The spectacular demise of the crypto exchange has suddenly reminded us of major risk principles that were forgotten. The FTX failure is similar to the Madoff, WeWork or LTCM cases.
It’s always about risk. Risk is a vindictive goddess that hates being forgotten and seeks retribution. Every now and then, a major financial demise forces us to relearn the basics of risk after delusional market players have tried, once more, to treat it as a negligible concern. The FTX collapse is a case study in how gambling with investor money can be left unchecked amid market euphoria.
The very minute euphoria is gone, and markets crash, the fraudulent or irresponsible behavior becomes exposed. Usually too late. The crypto exchange founded by Sam Bankman-Fried in 2018, which filed for bankruptcy this year after insane risk-taking revealed the Ponzi scheme, is reminiscent of the Madoff (2008), WeWork (2019) and LTCM (1998) cases in many ways. Similar patterns produce similar outcomes.
Market euphoria paints everything in rosy colors. All of the FTX, Madoff, WeWork and LTCM cases were helped by market bubbles that altered investor judgement (the Dotcom bubble, the 2004-2008 bubble, and the 2017-2020 tech-crypto bubble). Like WeWork’s Adam Neumann who easily duped SoftBank’s Masayoshi Son with his delusional tech narrative, FTX’s Bankman-Fried raised funds easily amid the crypto euphoria, promising exceptionally high returns.
For a while, the sheer market rise covered the fraud and crazy exposure, and was wrongly interpreted as genius. The lesson is that one must be extra vigilant when investing during rising markets.
One key blinder has been legitimacy. The son of two Stanford law professors, Sam Bankman-Fried studied physics and mathematics at MIT. Such a CV gave him a sort of blank check, equating pedigree with honesty, as if malfeasance or irresponsibility wasn’t a thing of the highly educated.
Caroline Ellison, the head of the FTX sister company, Alameda, was the daughter of two top MIT economists. Alameda is the trading firm that diverted $8 billion of FTX’s client deposits (without their knowing it) into highly risky crypto assets. Her reputation as a math wizard gave her credibility.
This shows we haven’t learnt much from the LTCM case. Long Term Capital Management had Nobel Prize winners Myron Scholes and Robert Merton on its board. This gave the hedge fund an automatic seal of approval and made investors too confident, until the extremely leveraged hedge fund lost $4.6 billion in 1998.
The key take-away is that «highly educated» doesn’t equate «perfectly honest» or «responsible».
FTX was incorporated in the Bahamas to avoid scrutiny. Being far from the U.S. regulators was one of the major enabling factors of the fraud. LTCM’s portfolio was a partnership incorporated in the Cayman Islands where regulation is loser. The co-founder of LTCM, John Meriwether, actually chose to start a hedge fund in order to avoid the regulation imposed on mutual funds.
Crypto trading funds like Alameda, which is at the core of the FTX scandal, have been nothing but version 2.0 of highly leveraged hedge funds. When founders seek the least regulated options, they have more room for wrong-doing.
As in the WeWork case of Adam and Rebekah Neumann’s John Lennon/Yoko Ono hippie style and new-age philosophy, the FTX legend rested on a philosophical idea, «effective altruism», promoted by Sam Bankman-Fried and his colleagues. The climate was particularly ripe for such guru-style investing during the crypto euphoria of 2017-2020, when ideas like democratizing finance with cryptos were thriving.
Together with Bankman-Fried’s T-shirt and cargo shorts, the speech about altruism made it look like the whole crypto operation was something new, noble and selfless – even while he was the youngest billionnaire living and owned a multi-million property in the Bahamas. Another red flag that deserves better judgement. A less conformist eye should have seen beyond the nerdy dress code.
After the FTX disaster, those tech gurus wearing t-shirts are having a very different meaning. «Mr. Bankman-Fried has cast the whole look in a different light. His sloppy dress seems less a reflection of a higher calling or of a decision to devote his own finances to ‹effective altruism›, than a red flag about a sloppy approach to other people’s money. A clue that someone who doesn’t care about showering or style is maybe someone who doesn’t care about audits and the commingling of funds», writes «The New York Times».
What the founders say in interviews is also interesting to analyze. Sam Bankman-Fried talked a lot after the FTX bankruptcy. He didn’t seem to realize the full extent of the failure. To the suggestion of relaunching new FTX tokens, Sam Bankman-Fried replied on Twitter that it would be a «productive path for parties to explore». A blogger commented that the ex-CEO of FTX, «after causing one of the biggest bankruptcies in history, has learned nothing and is willing to double-down on shitcoinery».
As to Caroline Ellison, she gave few interviews but was quoted twice promoting risk taking, without having any long term experience of what it means. In 2021, in the middle of crypto euphoria, she said she would advise her younger self «to be less risk-averse». In May, she again complacently defended the idea that taking risk was basically a question of daring. «Being comfortable with risk is very important,» she said on a podcast.
Back then, bitcoin had only lost half the value it ended up losing in 2022. It is now obvious that market experience matters. Unexperienced money managers, entrusted with billions of client assets, mistaking market bubbles for low risk, are a ticking time bomb.