The cryptocurrency industry has "collapsed" in recent weeks because of a Madoff-style Ponzi scheme. Sean Farrell, head of digital asset strategy at FSInsight, wrote in friday's report, looking at the implications of the collapse of cryptocurrency hedge fund Three Arrows Capital, also known as 3AC.
Bernie Madoff is an American financier who ran the largest Ponzi scheme in U.S. history.
Madoff in this scenario is the founders of 3AC, Su Zhu and Kyle Davies, who have used their reputations to "borrow recklessly from every lender," leading to the predicament of several well-known companies in the industry, including Voyager Digital, Babel Finance and BlockFi
At its peak, 3AC had total assets under management (AUM) of more than $18 billion. But due to the amount of debt owed to the company, it is unclear how much actual equity is at risk. It is likely that Zhu and Davies simply "used borrowed money to pay interest on loans issued by lenders, while cooking to show large capital returns," the note added.
Given the scale at which companies like Voyager Digital and BlockFi are affected, it seems that the majority of 3AC's assets are purchased with debt and its mortgage rate is quite small, according to Farrell.
"Macro conditions lead to the destruction of global asset prices, which reduces the collateral value of any crypto assets, and 3AC has invested heavily in LUNA/UST, which cannot help the situation, however, we think the downward spiral began with the excessive collection of 3AC bets on grayscale Bitcoin Trust (GBTC)"
Grayscale has applied to the U.S. Securities and Exchange Commission for approval to convert the trust to ETF. GBTC's share price has been trading at a discount to its net asset value.
GBTC trading is highly leveraged, and when trading a dark futures outlook, 3AC is likely to remain locked in at GBTC, FSInsight said. However, instead of exiting and cutting losses, 3AC has averaged the price, added capital, with the expectation of "going to shore".
FSInsight said the GBTC transaction will eventually bring returns to patient investors, but the timing is unclear, as spot ETFs can be approved in a matter of weeks, but can also take years.
When asset prices collapse and margin calls are triggered, 3AC can no longer hold its "aggregate leverage chain together," which causes liquidity issues across the entire cryptocurrency lending market, the report said. The report adds that the excessive nature of trading this spread is similar to the types of trades that used to be a "death knell" for long-term Capital Management.
Recent data suggests speculation among bitcoin holders, but there is still a risk that growing miner positions could be the source of further selling pressure.
While the short-term picture of digital asset prices remains "difficult," the market has reached an undervalued area for bitcoin (BTC) that long-term investors should take advantage of, FSInsight added.
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