(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)This current crypto nuclear bear market marks my third brush with generalised market carnage. And while they can sometimes feel like reruns, every episode yields new lessons to be learned. Everyone is always going to have their own view of what those lessons are – but if it’s the mainstream financial media you’re listening to, I can tell you with confidence that you’re being fed the wrong takeaways. They, in the service of the devil that is TradFi, will use any and every opportunity to poke fun at our economic / social experiment – gleefully proclaiming, “we warned you crypto was worthless!” In the holy name of our Lord Satoshi, I shall attempt to correct the invective that seeps forth from these malicious harpies.

In this piece, I’ll be using the Three Arrows Capital (3AC) saga as a lens through which we can better understand the true insights that should be gleaned from the current bear market. Please note, while I personally know Su Zhu and Kyle Davies (the principals of 3AC), I have no knowledge of what transpired other than what has been reported publicly. I intend to use my knowledge of crypto, financial services, and common sense to tease out the story of what I think led to its collapse, starting with the implosion of TerraUSD and Luna.

The collapse of 3AC in and of itself is unremarkable. A hedge fund that was previously successful executing boring but stable yielding arbitrage strategies decided to strap on leverage to accelerate returns, and paid the price. The use of borrowed funds to play the TerraUSD carry trade sealed their death sentence.

But what made the 3AC default so impactful is that it blew a whale shark-sized hole in many of the largest centralised crypto lending businesses. Due to losses on 3AC loans, many of these lending businesses have gated customer funds and become functionally insolvent. The withdrawal of credit from the crypto ecosystem has caused a generalised market crash of Bitcoin, Ether, and the whole pantheon of shitcoins. No coin has been spared.

But what’s conveniently going unmentioned by much of the media is that both centralised and decentralised lending companies / platforms had exposure to 3AC – and only the players in one of these two markets went belly up. The centralised lenders failed en masse, while their decentralised counterparts liquidated collateral and operated with no hiccups. Using the story of 3AC as the canvas, let me paint you a picture that illustrates why Lord Satoshi and Archangel Vitalik’s creations stood the test of time, and what this means for the future of crypto.

Hong Kong

Before we get too deep into it, though, let’s first take a quick stroll down memory lane to better understand how 3AC’s principals, Su Zhu and Kyle Davies, ascended to greatness.

Su and Kyle graduated university in 2008, the same year as myself, and at some subsequent point made their way to Asia Pacific as employees of TradFi banks / market makers.

The Hong Kong, Singapore, and Tokyo investment banking scene is very close-knit. While I didn’t know either Su or Kyle directly until many years later (when we all entered crypto), we ran in adjacent circles of friends and were at most one degree separated at that time. The first time I met Kyle at a tempura restaurant in Singapore, I could have sworn I had seen him before at a party in Hong Kong.

I never did any business with Kyle, who worked for a time at Credit Suisse, but I did trade against Su while he was a market maker at FlowTraders. As the head market maker for the APAC Exchange Traded Fund (ETF) business at Deutsche Bank, I posted buy / sell quotes on the Hong Kong and Singapore stock exchanges for a large ETF product suite. I routinely made errors, and got served many ass whoopings at the hands of FlowTraders. No excuses – I just regularly lost money to them. Su was one of the FlowTraders professionals who kept me on my toes on a daily basis. Su followed up his time at FlowTraders with a stint at Deutsche Bank, and worked on an adjacent trading desk to Killah, who I talked about in a previous essay.

The point of this story is that Su and Kyle are arbitrage guys. In their banking careers, they were trained to profit off of small discrepancies in price. Do it over and over again, and the money adds up. They brought this same approach and mentality to their founding of Three Arrows, which got its start by arbitrating the very inefficient over-the-counter Non-Deliverable Forward (NDF) market.

Now, moving on to my time at Citibank…

While I was the head ETF trader at Citibank, I also dabbled in equity index forward trading, including NDFs. Our desk traded equity index forwards on the major Hong Kong, Taiwanese, Indian, and Korean indices. I also ran the entire China A-Share ETF trading book and traded a large amount of equity-linked derivatives.

An NDF is a currency bet, but instead of exchanging home and foreign currency cash flows at the start and end of the swap, the difference between the entry and exit exchange rate is paid or received in USD.

Let’s take the USDKRW (Korean Won) exchange rate. Korea does not allow Korean Won to be freely exchanged. Assume I would like to sell KRW vs. buy USD 30 days in the future and I want to lock in the rate today. I would trade on the Right-Hand Side (RHS) of a USDKRW NDF. If I enter the 30-day NDF at a rate of 1,000 Won and the spot rate settles at 1,200 Won, I make [200 Won * the USD Notional / USDKRW Spot Exchange Rate]. If I traded a size of 1,000,000 USD that would equate to a profit of approximately 166,666 USD.

Understanding why NDFs are a necessary part of equity index forward trading isn’t essential to this story, so I’ll spare you the gory details*.*

The OTC NDF market is very large and all the major investment banks have trading desks specialising in these derivatives. Back in the 2010’s, trading happened over Bloomberg chat. That meant that while traders had a general idea how a particular NDF should be priced, they couldn’t see a consolidated market like they could for spot currency. As a result, it was very easy to arbitrage the different NDF trading desks.

Every day I would pick a currency and attempt to “arb” two trading desks. Let’s say I wanted a 20,000,000 USD notional 30-day KRW NDF. Bank A would quote me 1,000 / 1,001; Bank B would quote me 1,002 / 1,003. Do you see the trade?

I buy at 1,001 vs. Bank A, and then I sell at 1,002 vs. Bank B. In 30 days I will net 1 won per dollar in profit. On 20 million USD notional, that’s a total profit of 20,000 USD assuming the spot rate is 1,000 Won. That’s not much for a bank trading desk, but if you do this enough times, it adds up to a few million dollars a year of risk-free PNL each year.