Lessons from the fall of FTX

On 5 November, the price of bitcoin, the most popular and the biggest crypto, was slightly higher than $21,300. By 9 November, by when it was clear that things weren’t all right at FTX, the price of bitcoin had fallen by more than 25% from the 5 November price.

Since then, the price of bitcoin has largely moved in the range of $16,000-17,000. This means that the price has fallen by more than 75% from the peak price of around $69,000, reached in November 2021, with the collapse of FTX being responsible for the most recent fall.

In this piece, we will try and understand why FTX failed and the lessons, both investing and otherwise, that we can learn from it.

So, why did FTX collapse?

As time passes by and journalists dig more, more details will keep coming out. Nonetheless, at its heart, the fall of FTX can be explained in a very simple way. It was an exchange with the ambitions of being a hedge fund.

What does that mean in simple English? An exchange brings the buyer and the seller together. Take the case of a stock exchange. If I want to sell a stock, I do that on the stock exchange and someone buys it. The exchange makes money on every trade carried out on it. Hence, it’s largely a low-risk business, given that it is simply bringing the buyer and the seller together.

So, how did FTX go bankrupt then? FTX was controlled by 30-year-old Sam Bankman-Fried. He also controlled a trading firm called Alameda Research, which was built pretty much like many Wall Street hedge funds. It made money out of arbitrage, buying bitcoin and other crypto tokens in one part of the world and selling them in another part of the world. The difference in price was the money that it made. Hedge funds which play on arbitrage drive up their returns by borrowing money and making bigger bets. Alameda operated on similar lines. It was basically a crypto hedge fund.

This is where things get interesting. Typically, a Chinese wall should have existed between a hedge fund and an exchange. As things turned out, there was no wall. The details coming out suggest that FTX let Alameda Research borrow crypto tokens it held on behalf of its customers. Alameda Research, in turn, traded those assets and made more money in the process.

Now trading customer assets without the prior permission of the customer is illegal under American law. To get around strong American laws, FTX was based in the Bahamas.

As mentioned earlier, like Wall Street hedge funds, Alameda Research drove up returns by borrowing crypto tokens from FTX and making bigger leveraged bets. A recent report on CNBC.com points out that “Sam Bankman-Fried declined to comment on allegations of misappropriating customer funds, but did say its recent bankruptcy filing was a result of issues with a leveraged trading position.” 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, it seems that a trade or trades made by Alameda Research using crypto tokens it had borrowed from FTX went wrong. This ultimately led to FTX having to declare bankruptcy and many of its customers losing out.

Why did things come to the fore now?

The reason for this is fairly straightforward. Charles Kindleberger and Robert Aliber make this point in Manias, Panics and Crashes: A History of Financial Crises: “The implosion of a bubble always leads to the discovery of frauds and swindles that developed in 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 came after the financial crisis of 2008 had started. In order to ensure that many large financial institutions don’t go bust and that economies don’t get into a depression, the central banks of the rich world led by the US Federal Reserve had decided to print a huge amount of money. This wasn’t the first time that something like this had happened. The history of fiat money, or paper money as it is more popularly known, is littered with examples of governments of the day creating lots of it from thin air by simply printing it, as and when they felt like it. Now they create it digitally.

Nakamoto had a solution. He proposed a new form of money and that was bitcoin. According to his plan, only 21 million bitcoin would ever be created with the last bitcoin being created in 2140. The trouble was that people weren’t exactly waiting to move from money as it existed to the form of money proposed by Nakamoto.

Meanwhile, in the post-2008 world, as central banks printed more and more money in order to drive down long-term interest rates, bitcoin emerged as an object of financial speculation. Investors gradually started buying and selling bitcoin and other cryptos, like they buy and sell stocks.

After the covid pandemic struck, the popularity of bitcoin and cryptos went through the roof. Again, interest rates had fallen to very low levels and a lot of money found its way into cryptos in search of higher and quicker returns.

Nonetheless, from the second half of 2021, high inflation became the order of the day through much of the rich world. In early 2022, central banks of the rich world gradually came around to the idea of raising interest rates in order to control inflation. This was the pin lying in wait for the crypto bubble. The bubble burst and many individuals who had started investing in crypto only late in the day, lost a lot of money. The recent 25% fall drove another nail in the crypto coffin and has broken the little trust that remained in the so-called new system that bitcoin and its offshoots had hoped to create.

But wasn’t smart money betting big on FTX?

Many big investors were betting on FTX. Among others, it had investments from the hedge fund Sequoia Capital and Temasek, the investment firm owned by the Singapore government. Media reports suggest that Sequoia Capital wrote off its investment of over $210 million in FTX to zero. Temasek wrote off its investment of $275 million to zero.

There were many other institutional investors like the Ontario Teachers’ Pension Plan, SoftBank Group Corp., and hedge funds Third Point and Tiger Global, who bet big money on FTX in particular. The question is: Why did so many big firms not do proper due diligence? The answer lies in what economist Robert Shiller describes in Irrational Exuberance: “The fundamental observation about human society is that people who communicate regularly with one another think similarly. There is at any place and in any time a zeitgeist, a spirit of the times.”

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 honest as this should have compulsorily got a few people talking, but it didn’t.

One thing that has become clear about the investing business over the years is that it likes to go with the flow. No one wants to be a killjoy and spoil a party. As Zweig points out: “Sam Bankman-Fried may be at the centre of what went wrong, but he didn’t act alone. Behind him lies a vast ecosystem of fantasy and fakery. It’s called the investing business.”

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” (whatever that meant) and “have fun 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 is worth remembering that what goes up at a very fast pace can also fall at an equally fast pace. And that so-called smart people don’t always do smart things. They also tend to go with the flow. As Warren Buffett once said: “When the tide goes out, you see who is swimming naked”. In the world of cryptos, that time is upon us.

Vivek Kaul is an economic commentator and a writer.