Battered Crypto Hedge Fund Three Arrows Capital Considers Asset Sales, Bailout

The crypto community continues to speed run the history of traditional finance.

This weeks lesson is that in an up market its leverage that makes you money and in a down market its the unwinding of leverage that kills you.

They are also learning that interconnectedness will hurt more in a downturn. You can be perfectly delta hedged( don't care which way the market moves) and its the counter party risk that will sink you.

Now as these firms start to unwind they spill over to the next one. The collateral taht you lent to the failed firm is now gone and your once well hedge d and collateralized position is now in shambles because someone else can't pay you.

TradFi normally solves this by having a firm have oversite on everyones positions and have everyone pay money into a pot to help bail out failed counterparties so they don't spill over to other firms.

Crypto has tried to solve this by strict liquidation rules that tend to make things worse by turning firms into forced sellers when they may have been able to ride things out, thereby forcing markets down even more. To the point where its a profitable trading strategy to intentionally force the market down to liquidate leveraged longs.

As more crypto firms fail, they'll end up selling their best collateral first(BTC and ETH) forcing down the price even more.

$5,000 BTC and $200 ETH are in site if Tether starts to fail. Tehter has lent money to almost all these firms but doesn't mark down its positions from what it originally held them at.

If tether holds we may get out of this with $10-15,000 BTC but if Binance/FTX walk away from Tether then we'll be down another 80% from here I bet.

TL/DR its going to get alot uglier than it currently is due to the interconnected nature of the crypto markets. We'll find out that pretty much everyone was linked to everyone else as there are only so many ways to make money in crypto and everyone piled into them.

Defi is about to find out how hard it is to make money when no one wants to stake.

In case the relevance isn't clear, this is a headline that was inserted into the Bitcoin origin block, presumably to prove that it hadn't been mined before that date. However, the specific headline chosen is often interpreted as an implicit jab at conventional finance by Satoshi Nakamoto.

Ironic, isn't it?

When you get margin called in traditional/centralized finance, humans intervene and liquidation is not immediate (except Interactive Brokers, who are closer to how crypto manages margin, and will liquidate you without a margin call). Maybe you put up more collateral, maybe you borrow from a line of credit, there is a buffer. As an individual, you work with your broker. As a larger participant, you work with the clearinghouse (of meme stock fame).

In crypto, there is no buffer. Auto liquidation of undercollateralized positions occurs. All of those humans in the loop, “unfair rules”, and settlement delays crypto proponents complain about are the very things that make traditional finance stable. This is why traditional finance doesn’t take seriously the idea of immediate settlement, and why end of day settlement is as good as it’ll get.

As the other comment says, liquidation in tradfi has manual intervention - the loans will say things like "IF the collateral mark-to-market value drops below $X, the lender MAY call the loan and force sale of the collateral" - the key being the IF.

In a case where there's contagion [549] the banks or even the government can work to negotiate what's happening, and slow down the collapse (or even prevent it) - an example being the subprime mortgage backed securities which got to the point that nobody knew how to value them, so the government bought them all (and eventually actually "made" money by riding it out).

DEFI has algorithms that lock up the capital and will automatically liquidate it if certain parameters are met - which others can use to "attack" it - if the oracle sees bitcoin fall below $20k in a flash crash, it triggers the selling of ten thousand coins, say, which floods the price down further, you snap them up, the crash is over, you slowly sell at $25k or whatever. Bitcoin itself is pretty resistant to this, but the other coins, not so much, especially the side coins.

As a side note, most US home loans do NOT have a "call" clause and the bank can only initiate liquidation after you've missed payments and gone delinquent for a certain number of days; this was instituted in the US after calling mortgages contributed to the Great Depression. Some business loans can be called after a period of time for any reason (usually, interest rates have gone up).

[549]: https://en.wikipedia.org/wiki/Financial_contagion