Crypto’s Hedge Fund Blow Up: A Tested Playbook of What Happens in Capital Markets

TLDR: We have the playbook to move forward. What’s happening in crypto around 3AC (et al) is the exact same thing that always happens when hedge funds blow up. Politicians and regulations will tell you when we’re at the bottom. It will be an extremely visible catalyst that crypto participants will be reluctant to embrace. That’s the real buying opportunity. It will happen sooner than we think.

Let’s focus on crypto yield/lending markets and what’s currently going on in DeFi and CeFi at present. This playbook as been, and will be, no different than any other traditional hedge fund or structured products blow up than we’ve seen for the past ~40 years. Here’s how it goes:

• 1/ Excessive greed drives over-speculation in shitty ideas and projects with no utility or chance of long term survival.
• 2/ “Sophisticated” institutional players are not immune from greedy behavior. They have leverage and enormous balance sheets. They move markets. In this case, they move markets higher but I will come back to this point later.
• 3/ Some catalyst comes along and proves to be a reality check. Maybe its macro or maybe it’s an idiosyncratic event related to a company or industry. In this case, it’s both macro and idiosyncratic.
• 4/ Bubble “bursts” quite violently in a short timeframe. Institutional players scramble to sell. Others press short positions. Both selling long positions and entering new short positions put extreme sell pressure on the market. Those with bigger long positions struggle to sell fast enough.
• 5/ Retail generally lags this process. A lot of retail initially buy the dip, only augmenting losses which will later be realized.
• 6/ Leverage (aka notional buying/selling power) comes out of the system as banks and prime brokers reduce risk. In other words, a hedge fund that was 10x levered on deployed capital is now 3x levered on a smaller base of deployed capital. Said differently, a fund with $100mm AUM deployed and 10x leverage is actually exposed to $1 billion in positions. Assuming that fund is still $100mm AUM deployed, 3x leverage would only be $300mm notional exposure to the market. The shear size of the market that burst decreases violently.
• 7/ Institutional players who are too far offsides fail. Retail investors capitulate with enormous realized losses.
• 8/ Volatility begins to subside. We begin to find a bottom. Pretty much all of the bad news is baked in. Shitty projects have failed. Retail has been annihilated, some “sophisticated” institutional hedge funds have filed for bankruptcy.
• 9/ Media talks about the negative consequences of doing what we just did. Mood on the industry is totally soured.
• 10/ LASTLY.. Politicians begin to peacock. Senate hearings pop up where generally poorly informed elected officials publicly chastise the survivors of the industry for misleading the retail investor and being irresponsible. Sometimes we get new legislation, sometimes fines, sometimes just the public shaming does the trick.
• 11/ Then we rebuild. The industry gets stronger and stronger. Initially the participants are the cream of the crop. They are the muscle on the bone. The fat and gluttonous behavior of the industry is gone. Its the best time for investment although it generally doesn’t feel too good when you’re in the middle of it. Even still, all of the bad news is baked in and we should all be aggressively deploying for the long term.

In crypto markets right now, I personally believe we’re somewhere between steps 8/ and 9/. We’ve generally seen everything above, culminating in the 3AC Hedge Fund collapse last month. The macro feels terrible and while it could still get worse, I think most of the negativity is baked into the broader markets as well as the crypto markets. This is not to say that things won’t get worse on the macro front, rather we are more or less expecting them to get worse and broader market multiples are reflective of that.

Because of the leverage coming out of the system (as described above), most prudent institutional counter parties are not taking a lot of risk right now. They’re not engaging in speculative lending. Most prudent borrowers aren’t asking for capital either, unless they absolutely need it. In turn, crypto lending demand is down meaningfully, hence yields have collapsed. In my view, this is all very healthy. Thats not to say it feels good. Crypto participants want yield, particularly in the context of macro rates rising as viciously as they’ve been. Prudent yields in crypto are now below the US Treasury risk free rate, which virtually deems them closed for the time being. That said, near zero yields in crypto for the time being will continue to allow weak actors to shake out for the time being.

We are seeing early signs that the politicians are waking up to the recent saga. Retail has clearly been burnt and public chastising and preliminary regulation of the crypto industry is actually very low hanging fruit during an election year. This industry is not particularly partisan, and I believe that step 10/ could be a fairly near term event. When legislation hits and congressional hearings are calendared, I think we’ll have our bottom.

For now, we’re still shaking out volatility. At the time of this writing, markets are squeezing and whats left of my schwab account is showing preliminary signs of a heartbeat. That’s not to say the bottom is in the crypto markets or broader markets, but I also wouldn’t be surprised if that’s the case. I’m encouraged by the negativity in the ecosystem. Memes are being replaced with talk of “real world applications for crypto.” The media hates us. Bad projects are dying (not enough, but still) and everyone is de-levered.

It’s cliche to say, but it really is a great time to build. Soon enough, we will be through the pain when DC inevitably drops its hammer. Til then, head down and don’t be near term greedy. When you see legislation, it’s time to start thinking about getting aggressive again.