Any time there is lots of money involved in a particular market, there will inevitably be a subset of people that emerge to capitalize on the situation by exaggeration, deception, and outright theft. Madoff, Enron, Lehman Brothers, Tyco — history is littered with financial frauds that cost investors billions.
How does nobody see it coming? Unfortunately the world today isn’t as simple as obvious good guys and bad guys, and it’s sometimes impossible for normal people to tell respectable companies apart from carefully constructed marketing images. The good news is that there are a few simple steps you can take to protect yourself from the fallout when things go terribly wrong from events you never saw coming.
But before we get to the good stuff, let’s unwind the most recent example of financial corruption that every investor should educate themselves about — the rise and fall of FTX.
Table of Contents
- The rise of a crypto juggernaut
- The house of cards catches fire
- When appearances deceive
- Lessons learned the hard way
- The many faces of counterparty risk
- How to build effective financial firewalls
In case it isn’t obvious, I’m not an investigative reporter and none of this is new information. But I’ll be summarizing dozens of articles in one place while providing lots of links back to the original sources if you’d like to learn more.
The rise of a crypto juggernaut
Sam Bankman-Fried (commonly referred to by his initials SBF) was born in 1992 to a remarkably accomplished family. His mother is a law professor at Stanford and a major political fundraiser. His father is also a Stanford professor and is considered a leading expert in tax law. His aunt is a current dean at Columbia University. His brother is a former Wall Street trader. You get the idea. Surrounded by those types of formative influences, it’s not too surprising that SBF would eventually dip his toes into influential financial and political waters.
After graduating MIT in 2014 with a degree in physics, he took a job on Wall Street with a quantitative trading firm. Just 3 years later he formed a company called Alameda Research focused on crypto quant trading. By arbitraging bitcoin price differences between the US and Japan, Alameda was able to make millions and build a reputation as a smart startup in the exciting new crypto space.
Using profits from Alameda, SBF formed a new company called FTX in 2019. FTX was a full-fledged cryptocurrency exchange with a special focus on derivatives and leveraged products, which required setting up shop in the Bahamas to avoid US regulatory frameworks that frowned on many of those practices. In just two years, FTX grew to revenues of $1billion while managing 10% of all global cryptocurrency trades.
To say that SBF was wildly successful is an understatement. FTX was valued at $36 billion, and its sister trading company Alameda Research had another $14 billion in assets. SBF was personally worth $26.5 billion, making him the 25th richest American at only 29 years old. And in internal documents, FTX had a stated goal of becoming the “largest global financial exchange.” To lots of observers watching the crypto frenzy, that wasn’t a crazy idea.
Times were good. The press wrote fawning articles about his brilliance and charity. Politicians invited him to advise on the industry. There were countless FTX commercials on TV with famous celebrities. And investors flocked to FTX in droves.
It was the work of a true generational genius, right up to the moment it all went to hell.
The house of cards catches fire
The veil of FTX invincibility was briefly pierced when CoinDesk wrote an expose in early November about the shady balance sheet at Alameda research. A significant percentage of its net equity was denominated in FTT — a crypto token invented out of thin air by FTX. That raised all kinds of questions not only about the financial overlap between the companies but also about potential manipulation of the FTT market price by a company owned by the man who created it. And the possibility that Alameda was using fake assets as collateral for real loans set off many alarm bells in the industry. After all, it’s fundamentally the same racket that doomed Enron.
Following that revelation, Changpeng Zhao (the CEO of FTX’s largest competitor Binance) announced that he planned to sell all of his holdings of FTT. That caused a rush in the markets with everyone looking to sell, and FTX was crushed with an estimated $6 billion in redemptions in just three days. It quickly became clear that they didn’t actually have $6 billion to pay out.
FTX faced a massive liquidity crunch. FTT collapsed, bringing Alameda Research down with it. And virtually overnight, two companies that were darlings of the financial media just days before were in ruins.
Binance is no innocent bystander in this, as they’re also under investigation for a myriad of financial issues. And Zhao and SBF were competitors, not friends. So it must have been extra painful for SBF to accept an offer from Zhao for Binance to buy out FTX at a huge discount to save it from bankruptcy. But after getting a look at the books, Binance backed out of the deal and left FTX to collapse. As Zhao explained, “In the beginning, our hope was to be able to support FTX’s customers to provide liquidity. But the issues are beyond our control or ability to help.” Was he ever serious or just twisting the knife? In the end, it doesn’t really matter as FTX was doomed.
After a few more desperate attempts to seek bailout funds, both FTX and Alameda filed for bankruptcy. And that’s when the truth of the situation started to finally leak out. Among other things:
- SBF had a backdoor that allowed him to illegally transfer $10 billion in FTX customer deposits to Alameda with no tracking. At least $1 billion of those assets completely vanished.
- Shortly after FTX filed for bankruptcy, a conveniently-timed “hack” walked away with another $600 million.
- Some assets appeared simultaneously on the balance sheets of both companies.
- FTX made $400 million in “software royalty” payments to Alameda that were then used to prop up the price of FTT tokens.
- SBF, his parents, and senior staff purchased Bahamas property worth $300 million.
- SBF and three FTX executives received $4.1 billion (with a B) in personal loans from Alameda research.
Long story short, it was a mess and may take years to fully unwind. The new FTX CEO in charge of the bankruptcy proceedings is a man named John Ray III, and he succinctly describes it in terms that a dry forensic accountant might appreciate:
“Never in my career have I seen such a complete failure of corporate controls.”
What if I told you this is the same person who managed the Enron bankruptcy? Yeah, that Enron. It’s bad.
And sadly, FTX investors were the ones left holding the bag. Over 1 million creditors with billions in total assets may lose everything.
When appearances deceive
When such blatant fraud and mismanagement brings a company down, it’s natural to wonder how so many investors were suckered into the scam. “Maybe they were just dumb or willfully ignorant, but at least that will never happen to me!”
Before you get too comfortable, though, it’s important to understand that it doesn’t work like that. FTX is a prime example of how even the most highly educated people can be led astray. In fact, the way FTX was promoted you’d probably have been considered crazy among the connected class to NOT buy into the hype. Consider these promotional points:
SBF was a proponent of federal regulation over the crypto industry
“[Regulation] is a long time coming, and it’s completely necessary — and we’re very much for it.”
In a 2021 interview with Bloomberg, SBF was positively effusive about his desire to see more crypto exchange regulation. And he was more than happy to make detailed suggestions — including to congressional committees — about how to manage the industry. Surely he’s a good guy looking out for the little man… right?
The problem is that he wanted increased regulation not to protect investors but to benefit himself. More regulation creates a higher barrier to entry for new competitors. SBF was very specifically lobbying for the crypto industry to be regulated by the CFTC as a commodity rather than a security controlled by the more onerous SEC. And he also understood that some level of regulation was required to allow larger institutions like banks to be lured into his web. “That’s frankly something I’m excited about here. I think a lot of them have been waiting for clear federal oversight of this space to get involved.”
And to be clear, SBF himself admitted it was all a cynical lie in his larger game. After the scandal broke, he DMed a reporter “Yeah, just PR… [Regulators] make everything worse. They don’t protect customers at all.”
SBF was held up as the ideal example of effective altruism
A 30-Year-Old Crypto Billionaire Wants to Give His Fortune Away
Sam Bankman-Fried drives a Corolla, sleeps on a beanbag, and has a Robin Hood-like philosophy.
That glowing headline from Bloomberg is hardly unique. Search for any article about SBF before the scandal broke, and you’re bound to come across the term “effective altruism”. That’s the idea of taking active steps to make the measurably greatest positive impact in the world around you, and SBF clearly sought to achieve that goal by donating as much money as possible to charitable organizations. Even moreso than SBF’s reported financial brilliance, his charitable streak made him a popular subject for positive press.
Interestingly, the hagiographic headline unintentionally hit on something profoundly truthful with the Robin Hood reference — SBF was giving away stolen money. Only he wasn’t robbing the rich to give to the poor. He was just funneling money to friends and greasing the palms of benefactors who would look the other way at his shady corporate practices.
That also could help explain why SBF was such a massive political donor, giving over $40 million to preferred politicians in the last election cycle and boasting about donating a cool billion more in the next presidential election. Assuming he testifies to the House Financial Services Committee as he claims to be willing to do, would you be interested to know that he donated to nine of the people questioning him? You probably won’t confuse that with altruism, but I can only imagine that it’s effective.
In fact, after the scandal broke SBF also came clean about how he truly feels about doing good. Speaking on the topic of ethics, he described it as “this dumb game we woke westerners play where we say all the right shiboleths and so everyone likes us.”
It was all a necessary facade.
FTX was a media darling with tons of mainstream advertising
“The patron saint of crypto. The Michael Jordan of crypto. The JP Morgan of crypto.”
For most normal people without access to the private books of a company in the Bahamas, investing faith largely comes from the words and actions of people they trust. And after watching respected financial outlets like CNBC absolutely gush over SBF, it’s no wonder that there was so little public doubt about FTX.
Combine over-the-top coverage like that from financial talking heads with endless commercials featuring superstars like Tom Brady and Larry David, and it’s safe to say that the media hype around FTX was not only intense but also insanely positive.
But that positive press actually got a bit creepy after news of the scandal broke, as several respected news organizations strangely refused to depart the bandwagon.
- Caroline Ellison — the girlfriend of SBF, CEO of the disgraced Alameda Research, and proud fan of regular amphetamine use — was recently headlined by Forbes as “a math whiz who loves Harry Potter, fringe political philosophy and taking big risks.”
- The Wall Street Journal published a slobbering article subtitled “The FTX founder pledged to donate billions. His firm’s swift collapse wiped out his wealth and ambitious philanthropic endeavors.”
- And the New York Times was roundly criticized for a softball interview with SBF that portrayed him as a charitable entrepreneur who was simply overextended and avoided most of the real questions people want answered.
The dirty little secret in all of the media coverage is that SBF also admits to sending lots of money to news organizations. As he said in his most recent NYT interview:
“Media matters a lot, and I wanted to support good media ventures. That was the whole thesis there. I don’t have governance over any of these. I was not looking for governance over them. I was looking to support journalists doing great work because I think what they do is really important.”
So exactly how much money did SBF and/or FTX give to media organizations who now operate as his marketing arm by sharing flattering coverage even AFTER the fraud was revealed? I’m guessing we’ll never find out, as the same media has no financial interest in honestly investigating itself. But I think it’s realistic to assume that the money influence is very real and that we’re not being given the full story.
Lessons learned the hard way
So to summarize what we know about FTX, it was a deeply dysfunctional company with fraudulent business practices that either lost or stole billions in customer assets that may never be recovered. Even the smartest people didn’t see it coming for a variety of reasons — they trusted SBF with his calls for regulation, they wanted to believe the charitable marketing, or they bought the media hype. Some players beyond the walls of FTX and Alameda absolutely financially benefitted from supporting the grift. And let’s be honest, plenty of investors were just excited about crypto and wanted in on the next big thing.
What can we learn from this?
Some might take this as an opportunity to simply dump on crypto as the Wild West of financial markets, but I’m not going to do that. Not only is it unfair to other legit players in the space, but it also completely misses the larger point.
If so many people can be this deceived, what else do we not yet know about other popular companies? Don’t kid yourself into believing this is an isolated situation. What will be the next FTX? It will absolutely happen again, and the same regulators and financial experts who are perpetually charmed by Bernie Madoff, Kenneth Lay, and Sam Bankman-Fried will be similarly blindsided tomorrow. So the cautionary tale here is much bigger than a single bad actor.
If there’s one lesson to take away let it be this:
Never put too much faith in any one company.
It doesn’t matter if they’re the most respected business you know, if they’re loved by financial experts and praised for their good works, or if you see them every day in TV commercials. The books could be cooked, the media could be in their pockets, politicians could be covering for them, and their old business model may not apply. And as we just witnessed with FTX, the institution you love could vanish overnight, taking your life savings with them while the perpetrators walk free and do the interview circuit from the Bahamas.
Real talk — don’t trust anybody.
The many faces of counterparty risk
While that may sound like a particularly dark conclusion, the good news is that it’s not the end of the story. There are actually some simple concrete steps you can personally take to protect yourself from future failures like FTX. So instead of sitting back and throwing stones, let’s get down to business and talk about actionable risk mitigation strategies.
From the perspective of an individual investor, the core issue here is the concept of counterparty risk. Any person or company you deal with financially can be described as a counterparty in a trade, and there is always a non-zero risk that they may not hold up their end of the bargain.
The thing about FTX is that even though there were tons of red flags in retrospect, at the time they seemed like one of the safer crypto trading options out there. So it’s not enough to simply say “do your due diligence and don’t invest with shady characters.” The next step is to assume that anyone could be the next FTX and to plan accordingly.
Companies die all the time, and entire industries can collapse in unison. For example, a significant percentage of overall stock market losses in 2022 can be credited to the fall in massive tech companies. And when you think beyond stocks and look at bonds, the risk of default is always a possibility and is directly reflected in their credit rating. The lower the rating, the higher the chance you will never see your money again.
If you buy a fund containing more than one security, the provider is the company that runs the fund. In the case of VTI it’s Vanguard, and there are many more including big names like BlackRock and State Street.
While fund providers may sound too big to fail, they’re not without very real risks. On a large scale, several have come under increased scrutiny for prioritizing political causes over shareholder returns. At the smaller level, some fund providers have a nasty habit of churning unprofitable funds to erase the poor performance record or completely changing the fund strategy with no easy way out. And if the fund is actively managed, the risk that the star manager will eventually hand over responsibility to someone new is 100% guaranteed.
This is the company that holds your money and buys securities on your behalf. You’ll know your brokerage well, since it is the one where you need to login in order to place a trade. The biggest brokerages include companies like Vanguard, Fidelity, and Schwab, and even if they’ve been around for decades and have earned wonderful reputations they’re still not immune from risk.
Maybe you don’t worry about Vanguard going bankrupt any time soon, but how would it affect you when their servers go down on a day you need to sell? Or what if your password is lost or stolen on the day your bills are due?
Do you use an investing adviser to directly manage your accounts? While there are some great advisers out there who make navigating the process a lot easier, they also introduce one more level of counterparty risk to the equation. Are they acting in your best interests? What happens when the person you like switches companies or finds a new career? Even the best adviser isn’t guaranteed to always be there when you need them most.
FTX is a particularly interesting example. While it ostensibly acted primarily as a crypto exchange, it was a complicated beast that also straddled the line between a company, fund provider, brokerage, and adviser through a myriad of subsidiaries like Alameda. And it was constantly looking to expand its reach through plans like acquiring a sizable stake in Robinhood, offering crypto derivatives directly to individual investors, and even acquiring a full-fledged brokerage.
That broad coverage with a finger in every crypto pie is what made them such a powerhouse in the space and also what made them so dangerous. Because of that concentration of power, the failure of a single company allowed the entire system to implode overnight.
How to build effective financial firewalls
So if so many smart and well-connected people bought into the hype, how can an ordinary investor protect themselves from being ruined by a company like FTX? That one is deceptively simple — plan for each counterparty to fail and diversify accordingly. As Harry Browne might say, by dividing your money among several different parties you build natural firewalls that protect most of your life savings if any one party spontaneously combusts.
- Never invest all of your money in a single company or even a single industry. Even when you’re sometimes right and feel like a genius, times inevitably change.
- When buying diversified funds, consider splitting your money across multiple fund providers. For example, instead of buying all Vanguard funds spread your money across iShares, SPDR, and other fund families. That will protect you from harm if any one provider has issues or gets a little too creative with prospectus changes.
- Think about opening accounts at multiple brokerages to reduce the risk of any one brokerage locking up your life savings. Even if that seems like overkill, maintaining a separate checking account in a different financial institution could make the difference between easily navigating a technical hiccup and missing a mortgage payment.
- Hiring multiple investing advisers generally doesn’t make sense, but finding a free second opinion who cares deeply about your financial success is a great idea. And the best person for that is you. So even while you lean on an adviser for skilled professional help, ask lots of questions and take the time to educate yourself on how it all works. Be the true financial oversight that your family deserves.
The common theme here is the idea of intelligently planning for failure. Completely immunizing yourself from investing risk is impossible, but minimizing the negative effects of inevitable problems is relatively straightforward. Engineers do that all the time with redundant systems and margins of safety, and that same defensive thought process can be applied to investing. And importantly, you don’t have to be an expert in complicated things like company structures or fund methodologies to protect yourself. You just need the foresight to not put all your eggs in one basket.
So as we all watch the FTX saga continue to unfold with more twists and turns sure to come, even if you never invested in crypto don’t sit back idly and imagine that it doesn’t affect you. Are you prepared for something similar to happen to your own life savings?
Think about how you can act today to protect yourself from counterparty risk, and you’ll avoid being caught off guard tomorrow.
Did this open your eyes to helpful new ways to minimize risk?