LTCM was a large hedge fund in the late 1990s, created by Nobel Prize laureates and the world's most famous arbitrageurs from Salomon Bros, a well-known investment bank
Known as the Smartest Guys in the Room, everyone wanted to deal with them. When I was a young stock derivatives salesman at Natwest, running the hedge fund department, they were my biggest client.
LTCM conducted three main types of transactions - stock arbitrage, volume arbitrage and convergence arbitrage.
Such deals were considered low-risk, and since these guys had a lot of money under management (at least then there was a lot of it), all the first-class brokerages and credit bureaus fawned over them, competing to provide them with the best conditions. The commissions were huge, and everyone was happy…
But their strategies in the stock markets were negligible compared to what they did in the interest rate markets, where their trading positions were truly gigantic…
LTCM seemed to have a license to print money, guided by complex strategies and complex models. They brought a yield of about 30% per year and were a model of the hedge fund industry.
In 1998, the Asian crisis was in full swing, and liquidity in the dollar financing markets began to become a problem. Central banks tightened measures, and the game of musical chairs with dollar financing began…
When the flow of financing runs out, the weakest borrowers suffer first. In this case, it was Asian economies with excessive use of borrowed funds, and this turned into a global crisis of epic proportions.
The credit shortage spread as banks began to take losses from Asia, and the next weakest link was discovered - hedge funds specializing in arbitrage/hedges. LTCM, with access to more cash and leverage, were not the first to exit the market, but as smaller funds began to exit the market, arbitrage spreads widened..
At first, LTCM started to increase the size of transactions, it was practically risk-free if you had enough capital! (Or so they thought...)
LTCM were going to exit the deals when the first shock passed.
Their complex models failed to take into account one key risk - liquidity.
Their whole strategy was to use a lot of leverage in arbitration. Liquidity at the beginning of the crisis was in a very large deficit!
Then all the investment banks suddenly realized that their biggest client was the same one - LTCM. LTCM had about $4 billion in capital, but they borrowed hundreds of billions (aha!).
Everyone began to tighten the financing conditions, and more and more LTCM copycat funds began to collapse, further increasing the spreads in positions. Then Wall Street smelled blood and began to hedge, standing on the opposite side of the deal from LTCM.
LTCM went bankrupt, the Fed had to cut rates, and Goldman (where I had moved by that time) and others, in fact, had to buy out LTCM positions and reduce risk in order to protect themselves on the instructions of the New York Fed.
Losses exceeding the capital of investors amounted to $ 4 billion. Investors were wiped out and many big banks suffered huge, huge losses.
At that time, it almost brought down the system, hence the need for an emergency Fed cut in 1998, which fueled the dot-com bubble.
There are many parallels between LTCM and 3AC and the crypto lending markets. CeFi (not DeFi) clearly had one main client - 3AC, the smartest guys in the room. Now it turns out that they were the biggest driver of CeFi's profitability
The market is busy with self-cleaning, there is no Fed in the crypt, but Goldman, FOX and others are trying to take on the role of cleaning up distressed assets, this is how the markets should be effectively cleaned.
This is not the end of CeFi or DeFi, but it will lead to improved risk management and possibly regulation.
The crypto space will learn the key lesson of leverage and liquidity.
After all, macro controls everything, and liquidity is a key macro variable.
Liquidity cycles will occur over time, and people, being people, will find another way to create leverage…
And we will repeat the same thing over and over again in another market indefinitely.
Remember - after LTCM, there was no end for arbitrage, stock trading, bond markets or anything else. This has simply shifted leverage to other sectors of the market, as banks create leverage to make money. It's their only job.
