Three Investor Lessons from The FTX Collapse
Digital assets and cryptocurrencies are not something we pay much attention to at Lawrance Private Wealth. Our view is that crypto is un-investable due to its highly speculative nature and little if any regulatory oversight. We also don’t see a repeatable and methodical way to determine intrinsic value, which is how we evaluate the investment prospects of other asset classes like equities, fixed income and property.
Subsequently, we don’t invest client portfolios in cryptocurrency.
However, the collapse of the crypto exchange FTX did capture our attention. In January it was a venture capital darling worth $47 billion. Today it’s worth zero, with its larger-than-life founder and chief executive Sam Bankman-Fried (pictured), commonly referred to as “SBF”, charged with fraud and accused of misappropriating US$8 billion in customer deposits. Its rapid rise and equally quick fall offer several key lessons for investors, independent of the asset class.
Conflicts of interest
Before delving into the learnings, we will provide some context on what led to FTX’s downfall. SBF founded a digital assets hedge fund called Alameda Research in 2017. He then subsequently founded FTX in 2019, known for its ultra-low fees and complex financial products, including allowing customers to use leverage to boost returns (or losses).
FTX had grown rapidly, with the US-based business growing revenue from $90 million in 2020 to $1.02 billion in 2021. Venture capitalists were falling over themselves to get in on the funding rounds. SBF himself was somewhat of a rockstar, known for his dorky clothing and everyman personality.
Alameda traded large volumes of FTX and provided essential liquidity on the exchange. The business also accepted client funds on behalf of FTX. Some investors did question if there was a conflict of interest, but SBF said the two remained independent despite the common ownership.
Since Alameda was trading with leverage, the business should have posted collateral. That way if prices fall, FTX can margin call the loans and recoup any losses. But Alameda played by different rules. It was never margin called. When losses began to mount, Alameda dipped into customer funds to cover the losses.
It secured loans against FTT, a token issued by FTX. When this came to light, the closeness of Alameda and FTX spooked investors. Customers withdrew their funds from the exchange. FTX did not have the funds to satisfy redemptions and was forced to file for Chapter 11 bankruptcy.
FTX founder and CEO Sam Bankman-Fried
Always do your due diligence
FTX attracted a bevy of reputable investment outfits including Tiger Global, Sequoia, Softbank, Singapore sovereign fund Temasek and the Ontario Teachers Pension Plan.
But even a simple scan of the company would have revealed some troubling red flags. For example, the board of directors is comprised of three members, SBF, an employee and the auditor. On the auditor, it was not a reputable big four or equivalent. Its claim to fame was the first accounting firm to open an office in the metaverse.
The company was run from a $30 million penthouse in the Bahamas, where some of the highest levels of employees resided, and reportedly held relationships. The company did not have a chief financial officer. Its chief compliance officer previously acted as an attorney at UltimateBet, which collapsed after it used software to rig poker games.
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.” - FTX Bankruptcy CEO John Ray
Armed with the above evidence, a reasonable investor would conclude this company lacks appropriate governance, which is particularly important when the main activity is acting as a custodian of financial assets. But it’s clear many of venture capital firms either failed to conduct even basic levels of due diligence; or accepted these risks and invested anyway.
Lesson #1: Don’t follow any investor blindly, regardless of reputation
The Wild West
One of the key benefits of cryptocurrency is its decentralised system free from the control of traditional finance regulators. But this turns into a big negative when things go wrong.
Traditional finance created laws and regulatory agencies to encourage trust in the financial system and protect consumers from bad actors. This is why banks are required to hold excess capital, public companies must publish audited financial results, and financial advisers are overseen by ASIC. Sure, this red tape leads to increased compliance (trust us, we know!) and limits innovation, but it’s an essential cost of maintaining an orderly financial ecosystem.
FTX was based in the Bahamas, primarily because it’s one of the few countries with dedicated laws that govern digital assets. This was supposed to foster trust that customer funds would be overseen and properly looked after.
In reality, it seems the laws were simply to encourage crypto firms to set up shop in the country rather than provide any level of rigorous oversight. Investors should always be cautious when investments reside in jurisdictions without a proven regulatory regime.
Lesson #2: Invest in assets and jurisdictions with strong regulatory oversight
Cult following
FTX’s rapid success is in large part due to SBF himself. He fostered a cult following based on his personable nature. He preached effective altruism and pledged to give away his fortune. SBF was also reputable in eyes of the public. He graduated from MIT. Then worked at the revered trading firm Jane Street. Both parents are law professors at Stanford.
When a company is predicated on the success of the founder rather than the business this lends itself to key-man risk. We’ve seen this happen before, most recently with Hamish Douglass at Magellan.
FTX, under the direction of SBF, also spent large sums of money on promoting itself. It hired popular sports stars including Tom Brady and Shaquille O’Neil for advertisements. It donated to both sides of politics, in addition to media outlets. He also personally lobbied regulators and government agencies.
You would think all of this would make him unlikeable, but SBF had an uncanny ability to convince a crowd on his side. Even after the collapse of FTX, he has been doing the media rounds − against the advice of his lawyers − trying to convince the public it was a complete lack of oversight rather than outright fraud.
To us, it seems odd a child prodigy didn’t notice an US$8 billion hole in his balance sheet.
Lesson #3: Beware of key-man risk and promotional activity
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