Crypto, FTX and the madness of crowds

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Rather than being the savior of the cryptocurrency space or the next Warren Buffet, Sam… [+] Bankman-Fried turned out to be the face behind one of the biggest frauds in history. (Photo by Craig Barritt/Getty Images for CARE For Special Children)

Getty Images for CARE For Special Children

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

The bankruptcy of FTX, which could have up to a million creditors, was dramatic and will likely take many years to resolve. In the meantime, investors big and small are wondering what happened to their money and how much, if anything, they will end up getting back.

Looking back, 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 Chapter 11, many of the people quoted describe themselves as experienced investors. However, it seems many of them simply joined the crowd out of greed or fear of missing out.

It’s not just individuals who have been caught up in this affair. Some of Wall Street’s biggest firms, like BlackRockBLK and Apollo Global ManagementAPO, have fallen for this, committing billions to the crypto space. Kevin OLeary, known to viewers for his investment acumen on Shark Tank, was an FTX spokesperson and reportedly lost up to $15 million in FTX. He says now: We all look like idiots, we all have eggs on our faces.

It’s pretty obvious that institutional level due diligence on FTX has never really taken place for those who have invested. In the aftermath, it is clear that even experienced investors, both individuals and institutions, have relied on audit opinions from firms that most professional investors had never even heard of, let alone had good faith. established.

Crowd madness and simple embezzlement

What brought us here with crypto was a speculative bubble, like others we’ve seen before. It inspired me to reread Charles Mackay’s Extraordinary Delusions and the Madness of Crowds, first published in 1841. The book deals with similar outbursts dating back to tulip mania in the 1630s and the sea bubble of the South in 1720, and its lessons still apply. today.

With interest rates so low that fixed income investments became a losing proposition and wild swings in stock markets, investors were desperate to find something to hedge inflation risk and crypto looked like the answer. . Due to the growing demand and because cryptocurrencies seemed to only go up, people got excited and it became a giant bubble. The nascent crypto market was unregulated and investors should have known that, but that’s what happens with many speculative bubbles.

People caught up in the frenzy wanted to buy. Everything was going up with crypto, much like the dot-com boom of the early 2000s. At the start of the correction, Sam Bankman-Fried was touted as the savior of the crypto market and the new Warren Buffett, who was coming to bail all of these failing companies and was to be the big new consolidator for the distressed crypto space.

As someone who has spent his career looking for investment opportunities in struggling companies, I can say that the resulting bankruptcy of FTX is a total mess that will take years to clean up. No one really knows the full extent of what happened, or what comes next, with FTX since its record keeping and controls were abysmal.

Even court-appointed head of restructuring John J. Ray III, who estimates an $8 billion shortfall in client funds, is baffled. It is an experienced hand that has guided the restructuring of Enrons and many others. However, he noted in a statement to the bankruptcy court, “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 happened.” is produced here. He went even further in his testimony before Congress, stating, I don’t trust a single piece of paper in this organization. Ray later added, It’s not fancy at all, it’s just plain old embezzlement.

It’s truly unbelievable that things have come to this point, but where we are now underscores the systemic risk facing the entire crypto space. Cryptocurrency as an asset class has appreciated rapidly, rising from virtually zero in 2009 when Bitcoin was launched to $2.5 trillion at its peak in May 2021, before falling back to around $856 billion. dollars now. These are big numbers, which means that some people have won a lot of real money while others have lost a lot.

Many got caught up in the crypto mania, and it probably even boosted the global economy to its peak because new crypto billionaires were spending money buying yachts, real estate and other luxury items as well as to hire staff. These crypto gains created a wealth effect that was now seeing the opposite.

We still don’t know the precise impact that the collapse of FTX and other similar companies will have on the economy, but there is bound to be one. Historically, when the Fed starts raising interest rates like it is doing now, it usually stops when something blows up. We saw it in the Latin American debt crisis of the 1980s and the Russian debt crisis in 1998. So far in this crunch cycle, crypto has been the main boom, but the repercussions seem relatively benign so far. Even so, Janet Yellen recently called it a “Lehman moment within crypto.”

One thing is certain, the trust that was so important to the upward momentum of this space is gone. The credit and funding that was so easy to come by for struggling crypto businesses just a few months ago has totally dried up. With that, the other shoe will fall in the next few months and many more crypto companies will be in trouble.

The underlying idea of ​​a decentralized currency, unbound to central banker mistakes and immune to devaluations against fiat currencies, still makes sense. The promise of crypto has always been the ability for individual users to perform anonymous actions while keeping transactions on a public ledger, with a limited currency supply that makes tokens immune to artificial inflation, said Jeffrey G Wang, a Harvard computer science professor, told The Wall Street. Log. The very purpose of FTX, as a centralized token exchange, betrays the momentum on which cryptocurrencies began.

Of course, it’s easy to see why people have lost faith in fiat currencies. Yes, the dollar is still backed by the full faith and credit of the US government, but a dollar buys a lot less than before. 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 McDonalds for a dollar. Purchasing power has continued to fall alarmingly and all the money printed to counter the effects of Covid has made matters worse. In the past, when inflation rose and currencies were devalued, investors hedged inflation risk with precious metals. This time, desperate for something even more efficient, cryptocurrencies seemed to be the solution.

Crypto offered a new lower-cost solution, but since it was also unregulated, it fueled a speculative mania and people went crazy, as usually happens with financial bubbles. They heard stories of crypto investors getting fabulously rich and wanted to believe it could happen to them too. Risk controls disappeared, greed took over, and people were so excited to buy that they weren’t diligent about their crypto investments. They stepped up risk-taking and speculated in crypto through derivatives and unrestricted margin borrowing.

Despite this, the blockchain ledger generally remains a viable solution for many processes in the financial services industry. This 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 serious setback that will really make everyone rethink their exposure to the crypto industry. Well, see a lot more regulation in the coming months, not just in the US but also overseas. While this may be a Lehman moment for the crypto space, 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 plenty of exciting profit opportunities among all the distressed crypto carnage.

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