How did the fall of Three Arrows or 3AC drag crypto investors down?

By March, Three Arrows Capital had managed nearly $10 billion in assets, making it one of the world’s leading crypto hedge funds.

The firm, now known as 3AC, is going to bankruptcy court after the combination of the collapse in cryptocurrency prices and a particularly risky trading strategy to destroy its assets and fail to repay lenders.

The chain of pain may be just beginning. 3AC had a long list of counterparties or companies that had their money wrapped around the firm’s ability to at least survive. Since April, the crypto market has fallen by more than $1 trillion, spearheaded by the decline in bitcoin and ethereum, while investors placing concentrated bets on firms like 3AC are hurting by the results.

Crypto exchange Blockchain.com is reportedly facing a $270 million hit in loans to 3AC. Meanwhile, digital asset broker Voyager Digital has filed for Chapter 11 bankruptcy protection after 3AC failed to repay the approximately $670 million it borrowed from the company. US-based crypto lenders Genesis and BlockFi, crypto derivatives platform BitMEX and crypto exchange FTX also suffered losses.

“Credit is being destroyed and withdrawn, insurance standards are tightened, solvency is being tested, so everyone is pulling liquidity from crypto lenders,” said Nic Carter, partner at Castle Island Ventures, which focuses on blockchain investments.

Three Arrows’ strategy included borrowing money from across the industry and then returning and investing that capital in other, often emerging crypto projects. The firm had been in existence for over a decade, which helped give founders Zhu Su and Kyle Davies a measure of credibility in an industry where startups live. Zhu also hosted a popular podcast about crypto.

“3AC was supposed to be the adult in the room,” said Nik Bhatia, professor of finance and business economics at the University of Southern California.

Court documents reviewed by CNBC show that lawyers representing 3AC’s creditors claimed that Zhu and Davies had not yet begun to cooperate with them in any “meaningful” way. The filing also claims that the liquidation process has not begun, meaning the company has no cash to repay its lenders.

Zhu and Davies did not immediately respond to requests for comment.

Tracing falling dominoes

The decline of Three Arrows Capital can be traced back to the May collapse of terraUSD (UST), one of the most popular US dollar pegged stablecoin projects.

The stability of UST has been based on a complex set of codes with little cash to support regulation, despite the promise that it will retain its value regardless of the volatility in the broader crypto market. Investors – on a lending platform called Anchor – are incentivized with a 20% annual return on UST assets, a rate that many analysts say is unsustainable.

“Risk asset correction combined with less liquidity has spawned projects that promise unsustainably high APRs and cause their collapse, such as the UST,” said Alkesh Shah, global crypto and digital asset strategist at Bank of America.

The panic selling associated with the fall of UST and its sister luna, cost investors $60 billion.

“terraUSD and luna crash ground zero,” said Bhatia of USC, who published a book on digital currencies last year entitled “Tiered Money.” He described the meltdown as the first domino to fall into “a long, nightmarish chain of leverage and fraud.”

3AC told the Wall Street Journal that it has invested $200 million in luna. Other industry reports said the fund’s exposure was about $560 million. Whatever the loss, this investment became almost worthless when the stablecoin project failed.

The eruption of the UST has shaken confidence in the industry and accelerated the decline in cryptocurrencies already underway as part of a wider pullback from risk.

3AC’s lenders asked for some of their cash back in a flood of margin calls, but the money wasn’t there. Many of the firm’s counterparties failed to meet demands from its investors, including retail owners who were promised 20% annual returns.

“Not only did they risk nothing, but they also evaporated billions in creditors’ funds,” Bhatia said.

Blockchain.com’s CEO, Peter Smith, said in a letter to shareholders viewed by CoinDesk last week that his company’s stock market “remains liquid, solvent and our customers will not be impacted.” But investors have heard this kind of sentiment before – Voyager said the same thing days before filing for bankruptcy.

Bhatia said the cascade hit any player in the market that was significantly exposed to a worsening asset and liquidity crunch. And crypto comes with so little consumer protection that retail investors have no idea what they’ll get in the end.

Voyager Digital customers recently received an email stating that it will take some time before they can access the crypto held in their accounts. CEO Stephen Ehrlich said on Twitter He said that once the company has gone through bankruptcy proceedings, customers with crypto in their accounts will potentially receive some sort of bag of possessions.

This could include a combination of the crypto they hold, common shares in the reissued Voyager, Voyager tokens, and any income they may receive from 3AC. Voyager investors told CNBC they don’t see much reason for optimism.

WATCH: Voyager Digital files for bankruptcy amid crypto lender solvency crisis

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