Blockchain Confidential - 22 July 2022

When the music stops

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance.”

— Chuck Prince, 2007

“If my funeral's tomorrow, wonder would they even call when the music stops.“

— Eminem, 2002

The founders of 3AC are en route to Dubai, expressing worries about death threats against them, and today’s interview with Bloomberg provided an inside look at how market risk, liquidity risk, solvency risk and credit risk can intersect to destroy a trading firm. With apologies to Tolstoy, unlike unhappy families, unhappy hedge funds are all alike. But so too are unhappy sell-side firms: as Su Zhu talked about the dynamic between his firm and the lenders, Chuck Prince’s telling words about why Citibank felt they had to stay in the sub-prime trade kept coming back to me: “the risk departments were very relaxed about … the kind of risks that we were taking: those firms benefited immensely when we were doing well, because as we were doing well, they could say, look, I make $200 million a year from Three Arrows’ financing business“ … and so they upped the leverage in pursuit of even higher profits.

Risk management should behave like an elastic band. As you venture further and further from a neutral position, the strength of the pull back to neutral should get higher. But that’s not what we saw with 3AC: success bred not just complacency, but an eagerness to increase risk levels; that elastic band got looser the harder they pulled. To be fair, central bankers during the Great Moderation faced much the same conundrum: during the good times yields collapse and so the spread between the risk free rate and the premium you pay to invest in, say, a leverage-folded staked ETH position also falls. A mild environment, while seemingly desirable, encourages investors to venture forth into higher-yield investments that under stormier conditions would be signaling that their much higher yield comes with disproportionate risk. As the music plays, a lull descends, until it stops.

The interview gave some intriguing hints as to the particular risks they faced.

As one crypto trader put it in a recent conversation we had, “in the end, it’s all liquidity risk.” And so it proved with 3AC. The initial pain came when LUNA’s rapid collapse squeezed not just their Terra positions, but all those other, even less-liquid positions that they could now not unwind: “What we failed to realize was that Luna was capable of falling to effective zero in a matter of days and that this would catalyze a credit squeeze across the industry that would put significant pressure on all of our illiquid positions.” We saw a similar pattern in the Great Financial Crisis: at the worst time, when you most need to trade, you cannot trade.

But the magic of leverage made matters that much worse, as it always does. The interview hints that in some cases the issue was solvency: they may have been able to cover a position, but due to lack of access to credit, trades that could have saved them were inaccessible, and again, this never happens when the sun is shining: “if we were more on our game, we would’ve seen that the credit market itself can be a cycle and that, you know, we may not be able to access additional credit at the time that we need it. If, if it kind of, you know, it hits the fan.”

And there’s more than one way to be insolvent. The interview talks about their Grayscale Bitcoin Trust (GBTC) position, a popular arbitrage position where 3AC was the largest holder. The problem: the premium inverted, and the six month lock-up made it impossible to get out quickly. And before you look down your nose at TradFi products and say this could never happen in DeFi, consider your favorite Layer-2 protocol: many of them impose lock-ups that could lead to similar paralysis. In the rush for the exits, sometimes the door is not just narrow, but barred.

Of course, over-collateralization will save us, right? This does not appear to have been the case for 3AC. Bloomberg reviewed the court filings, and “many of these loans had required only a very small amount of collateral” — so in the final Bitcoin price collapse, this led to liquidations: “So I just think that, you know, throughout that period, we continued to do business as usual. But then yeah, after that day, when, you know, Bitcoin went from $30,000 to $20,000, you know, that, that was extremely painful for us. And that was in, that ended up being kind of the nail in the coffin.”

The founders also highlighted crowded trades, another common pattern. In the chase for yield, traders gravitate toward similar positions, which then leads to a synchronized unwind: “We had different types of trades that we all thought were good, and other people also had these trades,” Zhu said. “And then they kind of all got super marked down, super fast.” Of course, as we saw in the sub-prime crisis, if you add leverage into the mix, the pain is amplified by de-leveraging. It is a steep descent to get to a level where you once again have a clearing price established. In some cases where the courts get involved, this process can be extended as lenders liquidate positions, recognize losses, rebuild balance sheets and gradually clean up.

But 3AC hedged, right? “We positioned ourselves for a kind of market that didn’t end up happening.” OK, um, maybe not very well hedged. Thankfully, investing is filled with kind and understanding people who will in your time of need support you, right? Or not. Maybe instead those people will wonder who is next to fall, and short the hell out of it. “Because Luna just happened, it, it was very much a contagion where people were like, OK, are there people who are also leveraged long staked Ether versus Ether who will get liquidated as the market goes down?” Zhu said. “So the whole industry kind of effectively hunted these positions, thinking that, you know, that because it could be hunted essentially.” Again, we saw much the same in the Great Financial Crisis. Post-Lehman, banks could not afford any mis-steps. One wobble, and the short-sellers would hunt them to extinction.

We need better models and better tools to understand not just the point risks with protocols and tokens, but the problems that exist in between them: the couplings and contagion, whether via CeFi or DeFi exchanges, or bilaterally through OTC trading and lending desks. There are great strengths in the transparency in the blockchain, both in terms of current holdings and transaction patterns; take a look at the Dispatch community views for an idea of what is possible. But a lot still happens in the shadows and that amplifies fear when it all goes terribly wrong. My great hope for Serenity, our digital asset risk system, is that we can build something to shine a light and discern worrying patterns so even when it all seems mild, even as the music plays, the dancers can know that maybe it is time to pull out a chair, and sit this next one out.