A Three Arrows Capital Founder Talks About His New Crypto Bankruptcy Exchange

Less than a year after Three Arrows Capital (3AC) imploded along with $2.5 billion of clients' money, the hedge fund's founders, Su Zhu and Kyle Davies, are back with a new cryptocurrency exchange where people can trade bankruptcy claims – a hot area given all the distress in the industry.

The Open Exchange (OPNX) was announced last month, garnering wry smiles and smirks. The crypto community hadn't always been so skeptical of the duo. Until the $60 billion Terra ecosystem collapsed last April, they were hailed as messiahs among their peers, touted for running the hottest hedge fund and often endorsed by trading firms and market makers.

That ended bitterly when the market tumbled last year. The company's long-only trading strategy rapidly unwound in a pool of bad debt and unsecured loans before ending in a period of contagion that hit a series of leading crypto businesses. (That includes Genesis, which has the same parent company – Digital Currency Group – as CoinDesk.)

Zhu and Davies attempted to evade the heat by traveling to Singapore. Zhu sold off his Singapore real estate, while a $50 million, 500-ton superyacht dubbed "Much Wow" was liquidated after the pair failed to keep up with monthly payments.

After months of relative silence, Davies surprisingly appeared on CNBC in November. Davies revealed he was living in Bali, one of seven countries that doesn't have an extradition treaty with the U.S. After that grilling Davies retreated again, awaiting a moment to re-emerge in hopes public perception had swayed.

That moment came earlier this month, when Davies spoke to CoinDesk from an office in Dubai – another place with loose extradition laws with the U.S. – about the launch of OPNX.

Copying FTX features

For all of the issues that spurred FTX's demise, Sam Bankman-Fried's exchange offered a series of features that made it stand out from the crowd. Portfolio margin revitalized crypto derivatives trading following the uninspiring user experience that came from the likes of BitMEX. It allowed traders to hold a diverse portfolio while using the nominal value to trade futures contracts.

This has been adopted by OPNX with one difference: Users will be able to use bankruptcy claims as collateral. Given the sheer volume of crypto bankruptcies in the past year, demand for such a product seems likely to be high. But how does it work? What happens when a trade using a bankruptcy claim as collateral gets liquidated?

"We [OPNX] don't take that claim risk," Davies told CoinDesk. "Let's say you have a $100,000 claim. You move your claim into an SPV [special purpose vehicle]. OPNX then tokenizes that SPV."

The SPV will then be added to a tranche of related bankruptcy claims that will create liquidity on an order book.

"If the claim trades at 25 cents, you can sell your claim for $25,000 in stablecoin and withdraw. We will also have a backstop, which will be a large fund that wants to buy below the market," Davies added. "The fund can bid for the entire tranche at, let's say, 20 cents in this case, they can hold it there for a month, then every month adjust it within a range."

People can use bankruptcy claims, priced against the backstop, as collateral to trade bitcoin (BTC) or ether (ETH) derivatives products. If a trader gets liquidated, the claim will then be sold into the order book, which will eventually hit the backstop price. A backstop is a price point that provides deeper liquidity, intended to prevent an asset from falling below that level.

One of the issues that ultimately plagued FTX was having its sister company, Alameda Research, be the market maker for various trading pairs. This not only created a conflict of interest, but also led to Alameda having unlimited risk parameters, which eventually caused a deficit in liquid assets against liabilities.

OPNX won't have internal market makers. Instead it will pay market makers to ensure that all order books retain a level of liquidity that can deal with the volatility of crypto derivatives trading.

On the surface, OPNX is a novel idea. It has immediate demand from those looking to claw back losses from bankrupt crypto companies and it has adopted several features that helped FTX become a market leader. Whether investors will put their trust into Davies and Zhu remains to be seen.

A 'legit' – albeit undisclosed – location

Starting a crypto exchange in the current market dynamic is certainly a risk. Macro headwinds and an emerging banking crisis has the potential to put a dent in this year's crypto rout, but OPNX plans to roll out a series of phases that will include tokenizing other assets like real estate and equities.

Regulatory restrictions will be a natural hurdle. Davies said OPNX has applied for a regulated stock exchange license in a currently undisclosed jurisdiction. "It's a legit jurisdiction," Davies said.

When asked whether Davies and Zhu will create another hedge fund or trading firm once the dust settles following the collapse of Three Arrows Capital, Davies was coy and defensive.

"My thinking right now is that if we want people to judge our product, not us," he said. "If you think about why people are angry, it has nothing to do with me actually. People are angry because the market went down. In terms of us, we have no regulatory action anywhere, no lawsuits at all. There's just nothing. So they're clearly not mad at anything. They're mad because the supercycle didn't happen, maybe, I don't know. Something like that, right?"