The State of Crypto Investing Right Now: A Flashback TO The 90's And How to Minimize Risk

By CK Zheng, Co-founder and CIO, ZX Squared Capital

Cryptocurrency hedge fund Three Arrows Capital (3AC) filed for liquidation in New York last month – the latest and biggest casualty in a crypto winter that’s claimed a majority of Terra USD UST/USD’s value and forced Celsius Network to pause withdrawals. As investors, these events make us reconsider systemic risk. The key underlying issue in 3AC’s downfall however is overleverage, which brings back memories of the fall of Long-Term Capital Management (LCTM) in the 1990s – as well as some lessons that are relevant for this moment.

If you recall, LTCM was the brightest star of the hedge-fund industry at that time, with two Nobel Prize winners on staff. Yet the firm stretched, chasing absolute return with a leverage ratio of 25 to 1. When markets at the time became stressed (due to the combination of a financial crisis in Asia and a Russian default), LTCM’s leveraged positions on the swap spreads and other convergency trades became very illiquid and very expensive to unwind.

With about $4 billion in AUM, its positions threatened the stability of the entire U.S. financial system. (From the perspective of 2022, $4 billion might not seem like such a large number, but for comparison, it was Apple’s market cap at the time.). The Federal Reserve, in order to restore calm to the financial markets, coordinated a consortium of a dozen Wall Street firms to bail out the firm in an orderly recapitalization.

Sound familiar? If we fast forward to today, 3AC is one of the most established hedge funds in the crypto space. Its leveraged positions on stETH and GBTC convergency trades are very expensive to unwind – especially after the UST/Luna implosion. As the 3AC breakdown plays out in front of our eyes, the fund’s leverage clearly has a contagion risk for our crypto industry, raising some questions… Such as, how will market players respond?

More regulation seems a certainty, as this bear-market cycle has exposed the lack of sufficient self-policing abilities within the crypto industry. As risk-management veterans who are currently running a cryptocurrency hedge fund with a commitment to minimizing risk and volatility while maximizing the Sharpe ratio, we expect:

• The classification of some digital assets as commodities vs. securities. We expect only a handful of major coins to be classified as commodities, with the vast majority of cryptocurrencies classified as securities – so that relevant government agencies may regulate them accordingly. This will likely include more regulation of stablecoins.
• Additional protection for retail customers. The industry’s explosive growth from the original Bitcoin market has outpaced regulation, a lag we expect to be corrected in the future.
• Disclosure requirements for hedge funds. The disclosure will be similar to the requirements under the Dodd-Frank Act

Increased regulation will put additional burdens on this young industry, but the stronger firms, and the more well-thought-out projects, will survive and undoubtedly become even stronger after this cycle. In the long term, it will benefit the industry as a whole if the regulations are fair and not so onerous as to kill innovations in this space. With tightening regulations, a handful of cryptocurrencies will emerge as predominant. On the other hand, small coins will not survive if they don’t serve the purpose of solving a real problem.

This shakeout, of course, presents an opportunity for investors. Crypto is volatile, and we have had four recent bear market cycles in its short history. Just like stock market bear market cycles, crypto cycles wash out – and will wash out – the leverages built during the bull market euphoria. This makes the market much healthier.

The bottom will be hit when the leverage cleansing is completed. Of course, nobody can predict exactly where the bottom is, but all the technical indicators show that the market is extremely oversold. For investors, this presents an exciting long-term investment opportunity. It is a good time to invest if you believe, as we do, that the digitization process will accelerate in the near future.