Crypto: A Bernie Madoff-style scheme may have crushed prominent lenders

An unprecedented crisis of confidence has been affecting the crypto industry for several months.

To measure it, just consider the prices of cryptocurrencies, which are often attached to a platform or a project. Cryptocurrency market has lost $2 trillion in value since hitting an all-time high of $3 trillion in early November, data firm says CoinGecko. Prices for bitcoin, the king of cryptocurrencies, have fallen by more than two-thirds since hitting an all-time high of $69,044.77 on November 10.

The severity of the crisis intensified in early spring with a seemingly contained event. In early May, sister coins Luna and UST or TerraUSD crashed. The fall of the two digital currencies was caused by the fact that many investors wanted to liquidate their positions at the same time. At least $55 billion was wiped out in this disaster.

Luna’s Collapse

What may have appeared as an isolated event finally revealed itself as an octopus with many ramifications. A month later, crypto lender Celsius Network, which operates like a bank, announced that it was suspending withdrawals, preventing its customers from accessing their money. A few days later, Three Arrows Capital, or 3AC, a Singapore-based hedge fund, said it was surprised by the rout of Luna, a digital currency in which the company had over $200 million exposure.

Voyager Digital, another crypto lender, announced that 3AC had defaulted on a loan of at least $630 million that it provided to it. Babel Finance, CoinLoan, CoinFlex and other crypto lenders have also suspended withdrawals. BlockFi, one of the big names in the industry, was forced to call for help from the young crypto-billionaire Sam Bankman-Fried, founder of the FTX.com platform. The liquidity crisis has spread to other small lenders like Vauld. Crypto exchange Blockchain.com has warned its shareholders that it could lose $270 million related to 3AC.

The dominoes began to fall: 3AC went into receivership, Voyager Digital and Celsius Network filed for Chapter 11 bankruptcy. BlockFi has been bailed out and the future of the others remains uncertain. As for their customers, they do not know if they will ever be able to recover even a small part of their money.

The link between all these companies and platforms is 3AC, the hedge fund. It appears from company statements and official documents that a large number of crypto lenders lent him money. But they seem to be unaware that they were all often creditors of the hedge fund.

3AC is an “old fashioned Madoff-style Ponzi scheme”

Three Arrows Capital was operating as a Bernie Madoff Ponzi scheme in disguise, research firm FSInsight, an independent research firm, said in a recent report. The company was an “old-school Madoff-style Ponzi scheme” that took positions similar to those that sank Long Term Capital Management (LTCM), FSInsight said.

Long Term Capital was a famous hedge fund, run by famous Wall Street traders and Nobel Prize-winning economists. The company went bankrupt in 1998, forcing the government to intervene to prevent the markets from collapsing.

In the case of Three Arrows, founders Kyle Davies, 35, and Su Zhu, 35, acted like Bernie Madoff, says the research note exploring the hedge fund’s implosion. Davies and Zhu had “used their reputations to borrow recklessly from nearly every institutional lender in the industry,” FSInsight wrote.

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Zhu and Davies were likely using borrowed funds to pay off interest on loans issued by lenders, while ‘preparing their books’ to show massive returns on capital,” the note adds.

This finding suggests questions about whether 3AC’s financial disclosures were true. At its peak, the hedge fund said it had more than $18 billion under management. But given the degree of exposure crypto lenders have to the hedge fund, it’s likely that most of its assets were bought with debt and its collateral rate is quite low, according to Sean Farrell, head of digital assets at FSInsight. .

A Ponzi scheme is a fraudulent financial arrangement that involves paying out large returns to existing investors using the capital invested by new investors. This fraud feeds on the credulity of the defrauded. It is often only revealed when the funds brought in by incoming investors are no longer sufficient to cover payments to previous investors. This fraudulent scheme was used by former Nasdaq Chairman Bernard Madoff for the biggest Ponzi scheme in history.

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“People can call us stupid”

“The Terra-Luna situation caught us off guard,” Davies tried to explain in June.

Since then, the two former Credit Suisse traders, who became friends in high school, have been hiding. They recently gave a telephone interview, published on July 22, to Bloomberg News.

“People can call us stupid. They can call us stupid or delusional. And, I will accept that. Maybe,” Zhu told the outlet. “But they’ll, you know, say I’ve leaked funds in the last period, where I’ve actually handed over more of my personal money. That’s not true.”

“The whole situation is unfortunate,” Davies told the outlet. “A lot of people lost a lot of money.”

“What we didn’t realize was that Luna was capable of going to zero effective within days and that this would catalyze an industry credit crunch that would put significant pressure on all of our illiquid positions,” he said. Zhu added.

Looking back, the two former Credit Suisse traders say their debacle resembles that of LTCM.

“It felt a lot like an LTCM moment for us, like a long-term capital moment,” Zhu said. “We had different types of professions that we all thought were good, and other people had these professions as well,” Zhu said. “And then they were all super marked, super fast.

The firms in charge of the liquidation of the hedge fund complained of the refusal of cooperation of the two co-founders, which the latter reject.

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