Lessons from the autumn of FTX

On 5 November, the value of bitcoin, the most well-liked and the largest crypto, was barely greater than $21,300. By 9 November, by when it was clear that issues weren’t all proper at FTX, the value of bitcoin had fallen by greater than 25% from the 5 November value.

Since then, the value of bitcoin has largely moved within the vary of $16,000-17,000. This implies that the value has fallen by greater than 75% from the height value of round $69,000, reached in November 2021, with the collapse of FTX being accountable for the newest fall.

In this piece, we are going to attempt to perceive why FTX failed and the teachings, each investing and in any other case, that we are able to be taught from it.

So, why did FTX collapse?

As time passes by and journalists dig extra, extra particulars will hold popping out. Nonetheless, at its coronary heart, the autumn of FTX will be defined in a quite simple means. It was an alternate with the ambitions of being a hedge fund.

What does that imply in easy English? An alternate brings the client and the vendor collectively. Take the case of a inventory alternate. If I wish to promote a inventory, I try this on the inventory alternate and somebody buys it. The alternate makes cash on each commerce carried out on it. Hence, it’s largely a low-risk enterprise, on condition that it’s merely bringing the client and the vendor collectively.

So, how did FTX go bankrupt then? FTX was managed by 30-year-old Sam Bankman-Fried. He additionally managed a buying and selling agency known as Alameda Research, which was constructed just about like many Wall Street hedge funds. It made cash out of arbitrage, shopping for bitcoin and different crypto tokens in a single a part of the world and promoting them in one other a part of the world. The distinction in value was the cash that it made. Hedge funds which play on arbitrage drive up their returns by borrowing cash and making greater bets. Alameda operated on comparable strains. It was principally a crypto hedge fund.

This is the place issues get attention-grabbing. Typically, a Chinese wall ought to have existed between a hedge fund and an alternate. As issues turned out, there was no wall. The particulars popping out recommend that FTX let Alameda Research borrow crypto tokens it held on behalf of its clients. Alameda Research, in flip, traded these property and made more cash within the course of.

Now buying and selling buyer property with out the prior permission of the client is unlawful beneath American regulation. To get round sturdy American legal guidelines, FTX was based mostly within the Bahamas.

As talked about earlier, like Wall Street hedge funds, Alameda Research drove up returns by borrowing crypto tokens from FTX and making greater leveraged bets. A latest report on CNBC.com factors out that “Sam Bankman-Fried declined to touch upon allegations of misappropriating buyer funds, however did say its latest chapter submitting was a results of points with a leveraged buying and selling place.” Another report on Forbes.com points out that: “According to several traders, many of Alameda’s long bets probably suffered big losses beginning in May 2022.”

Essentially, plainly a commerce or trades made by Alameda Research utilizing crypto tokens it had borrowed from FTX went improper. This in the end led to FTX having to declare chapter and plenty of of its clients shedding out.

Why did issues come to the fore now?

The cause for that is pretty simple. Charles Kindleberger and Robert Aliber make this level in Manias, Panics and Crashes: A History of Financial Crises: “The implosion of a bubble at all times results in the invention of frauds and swindles that developed within the froth of the mania.”

Over the last few years, the price of bitcoin and other cryptos went through the roof. In an environment where money is flowing everywhere, basic questions aren’t asked. Crypto prices peaked in November last year and even before the most recent crash had already fallen big time.

Similar swindles have been discovered in the past as well. Bernie Madoff ran the biggest Ponzi scheme of all time. Only after the crash of 2008 did it come out in the public. WorldCom and Enron scams were revealed after the 2000 dotcom bubble burst. Hence, it is almost a given that more big crypto swindles and scams will be revealed in the days to come.

What about the trust that bitcoin and cryptos had hoped to create?

Satoshi Nakamoto is said to have invented bitcoin. Nobody knows who, he, she or they really are. But what is known is why Nakamoto went about inventing bitcoin. As Nakamoto wrote on a message board in February 2009: “The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”

This got here after the monetary disaster of 2008 had began. In order to make sure that many massive monetary establishments don’t go bust and that economies don’t get right into a melancholy, the central banks of the wealthy world led by the US Federal Reserve had determined to print an enormous amount of cash. This wasn’t the primary time that one thing like this had occurred. The historical past of fiat cash, or paper cash as it’s extra popularly identified, is plagued by examples of governments of the day creating a number of it from skinny air by merely printing it, as and once they felt prefer it. Now they create it digitally.

Nakamoto had an answer. He proposed a brand new type of cash and that was bitcoin. According to his plan, solely 21 million bitcoin would ever be created with the final bitcoin being created in 2140. The hassle was that individuals weren’t precisely ready to maneuver from cash because it existed to the type of cash proposed by Nakamoto.

Meanwhile, within the post-2008 world, as central banks printed increasingly more cash so as to drive down long-term rates of interest, bitcoin emerged as an object of economic hypothesis. Investors step by step began shopping for and promoting bitcoin and different cryptos, like they purchase and promote shares.

After the covid pandemic struck, the recognition of bitcoin and cryptos went via the roof. Again, rates of interest had fallen to very low ranges and some huge cash discovered its means into cryptos looking for greater and faster returns.

Nonetheless, from the second half of 2021, excessive inflation grew to become the order of the day via a lot of the wealthy world. In early 2022, central banks of the wealthy world step by step got here round to the concept of elevating rates of interest so as to management inflation. This was the pin mendacity in look ahead to the crypto bubble. The bubble burst and plenty of people who had began investing in crypto solely late within the day, misplaced some huge cash. The latest 25% fall drove one other nail within the crypto coffin and has damaged the little belief that remained within the so-called new system that bitcoin and its offshoots had hoped to create.

But wasn’t good cash betting massive on FTX?

Many massive traders had been betting on FTX. Among others, it had investments from the hedge fund Sequoia Capital and Temasek, the funding agency owned by the Singapore authorities. Media reviews recommend that Sequoia Capital wrote off its funding of over $210 million in FTX to zero. Temasek wrote off its funding of $275 million to zero.

There had been many different institutional traders just like the Ontario Teachers’ Pension Plan, SoftBank Group Corp., and hedge funds Third Point and Tiger Global, who guess massive cash on FTX particularly. The query is: Why did so many massive companies not do correct due diligence? The reply lies in what economist Robert Shiller describes in Irrational Exuberance: “The basic statement about human society is that individuals who talk frequently with each other suppose equally. There is at anyplace and in any time a zeitgeist, a spirit of the instances.”

The prevailing zeitgeist ensured that these investors believed what they wanted to believe and did not even ask the most basic questions or spot the red flags being raised. As The Wall Street Journal columnist Jason Zweig pointed out in a recent column: “On the ‘Odd Lots’ podcast in April, Mr. Bankman-Fried didn’t even bother to refute a question about whether a large part of his business might be a Ponzi scheme, also saying that it was ‘completely reasonable’ to assume many crypto assets are ‘worth zero’.” For a crypto insider to be as trustworthy as this could have compulsorily received a couple of folks speaking, nevertheless it didn’t.

One factor that has turn out to be clear concerning the investing enterprise over time is that it likes to glide. No one desires to be a killjoy and spoil a celebration. As Zweig factors out: “Sam Bankman-Fried could also be on the centre of what went improper, however he didn’t act alone. Behind him lies an enormous ecosystem of fantasy and fakery. It’s known as the investing enterprise.”

But wasn’t bitcoin and crypto supposed to be digital gold?

The believers in bitcoin touted it as digital gold. Their logic was that like gold, and unlike paper money, bitcoin couldn’t be created out of thin air. The believers also made emphatic statements like “one bitcoin is one bitcoin” (no matter that meant) and “have enjoyable staying poor” (to those who did not believe in bitcoin).

What they did not bother to explain is the fact that while there is a limit to the total number of bitcoin that could be created, there is no limit to the total number of cryptos that could be created. Data from statista.com points out that, as of November, there are 9,310 cryptos in existence, down from 10,397 in February earlier this year. Clearly, people who had invested in the more than 1,000 cryptos, which have disappeared since February, have lost money. On the other hand, gold is still gold.

What are the lessons for retail investors?

As always, it brings us back to the most important investing lesson—don’t put all your eggs in one basket. Diversify your investment into different asset classes and when it comes to extremely speculative assets like crypto, don’t bet more than 5% of your total assets on them.

Further, be careful while following investing advice being bandied around by influencers. Everyone from standup comics who were out of work during covid to famous stock market investors to influencers who are influencers because they are influencers, have gone around recommending cryptos. These recommendations reached peak level after the price of bitcoin crossed $50,000. Hence, it is important to understand what incentive individuals have for recommending a particular way of investing.

Also, it is very important to understand which part of the world the crypto exchange you are investing through is based in. For instance, FTX was based out of the Bahamas, allowing it to escape the US regulatory radar. It is worth remembering that over the last few months, there has been a lot of talk about the founders of Indian crypto exchanges having moved to Dubai.

Finally, if you are the kind who still wants to bet on crypto, be sure about where exactly you store your crypto tokens. The moment you leave your crypto with an exchange, you are giving up control on it. You are trusting the same financial system that bitcoin’s inventor Nakamoto wants you to distrust. As a recent article on Fortune.com points out: “It’s far safer to custody your own assets. This means keeping them in a physical hardware wallet similar to a USB drive or, alternatively, in an online software wallet”.

To conclude, it’s price remembering that what goes up at a really quick tempo may fall at an equally quick tempo. And that so-called good folks don’t at all times do good issues. They additionally are likely to glide. As Warren Buffett as soon as stated: “When the tide goes out, you see who’s swimming bare”. In the world of cryptos, that point is upon us.

Vivek Kaul is an financial commentator and a author.

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