How to Protect Your Crypto from Three Arrows' Meltdown Contagion

Innocent crypto investors are getting caught up in an ugly contagion that's already caused a couple of crypto firms to declare bankruptcy and others to freeze or sharply limit withdrawals.

Even if you haven't been directly affected, a contagion is a problem every investor needs to watch carefully. It's quite possible more companies will be forced into policy changes that will lock up customer assets or impose withdrawal limits that will make them harder to access.

Today I'm going to give you an overview of what's been happening and what you need to do to avoid having your crypto stuck on a site where you can't access it.

This all started with the collapse of the TerraLuna ecosystem. That incident alone hurt a lot of crypto investors. But the bigger problem, as it turned out, was a crypto hedge fund called Three Arrows Capital.

Three Arrows (popularly known as "3AC") had no retail customers, but it borrowed money from many crypto firms that did, such as Celsius and Voyager. That was money was largely made up of customer deposits.

Three Arrows made a lot of risky bets with it. Some of the money was invested in startups, but hundreds of millions went into crypto-based investment strategies, including $200 million in TerraLuna. When the TerraLuna cryptocurrencies crashed to zero, 3AC suffered such heavy losses it could not repay its creditors.

"The TerraLuna situation caught us very much off guard," Three Arrows co-founder Kyle Davies told The Wall Street Journal in what may be the understatement of the year.

Top lending firms, among them digital asset broker Genesis and crypto exchange BlockFi, reacted by liquidating $400 million of 3AC's loans.

3AC's resulting liquidity crisis left companies like Celsius and Voyager holding the bag. Suddenly they didn't have enough liquidity to serve their customers - so they froze withdrawals. Voyager went a step further and froze all trading.

Customers with assets with those companies are stuck in limbo. Not only are their assets trapped, they have no idea when they'll be able to access them or how much might be lost forever. Voyager has filed for Chapter 11 bankruptcy. Celsius is desperately looking for a way to survive, but the prognosis is grim.

And while Celsius and Voyager have grabbed most of the attention, they weren't the only crypto companies hit by the 3AC implosion...

Ripples Spread from Three Arrows' Fall

A court in the British Virgin Islands ordered Three Arrows into liquidation at the end of June, so its fate is sealed. (A few days later 3AC filed for Chapter 15 bankruptcy in New York.)

The impact is global. Here are some of the companies we know are affected, either directly or indirectly:

  • Crypto exchange has announced it could lose as much as $270 million as a result of its exposure to Three Arrows, although CEO Peter Smith said in a shareholder letter that "customers will not be impacted."
  • Genesis: Its role as major 3AC creditor means Genesis potentially faces hundreds of millions of dollars in losses.
  • Babel Finance: This Hong Kong-based crypto lender froze withdrawals June 17 due to "unusual liquidity pressures." Babel was recently reported to have hired restructuring specialist Houlihan Lokey to help determine its next steps.
  • CoinFLEX: A crypto futures exchange, CoinFLEX halted withdrawals June 24 because of "extreme market conditions." The company is trying to fix a $47 million hole in its balance sheet by issuing a new token that offers a 20% interest rate.
  • 8 Blocks Capital: Hong Kong-based 8 Blocks is a crypto trading firm. Last month it accused Three Arrows of improperly taking $1 million to answer their margin calls, then "ghosting" 8 Blocks when it repeatedly tried to contact 3AC for an explanation.
  • FinBlox: FinBlox is a crypto staking platform that had loaned an undisclosed sum to 3AC. The company temporarily imposed a $1,500 monthly limit on withdrawals June 16. Last week FinBlox raised the limit to $3,000 as it worked to undo the damage and return to normal operations.
  • Deribit: The derivatives exchange Deribit reported in court filings that Three Arrows had failed to repay a loan of $80 million.
  • Vauld: This Singapore-based crypto lending platform froze customer accounts July 4. But Vauld customers have more reason to hope than most - crypto lender Nexo has signed a term sheet to acquire the troubled firm.

All that is bad enough. But many crypto companies with no connection to 3AC are suffering from fears that they might be next to fail.

Major crypto companies like Binance, Nexo, KuCoin, and have all been forced to make statements to combat rumors that they had exposure to Three Arrows, were considering freezing withdrawals, or looking at imposing tighter withdrawal limits.

Customers are rightfully skittish, particularly after Celsius CEO Alex Mashinsky called a customer's problems withdrawing from the platform "FUD" (fear, uncertainty, and doubt) just 24 hours before freezing all withdrawals.

It's hard to say if the worst is over, or there are more ugly surprises ahead for crypto investors. That means you want to play it safe for now...

What to Do to Protect Your Crypto from Contagion

Billionaire Sam Bankman-Fried, the CEO of the FTX exchange, suggested to CNBC recently that the industry has moved past "other big shoes that have to drop."

But it's clear SBF recognizes how serious contagion can be. He told CNBC he's committed to propping up as many crypto companies as he can with FTX's $2 billion war chest. And even he admitted a few smaller crypto companies could still fail.

Until it's clear this thing is really over, you want to make sure your crypto is as safe a place as it can be. And that means a wallet only you control - a wallet to which you own the private key.

If the Three Arrows episode teaches us anything, it's that every crypto investor would do well to heed the well-worn mantra of "not your keys, not your crypto."

That doesn't mean you need to lock your crypto away and forget about it. You can still trade, buy and sell crypto as much as you normally do. But you'll want to get your crypto off the exchanges and into a private wallet you control (like Exodus or Trezor) as soon as the transactions are complete.

And I'd recommend against keeping any crypto on interest-bearing sites, or sites that lend it out, or defi sites that use complicated "yield farming" techniques.

It may be wise to avoid such sites permanently, even after the 3AC crisis blows over. The unfolding Celsius story in particular should give every investor pause.

A new lawsuit filed against Celsius by a former investment manager alleges the firm failed to hedge risk and was pumping up the value of its own CEL token to reduce the amount of the token it paid customers in interest. Worst of all, the lawsuit says Celsius last year started using new customer deposits to fund the withdrawal requests of earlier customers - turning the company into a de facto Ponzi scheme.

Crypto has the potential to make investors very wealthy, but the 3AC meltdown is a stark reminder that the sector remains mostly unregulated and can be crazy risky. Act accordingly.

Keep your crypto in a safe place and be very, very picky about the companies with whom you choose to do business.

Once you've got your crypto secured, you'll be in an excellent place to take advantage of what's coming down the road. There's a rally coming, and the current crypto market downturn is an opportunity, not a crisis. This is the perfect time for investors to establish or strengthen their positions in digital assets.

But you don't have to take just my word for it.

In fact, there's a Wall Street insider - famous for being a conservative investor - who's even more bullish on Bitcoin than I am. For a long time, he was a huge crypto skeptic, but now he's saying it's the best investment opportunity to come along in the past 30 years.

Skybridge Capital's Anthony Scaramucci has a bold Bitcoin price prediction that's been making headlines, and you can see it right here, along with his advice on what every American should do right now...

Follow Money Morning onFacebook and Twitter.