The collapse of FTX and founder Sam Bankman-Fried (SBF) is among the biggest financial stories of 2022. The sheer size of the fraud is astonishing – FTX has over one million creditors. There are a variety of explanations for why FTX has crashed and burned. Some of these explanations will be painfully drawn out in congressional hearings and bankruptcy proceedings. Some are basic examples of what can go wrong with leverage and collateral that is highly volatile and thinly traded. But, if you ask me, the story of FTX is quite simple. It starts with this New York Times article in 2018:
This article was on the heels of bitcoin gaining 1,300% in 2017. Bitcoin had been around for years, but the astronomical returns introduced crypto to the masses. Nothing attracts attention like rising prices. The brash, “have fun staying poor”, overnight crypto multimillionaires, were perfect fodder for the financial media’s spotlight. That spotlight was fuel on the fire of the most powerful investing emotion: FOMO. Warren Buffett explains why:
“People start being interested in something because it’s going up, not because they understand it or anything else. But the guy next door, who they know is dumber than they are, is getting rich and they aren’t. And their spouse is saying ‘can’t you figure it out, too?’ It is so contagious.”
The FTX fraud (and let’s be clear: despite SBF’s “aw shucks I wish we had better accounting practices” apology tour, this was absolutely fraud) could not have taken place without the zeitgeist of crypto. The allure of mind-bending returns enticed a swarm of blurry-eyed participants, and the lack of regulation created a situation ripe for grifters. To his credit, SBF positioned FTX perfectly for his fraud to flourish.
How do you attract customers in a rapidly growing but still esoteric industry?
1. Offer them a “safe and easy way to get into crypto” as FTX’s tagline promised.
2. Loudly promote your company as the primary advocate for more regulation.
3. Become ubiquitous. Buy the naming rights to the NBA arenas. Get celebrities on board. Convince Tom Brady to change his Twitter profile picture to laser eyes. Have Katy Perry create Instagram posts fawning over the company. Pay a loudmouth like Kevin O’Leary $15 million to shill it to anyone who would listen. Create a buzzy Super Bowl commercial with Larry David (← worth watching.)
4. Borrow from Elizabeth Holmes’s playbook. Fully embrace the weird, visionary, futurist founder role. Only wear clothes that fit in your backpack, sleep on a beanbag chair, and tell people stuff like “it’s negative expected value for me to cut my hair.” Venture capitalists can’t help but fall in love with that character (← worth reading.)
5. Speaking of which, publicly tout your VC investors, which include the most prestigious and successful VC firms in the world. “Sequoia and Tiger Global are in? This must be legit.”
6. Become the industry’s white knight, selflessly bailing out other crypto projects “to protect the digital asset ecosystem”.
7. Lead the charge for “effective altruism.”
8. Schmooze.
For all the reasons why the FTX scam thrived, SBF’s biggest tailwind was FOMO spreading like wildfire. FOMO afflicts mom-and-pop investors and professionals without partiality. Sequoia has some of the smartest minds in finance. Tiger Global pays Bain Capital more than $100 million per year to research private companies. Before investing, the Ontario Teachers’ Pension “went through a tougher-than-usual gauntlet for an investment…with multiple investment committees reviewing it.” Experienced experts at due diligence, certifiable geniuses, are no match for FOMO…combined, these three lost all of their $343 million investment in FTX.
Back to Buffett for a moment – he isn’t specifically addressing crypto in that quote. In fact, it’s from an interview about the 2008 financial crisis. The reason his words still ring true, and the reason that this same story will happen again is simple: human nature.
Cycles of booms and busts, bubbles and implosions, and expansions and contractions, have always, and will always, be a part of financial markets. FOMO, jealousy, and greed dictate it. And the same human emotions that suspend rational thinking provide opportunity for fraudsters.
Fortunately, I have some advice to stay out of harm’s way:
• Remember the iron law of investing: risk and return are inseparable. There is no such thing as high returns with no risk. IT DOES NOT EXIST. There’s no bigger red flag than an investment that promises otherwise. Remembering that would have saved FTX/Alameda’s investors:
• Invest based on your goals. I’ve written about this before. Your investment strategy should match you. Blindly following someone else’s strategy, even if they are a billionaire, is a recipe for disaster.
• Keep emotions out of your investment process. They will cause you to bail on good long-term investments at the worst times. They will cause you to chase returns because your “dumber-than-you” neighbor is getting rich. They will cloud your thinking. This is extremely difficult to do, but you must commit to it. Having an impartial financial advisor can help.
• Embrace humility. No two market environments are exactly the same. Multiply the limitless, ever-changing variables (GDP, earnings, unemployment, interest rates) by the ever-changing sentiment of all market participants, and it becomes clear just how uncertain the future is. In a world that’s completely unpredictable, embracing humility is an underrated trait.
• Practice patience. If something sounds too good to be true, like the prospect of becoming an overnight millionaire, then it probably is. Those who become millionaires overnight don’t tend to remain millionaires very long. Becoming rich slowly, by forming strong savings habits, consistently making good decisions, and maintaining a long-term view, is much more sustainable.
FTX’s fraud is historic, but it’s only a matter of time before it is outdone. The specifics of the next scam will differ, but human nature endures. All it takes is a compelling narrative, convincing perpetrator, and heavy dose of FOMO that will blind victims to the familiar red flags.
Disclaimer: Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at TruepointWealth.com. Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products.