By Dr. James M. Dahle, WCI Founder
If you've been paying any attention at all to the news over the last couple of months, you've seen that an incredible human interest story with massive financial consequences has been playing out in the Bahamas. Sam Bankman-Fried—a young, philanthropic, seemingly successful crypto entrepreneur and effective altruism advocate—is the son of two Stanford Law faculty members. He is also, prosecutors allege, a fraudster. It appears that billions of dollars that people used to own have disappeared.
Bankman-Fried was the CEO of a cryptocurrency exchange known as FTX and the man behind a crypto trading firm called Alameda Research. Bankman-Fried's net worth peaked at $26 billion, although he is now down to something on the order of $100,000. FTX and Alameda Research have both filed for bankruptcy protection. Bankman-Fried has been arrested and extradited to the United States. FTX was the second-largest cryptocurrency exchange, so its collapse has had ramifications extending far beyond its own customers. In fact, a lot of people are now concerned about the viability of the largest exchange, Binance. The total amount of damage is over $7 billion. That's not as bad as Enron ($74 billion), but it's still a lot of money. Allegedly, FTX had loaned Bankman-Fried and other executives over $4 billion while losing a similar amount of money. Thus, the fraud charges.
While all of the details will come to light in the coming months and years, there are some important lessons that White Coat Investors should take away from all of this.
#1 Limit How Much You Put into Speculative Assets
Even if you make all kinds of other mistakes, you should still be OK if you will follow this one rule. I have consistently told people to limit how much they put into speculative assets (those that do not produce earnings, interest, dividends, rents, etc.), such as precious metals, cryptoassets, empty land, or commodities—make sure it's 5% or less of their portfolio. Even if you lose 5% of your portfolio, that should not delay your financial independence by even a full year. It's easily recovered from. Even if you lost all your crypto in the FTX debacle, you should still be OK as long as crypto was less than 5% of your portfolio. You don't need fraud to lose all your money either. Over the last year, many cryptoassets and exchanges have gone to $0, including LUNA, 3AC, Celsius, FTT, FTC, and Voyager. There will be more.
More information here:
What’s the Future of Cryptocurrency? These Fanatics Say It’s Pretty Darn Bright
#2 Don't Leave Cryptocurrency on an Exchange
For some reason, all of the exchange hacks of the past have not yet taught investors not to leave their cryptocurrency on an exchange. Put it on there when you're selling it; otherwise, keep it in a “cold wallet.” Not your keys, not your crypto. If you leave it on the exchanges, what you have is an IOU, and those aren't worth all that much in bankruptcy or a big hack.
#3 Geniuses Do Dumb Things and Bad People Are in Crypto Too
Loaning money from FTX to Alameda was stupid. Probably fraudulent too, but just insanely stupid to think that was going to work out OK. Bankman-Fried was supposed to be this genius worth tens of billions, but even smart people can do dumb things. Or worse. Here's the basic way it supposedly worked:
- FTX creates FTT out of thin air
- FTX lends FTT to Alameda
- Alameda borrows USD stablecoins using FTT as collateral
- Alameda sends USD stablecoins to FTX
- Repeat ad infinitum for an infinite money machine
The crazy thing is that he basically told everyone months before the collapse that he was running a Ponzi scheme (yield farming) and nobody listened!
#4 Diversify Your Business
Entrepreneurs take on so much risk that stock/bond risk tolerance questionnaires seem downright stupid. Who cares if I have 70% stocks or 80% stocks when 2/3 of my net worth is tied up in the value of my small business or, in the case of Bankman-Fried, a crypto exchange? It is tempting to double down on what is working, and then, double down again. But diversification is an important principle in business, investing, and life. Don't put all your eggs in one basket. Diversify your income streams. And if you happen to become a successful entrepreneur, do all you can to protect your life against the value of your company going to zero. While it might provide the highest rate of return of any asset you own, it is also one of the riskiest. Deleverage. Take money out and invest it somewhere else.
More information here:
Bitcoin Is Just like AOL; It Won’t Win the Race for Best Cryptocurrency
#5 Crypto Doesn't Use the Same Standards
In the typical finance world, there is a well-established set of compliance specialists, attorneys, and accountants who audit and ensure everything is on the up and up. Regulation has been in place for a long time, and it works reasonably well. By comparison, the crypto world is the wild, wild west. Instead of getting audits, the companies just publicly attest that they have reserves. Unfortunately, that allows them to not only lie but also to borrow their reserves from elsewhere. Instead of trying to reinvent everything in the brave new world of crypto, they would be better off using a system that has been well-proven outside of crypto to ensure accuracy and fairness. According to current and former US senators, crypto regulation is almost certain to happen.
#6 Trees Don't Grow to the Sky
Bitcoin was up 59% in 2021 and 1,133% from 2018-2021. Newsflash! If you start with just $1 million and earn a return of just 40% each year, you'll own the entire world in your lifetime. Those sorts of returns are not sustainable long-term. They cannot be. If you're buying something that just went up 40% or 60% or 1,133%, don't expect similar returns going forward. You can't buy past performance. And if you build a business that relies on those returns continuing, that business is going to fail. It has to. Trees don't grow to the sky. There is an upper limit on just about everything in business and investing.
More information here:
#7 Decentralization Is a Continuum
One of the selling points of crypto and the blockchains on which it runs is that it allows for decentralization. However, decentralization does not scale very quickly, centralization does. Thus, 90%+ of crypto exchanges occur on very centralized exchanges. In many ways, decentralization is an illusion. Decentralized protocols have centralized governance. Decentralized finance is underpinned by stablecoins, which are very much centralized. Decentralized exchanges may rely on technology that is centralized. The bottom line is that if you have cryptoassets, you probably aren't nearly as decentralized as you think.
#8 Regulation Is Worth More Than Reputation
FTX relied an awful lot on its reputation. It moved to the Bahamas to avoid being regulated like its US-based competitor, Coinbase. As the value of FTX rose, it was aided by the philanthropic actions of Bankman-Fried; sponsoring sporting events and celebrities like Taylor Swift; political lobbying; and the association of Bankman-Fried with business, technology, and political leaders. In the end, regulation was worth more than reputation. Coinbase might not have grown as quickly, but look at which exchange is still around.
#9 Beware of Cults of Personality and Celebrity Endorsements
Sam Bankman-Fried was widely celebrated for being an unkempt millennial who would play the League of Legends video game while on important phone calls. His company was plugged by Tom Brady (and his ex, Gisele Bündchen), Shaquille O'Neal (usually a pretty savvy businessman), and Larry David from Seinfeld and Curb Your Enthusiasm. Tom Brady is a heck of a quarterback, but you're a fool if you look to him for investment advice. Now, these celebrities are being sued, which should give future potential celebrity endorsers pause. Don't get caught up in celebrities, whether in business (like Bankman-Fried, Elon Musk, Steve Jobs) or outside of business (like Brady, Bündchen, or David).
#10 Beware of What Happens When Money Is Cheap
Money, specifically the cost of borrowing it, has been very cheap in the last few years. Before we saw inflation in the things we buy at the grocery store, there was inflation in the investment assets we use to save for our futures. Crazy things happen when money is cheap. As the cheap money goes away, previously viable businesses are no longer viable. As Warren Buffett has said, “You don't know who is swimming naked until the tide goes out.” The tide is going out now, and FTX was swimming naked.
#11 You Can't Go Bankrupt Without Leverage
Want an easy way to avoid bankruptcy? Don't borrow money. FTX/Alameda created its own cryptocurrency, FTT, and then used it as collateral for its loans. Kind of reminds me of the old adage, “When you owe somebody $100,000, you have a problem. When you owe somebody $1o million, they have a problem.” Don't loan money without adequate collateral, and be very conservative about any borrowing that you do yourself. There's a reason that just about every major religion in the world gives its adherents severe warnings about debt.
#12 Bubbles Happen
It's pretty easy to see that crypto has been a bubble, much like the historical bubbles that have come before—from the tulip bulbs mania of the 17th century to the dot-com bubble. That doesn't mean it has no value. It simply means that people dramatically overvalued it; it rose rapidly in price; and, subsequently, it collapsed causing severe economic pain to those who put the most into it. This will not be the last bubble. Every generation seems to have one. Follow a sensible written plan to avoid the investing pain they bring on.
More information here:
#13 You Can't Move Fast Enough
Binance began selling off its FTT on November 5, 2022. It announced that it was doing so on November 6. By November 7, withdrawals from FTX were “sluggish,” but Bankman-Fried said “assets are fine.” On November 8, he tried to sell FTX to Binance. On November 9, Binance said it was no longer interested, and that same day, withdrawals from FTX were no longer possible. On November 10, BlackRock marked down its stake in FTX to $0, and the Bahamas froze all FTX assets. On November 11, the bankruptcy filing was announced. Basically, if you wanted to get your money out, you had to be one of the very first people to know about all of this. Many times a year, I am disconnected from the world for a week or more at a time. There's no way I'm going to check on my investments every day, much less the multiple times a day it would require to get out of something like this. Don't invest in something you're not content to hold for decades, and don't leave it someplace that you are not content to leave it for decades.
Lots of lessons to learn here from this debacle for the crypto community, government officials, and the everyday investor. Be sure you internalize the ones that apply to you.
What do you think? Did you lose any money in FTX? Will this meltdown make you reconsider whether you should have cryptoassets? Why or why not? Comment below!
I followed the story even with minimal skin in the game. I had a $4000 “bucket” of crypto assets that included “blue chips, Web 3.0, Defi” and such. In my mind it was a crypto asset mutual fund. In reality it was a bucket of mostly speculative under capitalized junk.
I put $2000 in it twice and considered it “play money”. It didn’t feel quite as playful when I liquidated it during “FTX week” and lost 75% of it. Interestingly, it’s not close to my worst current loss which is my Amazon position (down 33%). I don’t own it, but Tesla is down 53% in the last six months. My guess is that some WCI investors are sitting on some notable paper losses in many individual Nasdaq issues even with diversified positions and no individual stocks. And it’s not all “play money.”
My prior Bitcoin trades from the tulip run had doubled an initial $8000 stake, so I lost half of my Bitcoin “winnings” with that loss. I assume I will be able to put the $3200 “bucket of crypto” loss on my taxes just as I had to put the Bitcoin win there in 2021 and give the IRS some of that gambling gain. Let’s be real. It’s gambling.
FTX is a fraud story. It is also a win for the cynical as the guy was doing it all under the cover of charity and effective altruism. The fellow will likely go to jail, but I doubt the time will fit the crime, as is usually the case in white collar crime (except for Madoff who died in prison).
The first step in effective altruism should probably not be criminal behavior followed by a pseudo- naive “I wasn’t trying to defraud anyone”.
The old saying about dumping an asset when you hear the shoe shine boy talking it up should be updated for the times. Dump an asset when you see celebrities getting millions in equity or endorsement fees…
I know there are still Bitcoin and crypto bulls out there, but they are mostly quiet at present.
Barron’s put out an article suggesting 2023 is not likely a good year for crypto, but the vast majority stock market prognosticators got 2022 very wrong: “As of November 2021, the median of 12 forecasts was 4,825, according to Bloomberg. The highest was 5,300, from Brian Belski of BMO. The lowest was 4,400, from reliable bear Michael Wilson of Morgan Stanley.”
This year was pretty bad for stocks and much worse for crypto. As you say, diversification and asset allocation are key, as is restraint with gambling.
Bitoin Bull here (NOT CRYPTO!). Still here. Been here for a long while now. Happy to not be quiet. But I actually agree that I think that Bitcion Price will likely trade sideways to lower over the next 1-2 years. I would love to be wrong. So in the short term I may be a Bitcoin “bear”…but since I’m not trading it and plan to hold for a long time, I’m still buying.
And no, I’m not playing with “Play money”
You Bitcoin maximalists have got to get off this “Bitcoin is not crypto” kick.
Crypto is defined as “1. short for cryptocurrency.
“the software gathers the fluctuations of the market and prices of all the cryptos”
2.
short for cryptography.”
That’s the Oxford dictionary.
Bitcoin is, by definition, a cryptocurrency.
What Is Bitcoin?
Bitcoin (BTC) is a cryptocurrency, a virtual currency designed to act as money and a form of payment outside the control of any one person, group, or entity, thus removing the need for third-party involvement in financial transactions. It is rewarded to blockchain miners for the work done to verify transactions and can be purchased on several exchanges.
https://www.investopedia.com/terms/b/bitcoin.asp
You’re entitled to your own opinions, but not your own definitions.
Jim just out of curiosity did you personally buy any crypto? You seem to know a lot about it.
I have not ever purchased any crypto. I find it interesting though so I read a lot about it.
“Coinbase might not have grown as quickly, but look at which exchange is still around.”
I would be careful supporting Coinbase. In the long term it will likely come back to bite you. Coinbase reputation is no better than FTX.
So you can’t trust the #1 company or the # 2 company? That’s a real endorsement for the asset class and its exchanges.
I think the point is, like you’ve said before, “not your keys, not your coins.” Use a cold wallet. Don’t trust ANY exchange to hold your money. They’re all likely doing funny business with customer funds.
Yes, probably the most important lesson. Really should have already been learned from the exchange hacks in the past.
Still, can’t blame anyone tempted by the “crypto savings accounts paying 10%” to leave some money on an exchange.
I bought $100 worth of BTC on Coinbase in 2015 really out of curiosity to see how it all worked and for the novelty. For the last few years, I almost pulled the trigger on investing a decent chunk of change into crypto (although I never considered anything near 5% of my portfolio, so maybe it really wasn’t a lot). My biggest fear more than anything was FOMO, which is a terrible way to invest. I’m glad I didn’t invest more, but not doing so still taught me a lot about my behavior. What stopped me were a few things:
1.) I never really (and still don’t) understand fundamentally what crypto is or what problem it solves. There are a lot of things I do understand with plenty of money making opportunity in those areas…I’ll stick to those rather than learn (and likely make mistakes) in something I don’t know anything about and don’t want to spend the time to learn.
2.) Expanding on #1, I don’t understand what “problem” everyone says the blockchain solves. Sure, I guess it’s a way to remain anonymous, but there are plenty of less onerous and risky ways to do this. Additionally, this doesn’t apply to me as an investor — I want to be found! It makes it easier to find mistakes, misallocated funds, fees, use customer service, have certain government/nongovernment protections, etc. None of this really exists in the US crypto space (interestingly, Japan crypto regulations are quite extensive. But to me, this makes the problem worse…one aspect of investing in crypto is to avoid the regulations. If I want to invest in a highly regulated asset class, I’ll just stay domestic).
3.) Probably the most important, the risk/return just didn’t seem to make sense in my portfolio. There is diversification benefits for assets that are negatively correlated with other assets, so in theory crypto should have performed well as a hedge against inflation/dollar. If anything, this would have been the year for crypto, but instead, it seems to be all falling a part. There are also plenty of other assets I can invest in with better Sharpe Ratios, etc. Crypto never seemed to make sense from a risk adjusted return perspective. It’s a great thing I have an investment policy statement, and objectively, there was no way to justify such an investment with what I had drafted.
Rule #0: Don’t speculate (invest?) in anything that generates no profits, no revenues, AND that has a complete reliance on greater fool theory in order to become more valuable.
Does anyone ever cut a floor board out, stash a couple thousand $, cover it up with a rug, and call it an “investment?” No! Everyone recognizes that would be ridiculous.
Just because the price of BTC (or other crypto) goes up sometimes, does not make it an investment. If BTC or some other crypto has a lasting future, it will be as money/currency/a medium of exchange, one which has a supply that can’t be manipulated by central banks and governments. A failure in other major currencies to hold their value would spur such a change. So would governments imposing strict capital controls.
And so, feel free to speculate in up and down price changes just as Forex traders do with EURUSD etc, but realize that’s what it is, and NOT investing. I was a serious crypto skeptic up until the second half of this year, but after learning more about BTC and seeing it’s resilience in the face of setbacks which should have destroyed it, I do believe bitcoin likely has lasting power.
BUT, I don’t feel the need myself to own any BTC at this time. If BTC becomes widely adopted, I will be able to exchange other assets for it as needed at that time – that’s the whole point of money. In the meantime, my USD can be put to much better use elsewhere. Like buying puts on NASDAQ equities the past year and next 3-4 months…
I feel the same way. Doubt BTC will ever go to zero given the fanaticism of the Bitcoin maximalists, but figure if it ever really becomes the currency I can just get it then.
As long as the value of cryptocurrency fluctuates wildly from day to day, as it does, you could never use it for any useful purpose like buying other assets or paying people without the risk of loosing “value” by overpaying when the price swings up the next day, or the recipient losses “value” when the price swings down.
On a side note, I was going to buy a $100/month in crypto on Coinbase just for kicks, but they wanted access to my checking account or debit card to set up my account. No way! LOL!
Another important lesson can be found in the fact that SBF, as reported by Bloomberg today, met with top White House officials 4 times in the months leading up to the FTX collapse. He was also the 2nd largest donor to Democrats in the 2022 midterm elections.
Just because crypto is “not regulated” doesn’t mean that basic laws don’t apply, such as wire fraud, money laundering, corporate governance, corporate oversight, etc. It wasn’t his crimes that got him caught per se (if you’re as politically connected as SBF was, you can get away with that). What uncovered his crimes for all to see was essentially a good old fashioned bank run of his ponzi-scheme-coin, which revealed the fraud.
You can buy politicians but you can’t defy the laws of economics forever. A lesson government would do well to learn.
The political slant on this whole thing is interesting, but pretty much just speculation at this point. Should be an interesting case to watch go through court though.
Indeed!
Getting back to the Enron example cited in the post…
“Enron gave about 70 percent of its hard and soft money to Republicans and GOP causes in recent years, the data shows.”
From… “Analysis: Enron’s Political Contributions“, ABC News, 2002.
https://abcnews.go.com/Politics/story?id=121259&page=1
Gotta love the internet. It never forgets. 🤔
To be fair, some of those who were victimized by SBF did not intend to speculate in crypto. Some thought they were “depositing” their money into an account that would pay higher interest than a bank. I suspect many did not know that the they were lending money to a crypto firm.
Still….10% from a savings account. Anyone with financial literacy knew part of that return was speculative. I still doubt most doing that expected to lose it all.