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What a heavy fall it was. Three Arrows Capital (3AC), the cryptocurrency hedge fund, filed for liquidation in New York at the end of June – a multi-billion-dollar default in a “crypto winter” that also took out Celsius, a major lender. As investors, these events make us reconsider systemic risk. The underlying issue in 3AC’s downfall, however, was overleverage. Remember the fall of Long-Term Capital Management (LCTM) in the 1990s? Both stories of overleverage provide us with some lessons that are relevant for those investing today.

LTCM was the star of the hedge-fund industry back at that time and had two Nobel Prize winners on staff. Yet the firm chased absolute return, using a leverage ratio of 25 to 1. When events (the combination of a financial crisis in Asia and a Russian default) shocked markets at the time, LTCM’s leveraged positions on the swap spreads and other convergency trades became extremely illiquid — and very expensive to unwind.

The firm had around $4 billion in AUM, so its positions threatened the stability of the entire U.S. financial system. (Remember that $4 billion then was worth significantly more than $4 billion now; to put it in perspective, it was Apple’s market cap at the time.) The Federal Reserve, eager to calm the financial markets, shepherded a consortium of Wall Street firms to bail out LTCM in an orderly recapitalization.

So, we’ve seen this movie. If we fast forward to today, 3AC is one of the more established hedge funds in the crypto space. Yet as the co-founders of 3AC admitted recently, they had over-exposed themselves too much to the TerraUSD stablecoin, stETH, and Grayscale BTC with leverage. 

What’s the difference between enough leverage and too much? It is critical to minimize risk and volatility while maximizing the Sharpe ratio, and know how to handle both boom-and-bust cycles (such as you can see in the chart of Ethereum values of the past few years.)

My personal view is that the cryptocurrency industry didn't price the wrong-way credit risks appropriately during the euphoria period of the recent bull market. When the market eventually turned bearish, as markets do – see this rainbow chart for historical Bitcoin prices – investors were surprised to find out the underlying prices, the counterparty credits, and the collateral values were all strongly inter-correlated. Now that this bear market cycle has exposed the deficit of self-policing abilities within the crypto industry, more regulation seems a certainty.

Coming out of this, we expect additional protection for retail customers, disclosure requirements for hedge funds similar to the requirements under the Dodd-Frank Act, and the classification of the vast majority of cryptocurrencies as securities, with only a handful of major coins to be classified as commodities. Increased regulation may be tough for this industry, which is still in its infancy, but the stronger firms – and the more well-thought-out projects – will survive.

In the meantime, this period of leverage cleansing gives investors an opportunity to come into the market. No one can predict exactly where the bottom is, but all technical indicators show that the market is extremely oversold. This presents an exciting opportunity for those who think long-term. As the recent partnership between BlackRock and CoinBase shows, more institutional investors are eager to have or add exposures in this asset class. If you believe, as we do, that the digitization process will accelerate in the near future, it’s a good time to invest. The imperative is simply to put risk management as the top priority in this relatively new, extremely volatile, but very promising market.