Crypto, FTX and the madness of crowds

When it comes to avoiding scammers and scammers, the most common advice given is usually “if it sounds too good to be true, it probably is.” That phrase was heard a lot after the Madoff Ponzi scheme collapse and I’m sure we will hear it a lot more in relation to the collapse of cryptocurrency exchange FTX. Unsurprisingly, FTX founder Sam Bankman-Fried has been arrested in the Bahamas and is fighting extradition following a federal indictment on multiple counts.

The bankruptcy of FTX, which may have up to a million creditors, was spectacular and will likely take many years to resolve. Meanwhile, investors large and small wonder what happened to their money and how much, if any, it will eventually get back.

In retrospect, it’s easy to see that this was a speculative bubble and that many people, who should have known better, jumped on the bandwagon. In articles since FTX filed for Chapter 11, many people quoted describe themselves as “savvy investors.” However, it seems that many of them simply got along with the crowd out of greed or fear of getting lost.

It wasn’t just people who got involved in this. Some of the biggest companies on Wall Street, like BlackRock
BLACK
and global management of Apollo
APO
, has been involved in this, committing billions to the crypto space. Kevin O’Leary, known to television audiences for his investment acumen in “Shark Tank,” was a spokesman for FTX and reportedly lost up to $15 million in FTX. He now he says, “We all look like idiots…we all have egg on our faces.”

It is quite obvious that institutional level due diligence on FTX has never actually happened for investors. As a result, it is clear that even experienced investors, individuals and institutions alike, have relied on audit opinions from companies that most professional investors have never even heard of, let alone had well-established good faith.

The madness of the mob and simple embezzlement

What got us here with cryptocurrencies was a bubble, like others we’ve seen before. He inspired me to reread Extraordinary delusions and the madness of the crowd by Charles Mackay, first published in 1841. The book tackles similar outbursts dating back to the tulip craze in the 1630s and the South Sea Bubble in the 1720s, and its lessons still apply today.

With interest rates so low that fixed income investments became a losing proposition and wild swings in the stock markets, investors were desperate for something to hedge their inflation risk and cryptocurrencies seemed to be the answer. Due to the growing demand and as cryptocurrencies seemed to be going nowhere but upwards, people got excited and it became a giant bubble. The nascent cryptocurrency market was unregulated and investors should have known better, but that’s what happens with many asset bubbles.

People caught up in the frenzy wanted to buy. Everything was going well with cryptocurrencies, just like the dot-com boom of the early 2000s. As the correction began, Sam Bankman-Fried was touted as “the savior of the cryptocurrency market” and “the new Warren Buffett” , which was coming to bail out all these failing companies and was supposed to be the new grand consolidator of the struggling crypto space.

As someone who has spent his career researching investment opportunities in struggling companies, I can say that FTX’s resulting bankruptcy is a total mess that will take years to clean up. No one really knows the full extent of what happened, nor what comes next, with FTX as its record keeping and audits were appalling.

Court-appointed restructuring officer John J. Ray III, who estimates that $8 billion in client funds is missing, is also baffled. He is an expert hand who has guided the restructuring of Enron and many others. However, he noted in a bankruptcy court filing, “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of reliable financial information as has occurred here.” He went even further when he testified before Congress, declaring, “I don’t trust a single piece of paper in this organization.” Ray later added, “This isn’t sophisticated at all, it’s just plain old embezzlement.”

It’s truly amazing that things have gotten to this point, but where we are now underscores the systemic risk facing the entire crypto space. The cryptocurrency as an asset class has appreciated rapidly, from virtually zero in 2009 when Bitcoin launched to $2.5 trillion at its peak in May 2021, before plunging again to ~$856 billion now. These are big numbers, meaning some people made a lot of real money while others lost a lot.

Many were caught up in the cryptocurrency craze, and it probably also boosted the global economy at its peak because the new cryptocurrency billionaires were spending money buying yachts, real estate and other luxuries, as well as hiring staff. Those crypto gains created a wealth effect that we are now seeing in reverse.

We don’t yet know the precise impact the collapse of FTX and other similar firms will have on the economy, but there certainly will be one. Historically, when the Fed starts raising interest rates like it’s doing now, they usually stop when something blows up. We saw this in the Latin American debt crisis of the 1980s and the Russian debt crisis in 1998. So far in this tightening cycle, cryptocurrency has been the main blowout, but so far the ripples look relatively favourable. Even so, Janet Yellen recently called it “a Lehman moment within cryptocurrencies.”

One thing for sure is that the confidence that was so important to the upward momentum of this space is gone. The credit and funding that was so easy for struggling cryptocurrency companies to obtain just a few months ago has completely dried up. With that, the other shoe will drop in the coming months and many more cryptocurrency companies will be in trouble.

The idea behind a decentralized currency, unencumbered by the mistakes of central bankers and immune to the devaluations facing fiat currencies, still makes sense. “The promise of cryptocurrencies has always been the ability for individual users to perform anonymous actions by keeping transactions on a public ledger, with a limited supply of currency making tokens immune to artificial inflation,” said the computer science professor by Harvard Jeffrey G. Wang The Wall Street Journal. “The whole purpose of FTX, as a centralized token exchange, betrays the impetus on which cryptocurrencies were born.”

Of course, it’s easy to see why people have lost faith in fiat currencies. Yes, the dollar is still backed by the full trust and credit of the US government, but a dollar buys far less than it used to. For example, when Prohibition was repealed in 1933, one dollar could buy 10 bottles of beer. Now, you can barely get a cup of coffee at McDonald’s for a dollar. Purchasing power has been steadily declining at an alarming rate and all the money printed to counter the effects of Covid has made things worse. In the past, when inflation was on the rise and currencies were devalued, investors hedged the inflation risk with precious metals. This time, desperate for something even more effective, cryptocurrencies seemed like the solution.

Cryptocurrencies offered a new low-cost solution, but because they weren’t regulated, they fueled a speculative craze and people just went crazy, as typically happens with financial bubbles. They heard stories of cryptocurrency investors becoming fabulously rich and wanted to believe it could happen to them too. Risk controls went out the door, greed took over, and people were so excited to buy that they didn’t pay attention to their cryptocurrency investments. They have increased risk-taking and speculated in cryptocurrencies via derivatives and unrestricted margin lending.

Despite this, the blockchain ledger generally remains a viable solution for many processes in the financial services industry. It can reduce the need for expensive staff just as ATMs have largely replaced the need for bank tellers.

The collapse of FTX and other major players is a major setback that will really cause everyone to rethink their exposure to the cryptocurrency industry. We will see a lot more regulation in the coming months, not only in the US but also abroad. While this could be a Lehman moment for the crypto space, the digital currency is unlikely to go away. Hopefully Crypto 2.0 will be a little less opaque and a lot more regulated for the average investor. Along the way, there are likely to be numerous interesting profit opportunities amidst all the anguished cryptocurrency carnage.

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