The Early Lessons for Investors From FTX’s Collapse

Shall we talk about FTX? This now-bankrupt cryptocurrency exchange, whose failure has apparently made billions of dollars’ worth of its customers’ assets disappear, has hogged headlines globally for over a week now. As the saga continues unfolding and investigators swoop in, questions abound: Did the company illegally lend customers’ assets to its sister firm? Were there misrepresentations to clients and investors? Will anyone be made whole? Could better regulation have protected investors? Was the entire firm a front for money laundering? Where do all of the firm’s political donations and international connections fit in? Investigative reporters and federal investigators from several jurisdictions will pursue all of these, and we have no doubt it will be fascinating. For now, though, we think it is most helpful for investors to back-burner these juicy details, tune out the politics (which, as always, we are neutral on) and consider this saga from a personal finance standpoint. Namely: Is there anything FTX’s customers could have done to avoid getting caught in the mess and losing everything? After reviewing the situation, we see some warning signs that all investors benefit from understanding.

First, understand: We aren’t calling FTX a scam or Ponzi scheme. Nor are we alleging founder Sam Bankman-Fried has committed any crimes. It will take time for the authorities to sort through everything and determine whether criminal activity was committed. Similarly, we aren’t taking a position on any of the allegations unearthed by reporters over the past week. Nor does any of this seem to carry much impact on non-crypto assets, considering the lack of linkage between FTX and stocks or bonds. The rally we have seen in those markets has occurred while FTX was falling apart, which illustrates that point pretty clearly.

Yet with all that said, it does seem that customers—as it stands—have lost vast sums of money. And after reading a wealth of reporting from the fine folks at Financial Times, The Wall Street Journal, The New York Times and Bloomberg—not to mention scrutinizing FTX’s terms of service and fee schedule—we think the company had many of the common threads we have observed in sketchy situations investors are best off running from. If you have read Fisher Investments founder and Executive Chairman Ken Fisher’s book How to Smell a Rat, which illuminated the tricks used by Bernie Madoff and other financial pirates, these will look especially familiar to you. (And if you haven’t read it, what are you waiting for, it is a classic!) Again, not that we are calling anyone involved here a crook—but warning signs of trouble are warning signs of trouble, whether the situation turns out to be criminal or not.

The first sign: A charismatic principal who generated borderline messianic buzz and banked on the credibility that came from big investors and celebrity connections. With Madoff, it was his ties to regulatory agencies and standing within both the Jewish and celebrity communities. With Bankman-Fried, it was the heaps of praise from venture capitalists (VCs), hobnobbing with politicians and celebrities and partnerships with a number of professional sports teams and organizations. Why do your due diligence if the Mercedes Formula One team, Major League Baseball and the Miami Heat have done it for you? Surely the glowing testimonials posted on the VCs’ websites must be worth something? Except they weren’t. If we are interpreting myriad quotes and profiles correctly, a lot of these investors couldn’t articulate what was so promising about the core business beyond its being a way to gain exposure to crypto. In place of sound business analysis, they hyped the cult of personality, heaping praise on Bankman-Fried’s philosophy, political leanings and demeanor. In one now-infamous example, investors wowed by his behavior in a pitch meeting were subsequently chagrined to learn he was playing mobile games the whole time. Now, there is nothing wrong with founders being charismatic and quirky—that is sort of the stereotype, after all. But getting past the surface is vital.

One way to do that: Look at the fee schedule to see if the company’s business model lines up with a huge valuation and visions of gigantic profits. We don’t think it does. (For now, it is still online.) FTX charged a fraction of a percent on transactions, ranging from 0 – 0.7% of the trade’s value. Customers who owned its in-house token, FTT, received fee discounts of 3 – 60% depending on their holdings and trade size. Those who “staked” their FTT holdings (basically, locking them down so they could be used to verify FTT transactions on the blockchain) received additional rebates and rewards. Now, if FTX is processing a huuuuuuuuuuge volume of trades, we guess these fees could be an ok revenue stream. More likely, however, its primary revenue sources were margin fees (customers seem to have loved trading bitcoin futures on margin) and leveraged tokens that it created and sold. Those are more inherently unstable operations, which should have raised questions about its ability to stay a going concern as crypto crashed. FTT should also have raised questions, given it was one of FTX’s primary sources of backing.^[i] FTX pitched it as a way for customers to participate in its profits (like a stock!), as the company promised to use its earnings to repurchase and “burn” tokens, similar to a stock buyback, boosting their value. But its large market capitalization should have prompted customers to wonder who owned all those tokens and what the risks were if those entities had to sell—and what it would mean for FTX’s balance sheet. Lesson: Suspect business models + complex, unclear finances = run.

Another warning sign is the fact that investors who used FTX had to give custody of their assets to an entity that wasn’t a registered, regulated bank or brokerage firm. Now, we know opening a crypto exchange account isn’t analogous to handing Madoff or your local con-man a check. It is an account in your name. However, because crypto exchanges are unregulated, clients didn’t have the protections that would have helped mitigate the personal damage, including regulatory checks and federal insurance via the Securities Investor Protection Corporation (SIPC). In our view, being outside the bank and brokerage world largely rendered the separate account factor moot, as there were no checks and balances. Parallel to this, because it wasn’t a publicly traded company or regulated financial institution, FTX didn’t have to publish its balance sheet or financial information, robbing customers of a major tool for due diligence.

The Terms of Service, which also remain online for now, also set off some alarm bells when we read it. One of the major allegations against FTX is that they lent customers’ assets to their sister firm, Alameda Research. This is not allowed under the Terms of Service, which state in Section 8.2.6: “All Digital Assets are held in your Account on the following basis: (A) Title to your Digital Assets shall at all times remain with you and shall not transfer to FTX trading. As the owner of Digital Assets in your Account, you shall bear all risk of loss of such Digital Assets. FTX Trading shall have no liability for fluctuations in the fiat currency value of Digital Assets held in your account. (B) None of the Digital Assets in your Account are the property of, or shall be loaned to, FTX trading; FTX trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading. (C) You control the Digital Assets held in your Account. At any time, subject to outages, downtime, and other applicable policies (including the Terms), you may withdraw your Digital Assets by sending them to a different blockchain address controlled by you or a third party.”^[ii] (Boldface ours.) That may seem to head off the alleged lending to Alameda Research. But the problem with relying only on terms of service to assess a counterparty’s credibility is this: If every financial entity followed their own terms of service, there would be no scams. Sadly, rules are only as good as the people involved. Again, the investigation continues, and we don’t know the exact circumstances here. But if the only protection is the Terms of Service, that isn’t strong.

Moreover, in our view, the Terms made it quite clear that FTX isn’t a traditional financial institution with traditional protections, including SIPC or FDIC deposit insurance. Section 2.10 states it plainly: “No deposit protection. Neither Digital Assets nor any fiat currency or E-Money held in your Account is eligible for any public or private deposit insurance protection.” (Boldface theirs.) That clause raises another question: What is E-Money? Turns out it is scrip, per Section 8.3.2 – 4: “Once we receive fiat currency that you load into your Account, we may issue you with an equivalent amount of electronic money (“E-Money”), denominated in the relevant fiat currency that you have loaded. This amount will be displayed in your Account. E-MONEY IS NOT LEGAL TENDER. FTX TRADING IS NOT A DEPOSITORY INSTITUTION AND YOUR E-MONEY IS NOT A DEPOSIT OR INVESTMENT ACCOUNT. YOUR E-MONEY ACCOUNT IS NOT INSURED BY ANY PUBLIC OR PRIVATE DEPOSIT INSURANCE AGENCY. E-Money held in your account will not earn any interest. Your Account may hold E-Money denominated in different currencies and we will show the E-Money balance for each currency that you hold.”^[iii] (All-caps theirs.) Sooooo clients deposited cash, and FTX replaced that with an accounting entry that isn’t legal tender, which raises a question: What did it do with the cash? In our view, this oddity hints that the company may—may—have had the ability to perhaps do a bit more with its clients’ deposits than was commonly presumed. Again, not accusing—just observing and deducing.

There are also precedents that clients could have been aware of. FTX isn’t the first crypto exchange to implode and take its customers’ money with it. In 2014, an exchange called Mt. Gox—then the most popular exchange—fell victim to hackers who stole 800,000 bitcoins. The subsequent investigations revealed that customers’ crypto holdings weren’t actually in their accounts but were held in the exchange’s master account, which was “hot”—meaning, it was fully online and exposed to potential cyber attacks. Only 200,000 bitcoins were recovered, and last we checked, the company’s creditors (e.g., its customers) are still waiting for partial settlements. It was a huge story at the time, but crypto enthusiasts seemingly memory-holed it during the 2020 boom. Had they not, they might have thought twice about storing their coins on an exchange rather than a hard wallet on their phone or computer, especially when FTX’s Terms of Service don’t inspire much confidence that customers will have any recourse if the company is hacked. They state, point blank, that FTX is not responsible for cyber attacks on any blockchain network or any client’s account.

Lastly, thinking through first principles could have prompted customers to pump the brakes at the very least. At a high level, holding crypto at an exchange for long periods runs counter to bitcoin’s founding vision and the whole premise of the blockchain. Bitcoin was supposed to be a decentralized currency that operated outside of governments’ and central banks’ influence. Exchanges were necessary for an investor’s original conversion from dollars (or any other fiat currency) to bitcoin, but that was the extent of their intended purpose. Where fiat money requires some level of trust in the issuers and counterparties, bitcoin supposedly didn’t because it used the blockchain—a decentralized, irrevocable digital ledger—to verify and record all transactions. Said transactions would be peer-to-peer, with no intermediary, and all holdings would be secure in owners’ digital wallets. The most secure wouldn’t be “hot”—perpetually online and vulnerable to attack—but offline and local to the owner’s computer, phone or USB drive. But this system was too slow for the masses who wanted to speculate on crypto, hence the use of exchanges as permanent custodians, which bypass all the things that made transactions slow … and wallets secure. It perplexes us, but those who were speculating on blockchain’s future were bypassing the blockchain and its purported benefits.

Again, this story is still unfolding, and new details come to light daily. But for now, we see a few broad takeaways. One: Perhaps regulators will amend the accounting rules that have made it next to impossible for American banks and brokerage firms to custody crypto assets. The Wall Street Journal published an op-ed arguing this point earlier this week, observing that these rules perhaps forced crypto owners into the Wild West of unregulated exchanges.^[iv] Or, perhaps the SEC or CFTC will bring exchanges under either of their umbrellas. Either way, it seems likely that investor protections will evolve, which is a key area for anyone who owns or is considering crypto to watch. In the meantime, if you own any crypto on a competing exchange, we humbly suggest you do some thorough due diligence: Research them inside and out, discover as many potential risks as you can, think critically about what you uncover, and don’t hesitate to make changes if you think it is wise. And lastly, for everyone, please don’t invest with borrowed money—especially in hugely volatile crypto. Any transaction that risks losing more than your initial investment likely isn’t worth it.