MODERN FINANCE
Swimming Naked Can Be a Bad Idea
A
By Philip Dudley
nother crypto corpse has risen to the surface in what continues to be a reckoning in the world of cryptocurrencies following the Terra UST/Luna collapse. The varsity crypto squad on the field at this moment is searching for answers but need not look any further than leverage, greed and ego. Three Arrows Capital (3AC) checks all three boxes. Philip Dudley 3AC repeated history when leveraged bets turned sour and the firm founders Su Zhu and Kyle Davies pressed their luck and lenders came calling. That ultimately resulted in a wipeout of approximately $20 billion as the 3AC leveraged house of cards collapsed. Yes, you read that correctly $20 BILLION to zero. So, what happened? It appears what we have here is a classic Madoff-style Ponzi scheme wrapped in massive leveraged trades. The fund was able to borrow money from nearly every institutional lender in the space, some of which, have become insolvent themselves as the collapse caused an unforgiving downward spiral. It’s believed that new borrowed money was used to pay interest on existing loans. All the while, the books were “being cooked” to show impressive asset growth in order to borrow even more. In reality, its collateral coverage ratio (the percentage of a loan that’s backed by a discounted asset) was quite small. As Warren Buffet, the “Sage of Omaha” once said to his shareholders, you don’t know who is swimming naked until the tide goes out. The tide went out and 3AC was swimming naked. While the collapse of Terra UST/Luna certainly contributed to 3AC’s weakening collateral, many believe the fund’s leveraged position in the Grayscale Bitcoin Trust (Ticker: GBTC) is to blame for the initial downward spiral. One needs to understand the GBTC to understand how it might have been at the root of the problem. It’s a closed-end trust that holds Bitcoin but often trades at a premium or discount to Net Asset Value (NAV) due to other liquid investment vehicles available on the market. The hot trade in 2020 was to borrow GBTC, lock it up in the trust, wait until the lock-up expired and then sell at a premium to spot Bitcoin. Sounds like an easy way to make money, and 3AC made plenty as the largest holder of GBTC. But what happens when the trust trades at a discount to NAV? As the bull market in Bitcoin progressed, there were fewer buyers of GBTC in the secondary market. That, in turn, put downward pressure on the premium to the point that eventually a discount to NAV prevailed and is still present. 3AC seemingly made a costly error by doubling down on GBTC with more leverage and the belief that the discount to NAV would disappear when the GBTC was approved by the SEC as a spot Exchange Traded Fund. Neither have occurred, so now we have another case study of a leveraged arbitrage trade gone bad. 3AC’s thesis regarding GBTC is not wrong in my humble opinion because I also believe the SEC will approve a spot Bitcoin ETF and the discount to NAV will close. You must have the time and the capital for the GBTC thesis to play out. 3AC had neither. Where the fund erred was its web of over-leveraged bets and the market proved once again to not care one iota about which lamb was sacrificed. Remember, always use leverage wisely or you, too, might be caught swimming naked. Philip Dudley is the founder and Managing Partner of Dudley Capital Management, LLC based in Middleburg.
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Country ZEST & Style | Autumn 2022
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