More troubling revelations from the fallout of Three Arrows Capital (3ac), and it’s unleashing FUD all around. Mainstream critics say this saga is a case against DeFi. I disagree. 3ac’s collapse is more specifically about problems with CeFi. In fact, it actually shows us the value of DeFi and I’ll tell you why.

But first, a couple of visualizations here for a TLDR on the unfolding saga.

As 3ac’s collapse widens, several crypto entities have come out to reveal their loan exposure to the crypto hedge fund.

3ac itself has invested in some unfortunate projects:

• BlockFi, which laid off hundreds of employees last month

• Terra, which collapsed two months ago

• Axie Infinity, which lost almost $700 million to a hack from North Korea last year

To really understand what led to 3ac’s downfall, it’s important to know the firm’s trading strategies. 3ac is known for doing two kinds of trades.

1/ GBTC (Grayscale Bitcoin Trust)

First is a popular arbitrage trading strategy that the crypto firm has been doing for years. GBTC is a closed-end trust that’s exclusively focused on holding Bitcoin. It has an AUM of around $12 billion. Despite a 2% annual management fee, GBTC has long been seen as an attractive way to start trading crypto. That’s because unlike directly owning Bitcoin, your shares are held along other stocks and ETFs. This makes it easier (and seemingly safer) to hold.

The biggest perk? GBTC is where you can buy Bitcoin for nearly one-third less than the market price. Once bought, you wait until you can sell at a premium, à la 3ac strategy.

2/ Lido Staked ether

The second type of trade used by 3ac is leverage staking. It did so on Lido Finance, an Ethereum staking firm. When you send your ether into the Lido liquid staking smart contract, you receive staked ether tokens or stETH, which is pegged 1:1 to ether.

You can trade with these liquid tokens, even after wagering. So users can use stETH in the same ways that they can use ETH - sell, spend, and even use in DeFi as collateral for blockchain loans.

First up, what’s wrong with GBTC trading? 3ac has been betting big on this strategy for years. Fresh from the LUNA setback, the firm appeared to have pitched for a new arbitrage trade to meet its margin call. 3ac never put up any collateral, thinking that this strategy was safe. It was hoping that the gap between GBTC and Bitcoin’s market price was going to close, like it did before.

Unfortunately, that gap has only widened. At one point, it hit an all-time discount of 36%. Things have slightly recovered for now due to falling Bitcoin prices. But what we’ve seen over the last few years is that there’ve been net outflows of GBTC as each filing of Bitcoin ETFs failed. Grayscale is now in a legal fight with the US SEC over its latest ETF application.

Regular net outflows as well as deviations between market price and GBTC’s actual value highlight a structural problem. One big value proposition of GBTC was always that investors can buy bitcoins without encountering restrictions, like KYC. But over time, more crypto exchanges successfully met compliance and there was less need to buy GBTC.

In a perfect world, the number of outstanding shares would match the level of demand for those shares. But GBTC (plus all other closed-end funds) lacks the flexibility to create or redeem shares. Only Grayscale can do so. It could implement a redemption program, whereby investors can redeem GBTC shares at net asset value (NAV). This would essentially remove the discount. Grayscale has previously tried this method, but was blocked by SEC.

It’s clear that GBTC trading was too risky for 3ac to take on (especially during this bear market), but the risk was compounded by its second strategy - trade through stETH. Unfortunately, stETH has become the center of high leverage lately. Lido users have started creating revolving loans, whereby stETH from Lido would be deposited in other DeFi lending protocols like Aave. The tokens would then be used as collateral to borrow more ETH, and this process repeats itself.

Sadly, it has turned into an arms race of who can get the highest yield regardless of growing risks. As crypto markets go bearish, firms chasing returns without having sufficiently hedged (e.g. 3ac and Celsius) started to unravel.

The dynamic that has led to 3ac’s downfall reflects the typical credit cycle, which forces investors to take more risk over time in order to stay competitive. Like I’ve mentioned before, it’s an ever-growing arms race. Lenders keep raising yields even though the safety threshold has gone down. The risk eventually blows up.

What makes this saga serious is that 3ac didn’t just lose its own money. It was borrowing loans from other firms and projects, while failing to tell these parties exactly how much leverage they were taking on.

3ac has borrowed so much from others that it has gone into negative equity. This means it owes more money than it has, and its losses have spread to other people’s balance sheets. Making it worse, 3ac has been borrowing massive amounts of under-collateralized credit from various crypto firms. When these so-called lenders lose their money, they would need to contain their risk to meet margin calls. One method is to start recalling their loans to other firms because they are not sure who else would be hurt by the contagion.

Another way is to start selling assets so that they can meet margin calls or repay their loans. The consequence is a massive selloff. But here’s another layer of complexity. A lot of market makers (those making sure there’s liquidity in the market) are most likely getting their loans recalled. Liquidity then worsens as the selloff grows, and it all culminates to a market meltdown. At times, we’ve seen BTC and ETH selling more than alts. This is rare. It means the meltdown is most likely forced and not because people have lost confidence in Bitcoin or ether.

FTX CEO Sam Bankman-Fried has stepped in to save affected firms like BlockFi and Voyager Digital. He’s offering credit lines so that they don’t have to default on consumer deposit. If BlockFi and Voyager keep their operations running by continuing to process withdrawals, then perhaps SBF would bail them out and take on their liabilities. This news is probably what’s keeping the market afloat right now and preventing a total loss of confidence in crypto.

But that hasn’t stopped lofty statements like “DeFi is dead” or “DeFi is dying” from being thrown around in the media and other platforms. What critics have failed to understand is that there’s a key difference. Celsius, BlockFi, Voyager, Babel are not DeFi. In fact, they’re all centralized “lenders”.

Actual DeFi protocols don’t need to be bailed out. They are designed precisely to avoid this kind of situation. BlockFi and other so-called crypto lenders have not only failed in managing their assets properly. They have failed because they operate like Wall Street, instead of leveraging on the intrinsic technological benefits of crypto.

The 3ac crisis actually shows us why we need to have DeFi protocols. They are autonomous and transparent. DeFi protocols run themselves on open-source codes, meaning you can see exactly what your funds are being used for. This democratization of info, including loan books, is one of DeFi’s big selling points. Both high-capital lenders and average retail investors get to see the leverage that they’re taking on.

Another key advantage of DeFi that has stood out amid this crisis is that such protocols can’t block withdrawals, like what Celsius and Voyager have done. In DeFi, rules don’t change simply based on a centralized authority’s decision or some closed-door deals.

Take Maple Finance for example. Its Orthogonal USDC pool has been at risk after Orthogonal Trading revealed its $10 million loan to Babel, which itself has incurred liabilities from 3ac. Luckily, Maple’s DeFi model is proving resilient. Current APY stands at above 9% at time of writing. Its loan book remains strong. No defaults or late payments to date.

Maple’s on-chain lending data offers clear insight into maturities that can meet withdrawal demands over time. This help investors to reallocate their funds. The combination of smart contract protocols and risk tranches mean there’s no need for a chaotic liquidity adjustment, which is what’s happening now in CeFi.

This is DeFi’s proof-of-concept.

When we take out trust and rely solely on transparent, coded lending standards, we get better results. That’s the moral of the story. The strong, surviving DeFi protocols out there have already learned the lesson on March 2020. They know how to be resilient, even with prices tumbling as much as 50%. They don’t need regulations or bailouts. Actual DeFi protocols can self-manage and self-regulate based on unbiased computer codes.

The 3ac saga shows that the crisis could have been avoided, if major players have properly understood DeFi. Even if they are not systematically connected, CeFi and DeFi remain deeply intertwined. If things do go wrong, both projects and stakeholders need to know exactly what’s happening. On-chain data can help the industry design better systems to solve existing issues. So this is a time for less blaming and more building.

More troubling revelations from the fallout of Three Arrows Capital (3ac), and it’s unleashing FUD all around. Mainstream critics say this saga is a case against DeFi. I disagree. 3ac’s collapse is more specifically about problems with CeFi. In fact, it actually shows us the value of DeFi and I’ll tell you why.

But first, a couple of visualizations here for a TLDR on the unfolding saga.

As 3ac’s collapse widens, several crypto entities have come out to reveal their loan exposure to the crypto hedge fund.

3ac itself has invested in some unfortunate projects:

• BlockFi, which laid off hundreds of employees last month

• Terra, which collapsed two months ago

• Axie Infinity, which lost almost $700 million to a hack from North Korea last year

To really understand what led to 3ac’s downfall, it’s important to know the firm’s trading strategies. 3ac is known for doing two kinds of trades.

1/ GBTC (Grayscale Bitcoin Trust)

First is a popular arbitrage trading strategy that the crypto firm has been doing for years. GBTC is a closed-end trust that’s exclusively focused on holding Bitcoin. It has an AUM of around $12 billion. Despite a 2% annual management fee, GBTC has long been seen as an attractive way to start trading crypto. That’s because unlike directly owning Bitcoin, your shares are held along other stocks and ETFs. This makes it easier (and seemingly safer) to hold.

The biggest perk? GBTC is where you can buy Bitcoin for nearly one-third less than the market price. Once bought, you wait until you can sell at a premium, à la 3ac strategy.

2/ Lido Staked ether

The second type of trade used by 3ac is leverage staking. It did so on Lido Finance, an Ethereum staking firm. When you send your ether into the Lido liquid staking smart contract, you receive staked ether tokens or stETH, which is pegged 1:1 to ether.

You can trade with these liquid tokens, even after wagering. So users can use stETH in the same ways that they can use ETH - sell, spend, and even use in DeFi as collateral for blockchain loans.

First up, what’s wrong with GBTC trading? 3ac has been betting big on this strategy for years. Fresh from the LUNA setback, the firm appeared to have pitched for a new arbitrage trade to meet its margin call. 3ac never put up any collateral, thinking that this strategy was safe. It was hoping that the gap between GBTC and Bitcoin’s market price was going to close, like it did before.

Unfortunately, that gap has only widened. At one point, it hit an all-time discount of 36%. Things have slightly recovered for now due to falling Bitcoin prices. But what we’ve seen over the last few years is that there’ve been net outflows of GBTC as each filing of Bitcoin ETFs failed. Grayscale is now in a legal fight with the US SEC over its latest ETF application.

Regular net outflows as well as deviations between market price and GBTC’s actual value highlight a structural problem. One big value proposition of GBTC was always that investors can buy bitcoins without encountering restrictions, like KYC. But over time, more crypto exchanges successfully met compliance and there was less need to buy GBTC.

In a perfect world, the number of outstanding shares would match the level of demand for those shares. But GBTC (plus all other closed-end funds) lacks the flexibility to create or redeem shares. Only Grayscale can do so. It could implement a redemption program, whereby investors can redeem GBTC shares at net asset value (NAV). This would essentially remove the discount. Grayscale has previously tried this method, but was blocked by SEC.

It’s clear that GBTC trading was too risky for 3ac to take on (especially during this bear market), but the risk was compounded by its second strategy - trade through stETH. Unfortunately, stETH has become the center of high leverage lately. Lido users have started creating revolving loans, whereby stETH from Lido would be deposited in other DeFi lending protocols like Aave. The tokens would then be used as collateral to borrow more ETH, and this process repeats itself.

Sadly, it has turned into an arms race of who can get the highest yield regardless of growing risks. As crypto markets go bearish, firms chasing returns without having sufficiently hedged (e.g. 3ac and Celsius) started to unravel.

The dynamic that has led to 3ac’s downfall reflects the typical credit cycle, which forces investors to take more risk over time in order to stay competitive. Like I’ve mentioned before, it’s an ever-growing arms race. Lenders keep raising yields even though the safety threshold has gone down. The risk eventually blows up.

What makes this saga serious is that 3ac didn’t just lose its own money. It was borrowing loans from other firms and projects, while failing to tell these parties exactly how much leverage they were taking on.

3ac has borrowed so much from others that it has gone into negative equity. This means it owes more money than it has, and its losses have spread to other people’s balance sheets. Making it worse, 3ac has been borrowing massive amounts of under-collateralized credit from various crypto firms. When these so-called lenders lose their money, they would need to contain their risk to meet margin calls. One method is to start recalling their loans to other firms because they are not sure who else would be hurt by the contagion.

Another way is to start selling assets so that they can meet margin calls or repay their loans. The consequence is a massive selloff. But here’s another layer of complexity. A lot of market makers (those making sure there’s liquidity in the market) are most likely getting their loans recalled. Liquidity then worsens as the selloff grows, and it all culminates to a market meltdown. At times, we’ve seen BTC and ETH selling more than alts. This is rare. It means the meltdown is most likely forced and not because people have lost confidence in Bitcoin or ether.

FTX CEO Sam Bankman-Fried has stepped in to save affected firms like BlockFi and Voyager Digital. He’s offering credit lines so that they don’t have to default on consumer deposit. If BlockFi and Voyager keep their operations running by continuing to process withdrawals, then perhaps SBF would bail them out and take on their liabilities. This news is probably what’s keeping the market afloat right now and preventing a total loss of confidence in crypto.

But that hasn’t stopped lofty statements like “DeFi is dead” or “DeFi is dying” from being thrown around in the media and other platforms. What critics have failed to understand is that there’s a key difference. Celsius, BlockFi, Voyager, Babel are not DeFi. In fact, they’re all centralized “lenders”.

Actual DeFi protocols don’t need to be bailed out. They are designed precisely to avoid this kind of situation. BlockFi and other so-called crypto lenders have not only failed in managing their assets properly. They have failed because they operate like Wall Street, instead of leveraging on the intrinsic technological benefits of crypto.

The 3ac crisis actually shows us why we need to have DeFi protocols. They are autonomous and transparent. DeFi protocols run themselves on open-source codes, meaning you can see exactly what your funds are being used for. This democratization of info, including loan books, is one of DeFi’s big selling points. Both high-capital lenders and average retail investors get to see the leverage that they’re taking on.

Another key advantage of DeFi that has stood out amid this crisis is that such protocols can’t block withdrawals, like what Celsius and Voyager have done. In DeFi, rules don’t change simply based on a centralized authority’s decision or some closed-door deals.

Take Maple Finance for example. Its Orthogonal USDC pool has been at risk after Orthogonal Trading revealed its $10 million loan to Babel, which itself has incurred liabilities from 3ac. Luckily, Maple’s DeFi model is proving resilient. Current APY stands at above 9% at time of writing. Its loan book remains strong. No defaults or late payments to date.

Maple’s on-chain lending data offers clear insight into maturities that can meet withdrawal demands over time. This help investors to reallocate their funds. The combination of smart contract protocols and risk tranches mean there’s no need for a chaotic liquidity adjustment, which is what’s happening now in CeFi.

This is DeFi’s proof-of-concept.

When we take out trust and rely solely on transparent, coded lending standards, we get better results. That’s the moral of the story. The strong, surviving DeFi protocols out there have already learned the lesson on March 2020. They know how to be resilient, even with prices tumbling as much as 50%. They don’t need regulations or bailouts. Actual DeFi protocols can self-manage and self-regulate based on unbiased computer codes.

The 3ac saga shows that the crisis could have been avoided, if major players have properly understood DeFi. Even if they are not systematically connected, CeFi and DeFi remain deeply intertwined. If things do go wrong, both projects and stakeholders need to know exactly what’s happening. On-chain data can help the industry design better systems to solve existing issues. So this is a time for less blaming and more building.