What lessons can we draw from the failure of the cryptocurrency exchange FTX? Financial history Edward Chancellor, author of a definitive history of past speculative excesses, from the South Sea Bubble onwards, gives his verdict in his latest contribution. An earlier version of this article first appeared on the online financial website, Reuters Breakingviews.
The Perfect Hoax?
Sam Bankman-Fried claims to be more interested in gaming than literature. Not long ago the founder of FTX, the failed cryptocurrency exchange, declared: “I don’t want to say no book is ever worth reading, but I actually do believe something pretty close to that. I think, if you wrote a book, you fucked up, and it should have been a six-paragraph blog post.”
Had SBF, as he’s known, opened the Oxford English Dictionary, he would have discovered that the original meaning of the word “bubble” is “anything fragile, unsubstantial, empty, or worthless, a deceptive show”. That pretty much describes the ecosystem in which FTX operated. Delving into financial history, Bankman-Fried might have recognised that his activities had many similarities with some of the frauds that accompanied past bubbles – with a possible twist.
The bubbler exploits the gullibility of investors. That’s not difficult at times of market euphoria. As Walter Bagehot wrote in “Lombard Street” in 1873, “The good times too of high price almost always engender much fraud. All people are most credulous when they are most happy; and when much money has just been made, when some people are really making it, when most people think they are making it, there is a happy opportunity for ingenious mendacity.”
Bankman-Fried persuaded some of the world’s most renowned investors, including Sequoia Capital, hedge fund manager Paul Tudor Jones, the Ontario Teachers’ Pension Plan, and Singaporean sovereign fund Temasek, to inject money in his business. Fortune magazine hailed him as “The Next Warren Buffett”.
The next trick is to flog worthless assets to the public. Dutch burghers fell for this in the 1630s when they paid the equivalent value of an Amsterdam mansion for a single tulip bulb. Nowhere, however, was wealth ever so virtual as in cyberspace, with its cryptocurrencies and tokens.
To spice things up, it’s a good idea to offer leverage. Once again, the Dutch were pioneers: the tulip mania was conducted with futures, the aptly named “windhandel”. In 1719 the Scottish economist John Law issued shares in the Mississippi Company on a partly-paid basis. FTX also offered its clients leverage.
Great swindlers cultivate political connections. In the 18th century directors of Britain’s South Sea Company slipped shares to King George I and bought up members of parliament. Bankman-Fried made large contributions to President Joe Biden’s campaign and to Democratic Party candidates in the recent midterm elections. He also hired a lawyer who previously worked for Gary Gensler, now chair of the U.S. Securities and Exchange Commission.
By their nature frauds are opaque. The avowed maxim of Sir John Blunt, the mastermind of the South Sea Bubble in 1720, was: “The more confusion the better; People must not know what they do, which will make them the more eager to come into our measures.” FTX’s multiple subsidiaries make the U.S. energy company Enron, which collapsed in 2001, seem straightforward.
Fraudsters often claim their investment success comes from exploiting market inefficiencies. Nick Leeson, the trader who brought down Barings Bank in 1995, claimed his profits came from arbitrage. Likewise, Bankman-Fried started out arbitraging crypto markets. When scams unravel, swindlers may turn to acquiring companies whose impending collapse threatens to expose them. As cryptocurrencies declined in value, FTX provided a line of credit to BlockFi, a stricken crypto-lender. It also agreed to buy the assets of another lender, Voyager Digital, out of bankruptcy.
Finally, there’s the misappropriation of customer funds – a common feature of financial scandals from Scotland’s Ayr Bank in 1772 to the exposure of Bernie Madoff’s Ponzi scheme in 2008. According to Reuters, Bankman-Fried secretly transferred some $10 billion of customer funds to his trading vehicle, Alameda Research. In a 2018 marketing pitch obtained by crypto news website The Block, Alameda offered loans with a 15% annualised interest rate. “These loans have no downside,” the document stated.
Bankman-Fried attributes FTX’s collapse to a “confusing internal account” which understated Alameda’s leverage, combined with a liquidity crisis as clients rushed to withdraw their assets. Yet past interviews display a tantalising awareness of the crypto bubble’s fragility. In April Bloomberg columnist Matt Levine asked Bankman-Fried whether “yield farming” – the practice of lending and borrowing against digital coins – was a Ponzi scheme. “That’s a pretty reasonable response,” Bankman-Fried replied. The trouble is “you just get liquidated eventually”.
In a later interview with Levine, Bankman-Fried said that certain crypto firms are dipping into customer funds and “marking their assets to whatever.” Such outfits, he says, care only about liquidity, not about net asset value. They operate with nosebleed leverage and take “random crap as collateral”. There’s no transparency: institutional investors don’t see the whole books. He talked about Three Arrows Capital, the failed crypto hedge fund, as engaged in “punting”. Recent revelations suggest these descriptions could also apply to Bankman-Fried’s operations.
These interviews, where Bankman-Fried was usually dressed in his trademark shorts, now appear to predict his own downfall. There were other omens. His firm launched a product based on a basket of crypto assets that it called Shitcoin Index Perpetual Futures, with the unsubtle ticker SHIT-PERP. He invited Michael Lewis, the author of finance classics including “Liar’s Poker” and “The Big Short” to follow him around. He commissioned an advertisement, aired during the Super Bowl, in which the comedian Larry David casts doubt on the viability of FTX.
The government investigators and bankruptcy experts who are now poring over the wreckage of FTX will establish whether Bankman-Fried and his colleagues are responsible for mismanagement or outright fraud. On one level, however, the whole episode could be construed as a hoax. If so, it would be the greatest hoax ever perpetuated.
A reminder that without knowledge of your individual circumstances and tolerance for risk, it is not possible to make specific investment recommendations. However all our opinions are honestly held and we have no conflicts of interest arising from commercial considerations.