The Collapse of Cryptocurrency Exchange FTX

Nov 21, 2022

The Collapse of Cryptocurrency Exchange FTX

The Collapse of Cryptocurrency Exchange, FTX, is Further Confirmation that Investors Should Avoid Speculating in Cryptocurrencies Altogether

At its peak in 2021, FTX had over one million users and was the third largest cryptocurrency exchange by volume.  It was headed by a person named Sam Bankman-Fried (“SBF”), a thirty-year-old media and political darling.  The more often he appeared in televised interviews wearing shorts and t-shirt and evaded answering probing questions the more popular he seemed to become. The truth was that he was operating his crypto exchange like a badly managed Ponzi scheme.  In early November, investors started withdrawing money as the price of Bitcoin fell.  The withdrawals snowballed and led to a run on the exchange.  FTX had not segregated its customers’ money to keep it off limits from the company’s business operations.  Instead, it used their money to loan billions to other SBF-owned entities that then blew it by, among other things, placing risky cryptocurrency bets that went bad.  Around $2 billion of client money is currently unaccounted for and is probably gone for good.

 

At the 2018 Berkshire Hathaway annual meeting, a Berkshire shareholder sitting in the audience asked Warren Buffett for his opinion on cryptocurrencies.  Buffett’s response was prophetic:

 

“When you buy something because you’re hoping tomorrow morning you’re going to wake up, and the price will be higher, you need more people coming into it than are leaving.  And you can get that.  And it will feed on itself for a while, and sometimes for a long while, and sometimes to extraordinary numbers.  But in the end, they come to bad endings.  And cryptocurrencies will come to bad endings. And along with the fact that there’s nothing being produced in the way of value from the asset you also have the problem that it draws in a lot of charlatans who are trying to create various sorts of exchanges or whatever it may be.  It’s something where people who are of less than stellar character see an opportunity to clip people who are trying to get rich because their neighbor’s getting rich buying this stuff that neither one of them understands.  It will come to a bad ending.”

 

What Are the Lessons to be Learned from this FTX Fiasco?

We have great sadness for the individuals caught up in this.  Undoubtedly there will be some who invested a large part of their net worth in this and will have to start over or delay retirement.  How could this have been avoided?  The lessons are the old ones that we cover repeatedly in this

Newsletter and our seminars.  It's so easy to overlook them when under the influence of the latest market bubble, get-rich-quick investment or highly polished sales proposal.

1. The Most Important Lesson Is This: More Important Than the Deal Is the Person In the Deal - When we associate with good people, good things tend to happen. And vice versa. If you want to find out why someone has a bad reputation, become his partner.  The same applies when we invest in (i.e., become a partial owner of) a large publicly traded company.  We’re turning over the management of our business to others, and we want these people to be ethical.  How do we know whether these managers, whom we don’t know personally, are ethical?  We can’t know for sure, but we will assume they are ethical until they prove otherwise.  This can happen in various ways, from misleading investors about the company’s operations during the quarterly earnings calls, to backdating their stock options, to drawing excessive compensation even during long periods where the stock underperforms the market.  When that happens, we are quick to sell.  Bad news tends to compound on itself, and when the full scale of the misbehavior becomes know, it’s probably too late.

2. If It Looks Too Good to Be True, It Isn't True - That's different from the way most people state the rule.  They insert "probably" before "isn't".  While it's certainly the case that some too-good-to-be-true deals can actually be as good as promised, we've found that this is so incredibly rare that one is better off presuming none of these will live up to expectations.  Unless you have special expertise and insight in analyzing a particular kind of proposal, this is the better approach.

3. Never Buy an Investment You Don’t Understand – One of the great things about investing is that you don’t need an IQ of 200 to be successful.  The important thing is to be able to draw a mental line between the things you’re capable of understanding and things you aren’t.  You can grow very wealthy over time by limiting your investments to the things you understand, be they stocks of quality businesses, government and corporate bonds, and index funds.  We make our big mistakes when we speculate in things we don’t understand.  If you’ve spent the last decade making good faith efforts to try to understand the blockchain and cryptocurrencies to little effect, that’s OK.  Few people understand these things well enough to provide a simple explanation.

4. Just Because Successful People Are Buying, Never Assume They Have Checked It Out, And It Must Be Good – One of the most revealing parts of this story is the extent to which high profile and seemingly respectable people fell for this house of cards – from Silicon Valley and Wall Street venture capital firms who invested in FTX to popular media personalities on CNBC who never thought to question management suspicious business practices.  It's all too common that successful people fall for scams in fields outside their areas of expertise.  In this case, the allure of the getting rich in cryptocurrencies clouded their judgment in something supposedly within their area of expertise.

5. Greed Trumps Common Sense Almost Every Time - When something looks so good, it's easy to want to believe it's true. Greed does that.  If you hear a tiny voice shouting to be heard over the sales pitch, and it's saying, "Slow down, this is too good to be true", that's your common sense fighting to be heard. Take its advice.

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