Another market blow-up. FTX was one of the biggest cryptocurrency exchanges in the world. Founded in 2019 and based in the Bahamas. FTX specialised in derivatives, leveraged products and spot trading markets, developed at an extraordinary growth rate for three years, valued pre-collapse at $32 billion, ending with an $8 billion shortfall, numerous investor lawsuits and in bankruptcy.

This is nothing new in investment spheres. The narrative of another firm crashing is almost boring in the telling – if it were not so disruptive to the regular, careful and conservative investor selecting mainline assets supported by, or issued by well-regulated companies and/or highly credit rated sovereign governments with long-term track records of successful products and services.

Looking at a few other market disruptions. Different story, different causes, same end result – where the mistakes, errors of judgment, economic fluctuations, and in some cases, negligence, pushing the regulatory envelope, or absolute fraud can briefly or lengthily impact entire capital markets.

Just to name a few.

1998: Long Term Capital Management. Causes: very high equity valuations, Fed Reserve credit tightening, excessive speculation trading, derivatives, and Russian bond collapse

2000: Dot.com bubble. Cause: frenzied speculation in dotcom companies, highly overvalued assets that never achieved any profitability, and died on the vine

2007-2008 crisis: sub-prime mortgage securities, credit default swaps, leverage, Fed Reserve raising interest rates

2008: Bernard Madoff’s complete Ponzi scheme

2010: May 6, mini flash crash. Causes: spoofing of high frequency trading, e-mini futures contracts

2021: Archegos collapse. Causes: borrowed money, derivatives, leveraging, margin calls, securities’ price manipulation

2021: GameStop market crash. Causes: social media collaborative investing mania, short squeeze, heavy losses in hedge fund trading

2022: FTX. Alleged mismanagement of funds, lack of liquidity, no underlying asset collateral back-up and a run on withdrawals by investors leaving a massive cash shortfall. FTX filed for bankruptcy, while the collateral damage impacted other crypto companies as well as depleting confidence in digital currency technology.

How do products, services of any kind really receive concentrated interest from the public?

The marketing, and verification cycle of an investment product/service launch is a fascinating topic all on its own.

Readers, keep in mind this is a layperson’s overview only!

• Start marketing perpetually on social media and other popular chat/investor sites

• Friends start talking to friends about using the product/service

• Business associates and influential friends take an equity stake or loan the new business operating cash

• Famous people become enthusiastic spokespersons because they legitimately believe in the product/service or have been given equity participation incentives

• Venture capitalists start to invest. They are tough, critically astute financiers who do not pledge/invest without serious “under the hood” scrutiny

• Product/service is verified by rating agencies that have done their full investigative analyses

• Product/service meets regulatory approval and licensing by a securities and exchange commission

• Pension funds, major finance houses, then retail persons invest

• The product achieves legitimacy.

The actual process is rigorous, lengthy, extremely detailed, includes all manner of finance, legal, tax, corporate, other regulatory authorities and is also ongoing monitored.

But sometimes, even given all that above, the process isn’t fast enough, or too hard to achieve through normal regulatory investment approval channels.

According to Reuters: “FTX spent some $2 billion on ‘acquisitions for regulatory purposes’, by purchasing companies that already owned licences for US commodities in derivative markets and other deals contemplated for access to securities and exchange crypto regulation, country operation authorisation and more.

“The outcome of owning or equity investment in licensed companies, gave FTX immediate regulatory access to regulators and a bona fide advantage to accessing more capital investors.”

The editors of Bloomberg also wrote an editorial on the FTX debacle, which suggested that “Sam Bankman-Fried’s spectacular flame-out illustrates just about everything that’s wrong with crypto markets”.

Below are excerpts from the article, which illustrate a few home truths.

Beware of assets denominated in crypto

“FTX was vulnerable not only because it was leveraged, but also because its assets weren’t really assets.

“Judging from the balance sheet that the company reportedly sent potential rescuers, they consisted largely of notional digital tokens.

“Unlike stocks, bonds, or commodities, they had no associated cash flows or practical uses.

“At best, they represented fee income from trading other similarly made-up tokens.”

Market capitalisation is not value

“If a company has 100 beads and sells one for $1 million – maybe to itself, maybe to someone to whom it loaned the money, it can say the beads have a market capitalisation of $100 million. Clearly, those beads aren’t worth $100 million. Attempting to sell them all might yield nothing. Anyone who accepted them as collateral might end up with nothing, too.

Accounting matters

“Cryptocurrencies on public blockchains are highly transparent: everyone can see what belongs to whom at any time. Not so crypto intermediaries. They don’t publish financial statements audited to generally accepted standards (with the exception of Coinbase, a public company).

“Before FTX’s demise, investors and customers had little idea of what was going on beyond some not-so-reassuring tweets from Bankman-Fried, such as ‘assets are fine’.”

Consumer protections are essential

“Billions of dollars in FTX customers’ funds have effectively gone missing, lost to a tangle of entities and at least one apparent hack.

“This was possible in part because FTX – with the exception of its US derivatives-trading subsidiary – operated in a regulatory vacuum, with none of the requirements governing capital, liquidity, segregation of funds, cybersecurity or conflicts of interest that traditional intermediaries must meet ….

“There is no ‘cop on the beat’ making rules and enforcing compliance.

“Whatever the potential benefits of crypto, the surrounding speculative frenzy has little to do with them. On the contrary, it primarily serves to lure people in and separate them from their money, as FTX has now demonstrated.

“Proper regulation might help nudge crypto in a more useful direction, and is needed to ensure it doesn’t present a threat to the broader financial system.

“Meanwhile, the message for investors and traditional finance remains simple: Stay away.”

Sources

Investopedia: “What is FTX?” By Timothy Smith, November 17, 2022, https://www.investopedia.com/ftx-exchange-5200842

Reuters: “How FTX bought its way to become the 'most regulated' crypto exchange.” By Chris Prentice, Angus Berwick, and Hannah Lang, November 18, 2022. https://www.reuters.com/technology/exclusive-how-ftx-bought-its-way-become-most-regulated-crypto-exchange-2022-11-18/

Bloomberg: “FTX collapse offers a master class in crypto market’s flaws“, https://www.bloomberg.com/opinion/articles/2022-11-17/ftx-collapse-offers-a-master-class-in-crypto-market-s-flaws?srnd=premium&sref=70aFFrqe

• Martha Harris Myron is a native Bermuda islander with US connections. Author of Bermuda’s First Financial Literacy Primer – the Dawn of New Beginnings, a Google News contributor, and the Bermuda – Bermy Island Finance Blog. Contact: martha.myron@gmail.com