13 million ($670 million + $6 million + $80.13 million + $270 million). These loan figures provide us with an idea of the size of the crypto investment trading positions that 3AC Singapore was operating.
Overall, this demonstrates that by this stage, 3AC Singapore’s operations had experienced catastrophic losses from which it could not recover.

Remember, 3AC Singapore was only authorised to hold a maximum of not more than 250 million Singapore Dollars ($179.78 million), i.e., approximately
$180 million of assets under management (AuM). Also remember, that the MAS had opened an official investigation into 3AC Singapore in
June 2021 and in 2022 the MAS was actually still investigating 3AC Singapore regarding its potential breach of its authorised AuM limit. On the face of it, it would seem that the investigation by the MAS was so meticulous and thorough, that at
no time did it suspect that 3AC Singapore was somehow operating with more than
sixteen times its authorised AuM limit (i.e., $180 million limit compared to
$3,000 million valuation).

Final comments

It is highly likely that as investigations by the appointed insolvency practitioners get underway, more and more revelations about 3AC Singapore’s bad, shady, or perhaps even criminal practices come to light. For instance, the firm ‘8 Blocks Capital’ said
that they had learned that 3AC Singapore were ‘leveraged long everywhere and were getting margin-called’, and that by
16 June 2022, they had even discovered that 3AC Singapore had used $1 million
of funds deposited by 8 Blocks Capital with 3AC Singapore to answer margin calls (8 Blocks Capital 2022). If this is true, this represents
a clear breach of regulatory requirements which should have been investigated by the MAS.

A report from research firm ‘FSInsight’ accused 3AC Singapore of running an old-fashioned Madoff-style Ponzi scheme (Canny
2022). It accused the firm of potentially cooking their books in order to show huge (artificial) returns on capital, whilst at the same time it was contended that the firm had recklessly borrowed from nearly every institutional lender in the crypto
industry (Canny 2022). There are also theories that have
been proposed that 3AC borrowed money from individuals within organised crime, and this is perhaps the reason why the founders have vanished without a trace (Roth
2022). Wieczner (2022) remarked that:

‘The firm’s implosion, as a result of both recklessness and likely criminal misconduct, set off a contagion that not only forced a historic sell-off in bitcoin and its ilk but also wiped out a wide swath of the cryptocurrency industry’.

At the very least, the collapse of 3AC Singapore has caused crypto investment firms and regulatory authorities around the world to question the adequacy of their existing risk management methodologies and supervisory practices respectively. As was seen throughout
this Case Study, there are many questions that remain to be asked regarding the precise role of the MAS and the extent of its involvement in the collapse of 3AC Singapore.

Summary of Case Study findings

Some of the most relevant findings that have been identified in this Case Study
are:

1. on the face of the evidence the MAS failed to properly carry out its duty of supervisory capacity vis-à-vis the adequate, prudent, and timely supervision of 3AC Singapore;
2. had the MAS properly carried out its duty, it is likely this may have potentially prevented the firm’s collapse, or significantly reduced the extent of financial damage incurred; 
3. in 2021 and 2022 3AC Singapore should have been registered as a LFMC and not a RFMC;
4. the firm’s founders had failed to build an investment fund that was robust, that could operate independently, and that could independently hold its founders and managers to account for their actions;
5. 3AC Singapore exposed itself to massive investment asset concentration risk;
6. 3AC Singapore failed to adhere to a broad range of legal regulatory requirements that were subject to supervision by the MAS;
7. 3AC Singapore failed to employ and apply accurate and timely asset valuation models, policies, and procedures to its crypto investments;
8. 3AC Singapore failed to report to the MAS as legally required valuation of its AuM in an accurate and timely manner;
9. 3AC Singapore employed high risk and ineffective crypto investment margining practices;
10. 3AC Singapore exhibited a series of huge failures with respect to its internal audit function; compliance function; investment close-out procedures; management decisions and policies; regulatory reporting function; risk management framework; risk management
    models (accuracy and calibration); risk management, practices, and policies; and supervisory authority reporting function;
11. on the face of the evidence, 3AC Singapore seem to have intentionally failed to notify the MAS of its continued breach of its authorised AuM investment limit;
12. 3AC engaged in highly excessive leveraged trading with respect to its crypto investments (triple leveraged trading) which played a central role in the firm’s collapse; and
13. the three main contributing market events that led to 3AC Singapore’s collapse were the collapse of TerraUSD and LUNA, the Cryptocurrency Crash in
    2022, and 3AC’s failure to meet its loan payments and margin calls.

Summary of Case Study

In Part I of this
Case Study we provided a factual background about 3AC and its different operational entities incorporated around the world; we briefly discussed the backgrounds of the firm’s founders, Kyle Livingston Davies and Su Zhu; and we outlined the type of investments
made by 3AC. In Part II
we narrowed down the window of analysis within which we were attempting to analyse 3AC operations, we discussed private equity investments in crypto start-ups made by 3AC, and we provided a brief background about leveraged trading.

In addition, we set out details of the three main events that affected 3AC operations, namely the collapse of TerraUSD and LUNA; the Cryptocurrency Crash (First Wave,
May 2022; Second Wave, June 2022); and 3AC’s failure to meet its margin calls on its crypto investments and its loan payments on its DeFi loans. In
Part III of this
Case Study, we set out the regulatory framework that exists in Singapore, we provided details of 3AC Singapore’s RFMC registration application, and we set out a range of failures in the MAS regulatory framework in Singapore.

We also identified the wide range of regulatory compliance obligations that 3AC Singapore was supposed to put into effect, as well as a range of supervisory and regulatory failures identified on the part of the MAS. In
Part IV we provided an overview of investment fund regulatory frameworks; we set out an overview
of crypto asset risks and crypto fund risk management practices; and we outlined the evolution of the crypto ecosystem and regulation in Singapore.

We then detailed why it was contended that the MAS had failed in its duty of supervision vis-à-vis the adequate, prudent, and timely supervision of 3AC Singapore, and how this failure may have ultimately contributed to its collapse in
June 2022. Finally, in Parts V and
VI we sought to put together the issues raised regarding 3AC and the ultimate failure of its Singapore-based investment fund 3AC Singapore. Unfortunately, I did not have access to 3AC’s internal files, regulatory authority reports, or other non-public
information.

Therefore, the analysis set out in this Crypto Analysis Case Study has been based purely on publicly available information, and assumptions and deductions based on such information. If I had access to such information, I would have been able to definitively
put together the decisions and events leading to the firm’s collapse. In addition, as the
Case Study turned out to be longer than anticipated, I have been unable to cover any analysis of the liquidator’s case against 3AC in the British Virgin Islands and in the United States (US) under US law.

Nevertheless, I do hope that readers have been provided with a legal, practical, and operational case study to illustrate the range of crypto investment and management issues and risks that surrounded the collapse of 3AC Singapore.