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FTX's lessons for Australian investors

The FTX story has a bit of everything. Fraud, greed, lust, political connections, a relatively new concept in cryptocurrency, wealthy families, large financiers considered ‘masters of the universe’, suckers, the Bahamas and multiple other locations of business subsidiaries. That’s not to mention the employees and average investors who’ve been caught up in the downfall. Also, the lawsuits and court drama which are no doubt to follow. Knowing America, books and movies on the subject are already in the offing.

For Australian investors, it might seem the drama is too movie-like to have any relevance to them. However, I think there are many lessons to take away from FTX. Some obvious; others not-so-obvious.

Obvious lessons

Some of the key lessons include:

Ideas don’t make investments. The idea of a cryptocurrency exchange may appear like a great idea. What’s not to like about taking fees via a trading platform in the then hottest idea going around? There are lots of ideas for businesses; many of them are sound ones. Ultimately, though, business is all about execution, and FTX had none of that.

Do due diligence. A big question mark hangs over the funds which invested in this company. One of them, Singapore’s Temasek, has defended its due diligence process saying it did eight months of work on FTX before investing. I’m not sure what work they did but it clearly wasn’t enough.

Always look at balance sheets. It’s alleged that when investors asked to see financial statements beyond profit and loss statements, they weren’t forthcoming. No wonder – they didn’t have any cash left. The lesson is that balance sheets and cashflow statements are just as important as the profit and loss.

Don’t follow the crowd. It seems likely that the funds which invested in FTX thought others had done due diligence on the company and therefore they didn’t need to do any themselves. Big error.

Be sceptical about your ‘network’. This is related to the prior lesson. I’ve previously written about how ‘networking’ and having a ‘network’ are overrated when it comes to investing and life. It’s especially the case when big money is on the line. Do your own work and be sceptical of others piling into investments.

Invest in people with a track record. This may seem obvious, and it is. But the people who invested in Sam Bankman-Fried invested in a guy who was a junior trader for three years and had no track record in anything.

Keep on top of your investments. When you invest in something, it’s not a case of set and forget’. You need to keep track of the investment. In the FTX case, Caroline Ellison, who headed the related company Alameda Research, bragged about regular methamphetamine use on social media in May last year. A red flag, one would have thought.

A less obvious lesson

There is a less obvious lesson from FTX and the cryptocurrency sector which I believe is more important than the obvious ones mentioned above. Investors should be wary when significant money is flowing into a sector. Particularly if there are a host of company IPOs in the same sector at around the same time.

The process often goes like this:

  1. There is a hot new idea or technology. Startups raise money, which leads to further money raising. That leads to institutions investing alongside venture capitalists. Which leads to more startups trying to raise money in the space.
  2. Investment banks will want a piece of the action, so companies will IPO to raise more money and/or cash in for themselves and their investors. After IPO, these investment banks will put buy ratings on companies, and more investors will pile in.
  3. All of which results in significant investment in the industry, and often, over-investment. That can lead to lower returns, increased regulation, investments fleeing the sector, cost cutting and eventually, industry consolidation.

This cycle has played out many times before cryptocurrency came along. There was TMT in the late 1990s and subprime lending in the US prior to 2008.

In Australia, it’s recently played out in industries such as aged care and fintech. Think about Afterpay and all the Afterpay wannabees. In essence, these are subprime lenders who’ve been marketed as extending credit to the average person.

Venture capitalists piled into these digital payment providers from 2015 and a slew of companies IPO’ed on the ASX and the Nasdaq. More investors got on board and investment banks promoted their virtues with buy ratings. That got the attention of mum and dad investors. And the share prices of these companies skyrocketed.

About 12 months ago, online spending growth started to come down from the highs of Covid, the share market started to decline, and large question marks came upon these digital payment providers. Investors have since fled the sector.

Price chart for Zip Co Ltd (ASX:ZIP). Source: Morningstar

The capital cycle theory

This whole process of industry investment, over-investment and creative destruction isn’t new: it’s related to two well-known economic theories: Porter’s Five Forces and Joseph Schumpeter’s process of creative destruction.

Recently, it’s been successfully adapted to the share market by a London-based funds management firm called Marathon Asset Management and given a name: the capital cycle theory. The firm’s capital cycle theory has gained a wider following after the publication of two books on the subject (Capital Account and Capital Returns) by well-known finance author Edward Chancellor.

In the book, Capital Returns, Chancellor provides a hypothetical example of the capital cycle theory at work:

“Here’s how the capital cycle works. Imagine a widget manufacturer — let’s call it Macro Industries. The firm is doing well; so well, that its returns exceed Macro’s cost of capital. The firm’s CEO, William Blewist-Hard, was recently featured on the front cover of Fortune magazine. His stock options are in the money, and his wife no longer complains about being married to a boring industrialist. Of the nine investment bank analysts who cover Macro’s stock, seven have buy recommendations and two have holds. The shares are trading at a price-earnings multiple of 14, below the market average. Macro’s stock is held by several well-known value investors.

Macro’s strategy department anticipates strong demand growth for its products, especially in emerging markets where widget consumption per capita is less than one-tenth the level found in the advanced economies. After discussions with the board, Macro’s CEO announces his plans to increase manufacturing capacity by 50 percent over the next three years in order to meet growing demand. A leading investment bank, Greedspin, arranges the secondary share offering to fund the capital expenditure. Stanley Churn of Greedspin, a close friend of Macro’s Blewist-Hard, is the lead banker on the deal. The expansion is warmly received in the FT’s Lex column. Macro’s shares rise on the announcement. Growth investors have lately been buying the stock, excited by the prospect of rising earnings.

Five years later, Bloomberg reports that Macro Industries’ chief executive has resigned after longstanding disagreements over corporate strategy with a group of activist shareholders. The activist, led by hedge fund Fantastic Investment, want Macro to shutter under-performing operations. Macro’s profits have collapsed, and its share price is down 46 percent over the last twelve months. Analysts say that Macro’s problems stem from over-expansion — in particular, its $2.5bn new plant in Durham, North Carolina, was delayed and over budget. The widget market is currently in the doldrums, suffering from excess supply. Macro’s long-established competitors have also increased capacity in recent years, while a number of new low-cost producers have also entered the industry, including Dynamic Widget, whose own shares have disappointed since its IPO last year.

The market for widgets is suffering from the recent slowdown in emerging markets. China, the world’s largest consumer of widgets, has vastly expanded domestic widget production over the last decade and has lately become a net exporter. Macro is reportedly considering a merger with its largest rival. Although its stock is trading below book, analysts say there’s little near-term visibility. Of the remaining three brokerages that still cover Macro, two have sell recommendations with one hold.”

Conclusion

It’s easy to get caught up in the drama of the FTX saga and wonder how sophisticated investors got caught up in the firm’s downfall. The capital cycle theory helps explain how such events happen and what investors can do to avoid similar things happening to them.

 

James Gruber is an Assistant Editor at Firstlinks and Morningstar.

 

21 Comments
Dan
November 23, 2022

It's bitcoin, not crypto.

Plenty of lessons to be learnt out of the FTX drama. Most alt-coins rightly deserve to be left in the rubbish dump and the snake oils salesmen to be chased out of town.

Using bitcoin and crypto interchangeably reflects a lack of understanding about what bitcoin is. APayne and others, if you're so certain of what the future holds tell me the next sure thing and I'll put my money there.

Do I have 100% of my portfolio in Bitcoin? No. It's less than 5%. I can't be certain about it's future, but I'm not certain about anything. I do know I'm not brave enough to bet against something (Bitcoin I'm talking about) that offers more solutions than problems.

James Gruber
November 24, 2022

Hi Dan, what everyday problems does Bitcoin solve? (genuine question)

Dan
November 25, 2022

I'm certainly no expert, others would be able to articulate this better than me.

The question is around the solutions (or benefits). Yes, there's downsides (physical loss - if held in cold storage and you lose your key and seed phrase, gone for good. Also lack of global acceptance).

But the upsides:
A) Decentralised money - fiat currency can be de-based whenever government decides to increase money supply. Bitcoin is decentralised. Could it face a "51% attack". Possible but highly improbable. Status quo (fiat and government control) greater risk.
B) Transparent but private to a degree. All transactions are on a blockchain. Totally transparent. Addresses are somewhat private but law enforcement can, and has, used it to track down illegal activity. Google the name Chris Janczewski to get started if interested.
C) Inflation. Bitcoin will ultimately be deflationary due to fix supply and halvings. Yes yes yes, at moment there is great volatility therefore use a means of "traditional" money becomes less likely. Many people smarter than me can demonstrate it's volatility is decreasing over time. Incidentally, it's volatility over last 30 days is less than S&P, but admittedly that's a short time period to extrapolate anything meaningful
D) International remittance. It's instantaneous (as opposed to waiting days) and comparatively cheap (circa 0.2-0.4%, compared to World Bank estimate of sending $200 which is 6.8%).
Given roughly 20% of the world's population is unbanked (hard to get an accurate figure), and this is mostly developing countries and majority women, who rely of remittances, having an "internet money" devoid from these issues could be helpful.

I'd welcome people who know the issue in more detail to either add to, or correct the above.

If people out there want to to troll and laugh go ahead. It's of not consequence to me. It's about respecting another's view, not belittling people.

Colin
November 26, 2022

Hi James

It's a bit worrying that you write in the space and can't answer this question. The technology stack continues to grow and with solutions to more problems emerging month by month.

The biggest and most obvious is the problem of currency debasemnet and the irresistible temptation for human beings to do this. The last 4 global reserve currencies have ended in spectacular busts. The $US is spiralling towards one now.

Next, bitcoin is a bearer asset with zero counter party risk (when you hold it yourself) that can provide worldwide *settlement* in under an hour. Those are theee things that have never been true before. Bitcoin provides the necessary velocity of money for current financial systems without debt.

It also creates a (broadly) deflationary asset for savings that does not require a pusuit of yield that is necessary in an inflationary economic system. This limits the ability of the SBFs of the world to gamble with other people's money because they don't have to park it in an institution to try and hold its value.

FTX is an example par excellance of the problems that Bitcoin solves. FTX had zero Bitcoin on its balance sheet. It had customers who thought they owned 90,000 BTC but who left their paper butcoin with a "trusted" third party. If they had used Bitcoin as it was intended and withdrawn their holdings they would have lost nothing in the collapse. In this case, Bitcoin is a solution that the users simply didn't understand. The equivalent to handing M-16s out to soldiers in the middle ages, only to have them charge into battle and start hitting people with them.

James Gruber
November 26, 2022

Hi Colin, it's interesting how you think that asking a question translates to ignorance of a topic.

What is surprising is that 14 years after Bitcoin was invented, and the hundreds of billions of dollars spent in the space, and the thousands of the best and brightest students who've worked in the sector, is how little progress has been made in providing everyday solutions to problems. Bitcoin and other acolytes appear to offer little improvement upon traditional forms of finance.

Now that could change, of course. But your case doesn't seem strong to this observer at least.

Colin
November 26, 2022

The fact that I gave you three direct examples of the problems Bitcoin solves and you responded with glib repetition of tired trad-fi talking points shows you know very little about the subject and much of what you do know is wrong. If you don't know monetary theory, you don't get bitcoin. If you dont understand global macro finance, and how broken it is then it is hardly surprising that you think you must be able to buy coffee with Bitcoin for it to be useful "every day".

The reason you can't see the solution is because you are blind to the problems. Bitcoin solves a number of systemic problems. By their nature, systemic problems are not typically understood by the components of the system (especially those benefitting from that system). They are generally treated as if that is "just how things are". As a beneficiary of relatively well regulated and stable financial system you don't see the point yet. When currency debasemnet reaches cisis point you probably will.

People in Argentina, Lebanon, Turkey and Nigeria see bitcoin in a way that you simply can't. There are billions of unbanked people in the world who are acquiring the ability to save. "I'm right thanks Jack" is not an argument that makes Bitcoin any less useful to them.

In any event, your supposedly good faith "genuine question" was clearly anything but. Ultimately I may be wrong about Bitcoin's evolution and trajectory. But me being potentially wrong in the future remains a vastly superior position to you being categorically wrong about it now.

Rose Baker
November 27, 2022

I'm not the type to get conned and when that happens I don't go down without a fight, but this time, they almost got away with it, but thanks to Adrian and his team for their intervention in getting me out of this mess of an investment. The basic truth about binary/crypto investments is the same old story, knowledge is key and information is power, those will never get old. I've had several specialists assist me in difficult situations, but this one was different. I gave them the information they needed, and they got to work promptly.
I must admit that they were quite helpful. I was able to contact this wonderful group of excellent recovery specialists using the email address (hack with adrian lamo At gmail com).

Economist
November 28, 2022

OK Colin, I'll take up the challenge.

You say: "The biggest and most obvious is the problem of currency debasemnet (sic) and the irresistible temptation for human beings to do this. The last 4 global reserve currencies have ended in spectacular busts. The $US is spiralling towards one now.''

I reply: what do you think you mean by this statement? To me it's one of those that proponents of Bitcoin keep arguing, but they don't usually know what currency debasement actually means nor how Bitcoin can actually avoid it. What currency debasement means is inflation. This is not the fault of the currency regime, but of monetary policy and fiscal policy acting together in the wrong ways at the wrong time. Bitcoin advocates try to say, 'but there will only ever be a limited number of Bitcoins mined so we can't have currency debasement'. OK, maybe, but of something becomes the 'reserve currency' that can't grow in number with the growth of the population and the economy then at the very least that will mean there is no more economic growth. Creates the opposite problem! And of course, for every Bitcoin there's a dozen or more other digital currencies come along, so here we go with the risk of excess money supply all over again.

You even say that Bitcoin will be deflationary, as if that's virtue! Deflation means recession, unemployment and poverty. Doesn't sound very attractive to me.

Further, please explain 'the last 4 reserve currencies' and their spectacular busts? Gold was the reserve, but it collapsed for very practical reasons, not debasement. And since then we've had the US dollar. Which hasn't collapsed. So please, an economic history lesson - with facts and evidence, not just bombastic assertions - would be appreciated.

You say: ''Next, bitcoin is a bearer asset with zero counter party risk (when you hold it yourself) that can provide worldwide *settlement* in under an hour. Those are theee things that have never been true before. Bitcoin provides the necessary velocity of money for current financial systems without debt.''

Um, a US dollar is a bearer asset with zero counter party risk too, and it can provide worldwide settlement in, oh, a couple of seconds (at least in countries that allow it). Please tell me more to try to convince me of the virtues of Bitcoin's contribution to monetary velocity.

Oh and back to my previous point, you need money supply growth to keep pace with economic growth. MV = PT and you are expecting Bitcoin to do an awful lot of heavy lifting via it's alleged V contribution.

I could quote more of your guff, but I think you get the drift of where my comments will go. You have given us nothing but the same sort of high sounding rhetoric that proponents of Bitcoin have always given us, but with no substance whatsoever. You are merely tapping into the irrational anti-vax type fear of those ''in authority'', which has always been based more in personal neuroses than any actual facts or understanding of how the global economic system works.

Digitalisation is here to stay and there is definitely a growing role in the world for blockchain technologies. But the role this plays will unfold in a sensible manner if the hyperbole of arguments like yours is ignored and the genuine usefulness of the technology can be allowed to become more appreciated.

Michael
November 23, 2022

Hi James,

Great article. From other news snippets I assumed that investors who used FTX as a mere platform to hold crypto also lost money. Was it only those who had invested in FTX as a company itself that lost money - or was it also investors who had crypto accounts with FTX? I understand FTX was an exchange. If I hold bank shares on the ASX exchange and the ASX collapsed I would still have my bank shares. Is that the case here with FTX investors? It would be great if you could clear up this confusion as I might not be the only one.

James Gruber
November 23, 2022

Michael, thanks for the query. The simple answer is that it's not only investors in FTX which have lost money. It's customers, up to 1 million of them, who've also lost money. What FTX suffered was akin to a run the bank. The reality is more complex. FTX, before its demise, was the world's 3rd largest crypto exchange. An exchange is normally a straight forward business. You have buyers and sellers of various crypto and the exchange takes a spread. And it holds assets on behalf of investors. Trouble can come though when an exchange makes loans, 'on margin' to customers, or lends out crypto tokens they hold on behalf of investors in exchange for collateral, such as cash or other tokens. It seems FTX lent customer deposits to its related firm Alameda by posting FTX tokens - which they created out of thin air - as collateral. When the value of FTX tokens fell in value, the company didn't have enough assets to cover all of the liabilities owed to its customers - and it escalated from there.

David Toohey
December 04, 2022

This sums up the big issue that is missing from so many discussions about FTX.

The FTX failure is not about crypto, but it seems that this is an opportunity for so many people with an axe to grind to get carried away. All the other major crypto exchanges are still running.

It's about fundamental safety of clients' deposits.

Everyone thought their money was safe, and was being held separate to the company's general funds, but that wasn't the case. Everyone expects that a broker can pay back 100% of clients' moneys if 100% of clients withdraw. It shouldn't be a "bank run" situation. It's a broker, not a bank.

Non-crypto brokers who've failed because of mismanaging clients' accounts in the way you describe include MF Global and Tricom, and others. So it's not about crypto.

Worse - as you mentioned - FTX was boosting its asset backing by writing itself IOUs. The value of which vanished when the "bank run" occurred, so a massive deficit suddenly appeared in the net assets.

APayne
November 23, 2022

Hahaha crypto was ALWAYS a joke. It has no value whatsoever and never, ever did. Yet, for years when I mentioned this at gatherings I would be shouted down and sneered at. For years I argued that blockchain technology and craptocurrency speculation need to be decloupled. I am now sneering at colleagues who - despite being warned - have dusted $'000s on this rubbish. Bill Gates' 'greater fool theory' comments were most apt. Now - we need to all agree that crypto is not actually an 'investment' at all. It does not warrant discussion or analysis in the same breath as equities, bonds or property (or even wine, cars or rare guitars!).

Shiraz
November 23, 2022

As Investor the first question I ask "Do I understand the Product" If NOT move ON.
Reading Balance Sheet and Due diligence can not help unless you know the Product.
Be aware of Invisible Seamless Complicated Investment Product.

AlanB
November 23, 2022

Cryptomania shows we have basically the same mentality that was evident in the speculative Tulipmania of the 1600s, South Sea Bubble of the 1700s and all other subsequent manias, scams and swindles. At least with tulips it was something real. With cryptomania speculators (not investors) pay extraordinary amounts for something that doesn't physically exist. Cryptocurrency is 'created' using computers to solve maths problems that generate 'digital' coins. The common factors of manias are greed, combined with debt, combined with faith in the promises of spruikers, plus the hope there is a greater fool willing to pay more than what you paid.
"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." 'Extraordinary Popular Delusions and the Madness of Crowds' (1841) by Charles Mackay. I can also recommend 'Manias, Panics and Crashes' by Charles Kindleberger.

Trevor G
November 24, 2022

It is slightly off topic but I reckon the whole net zero, climate emergency rush to shut down fossil fuel energy could fall into the "manias, scams and swindles" category. The net zero hype is based on climate modelling and the climate is too complicated to model. The climate has always been changing and it always will. Better to spend money on adapting to gradual climate change as required over time.

R. Gordon
November 24, 2022

Well said Trevor G. I have been saying much the same thing about climate change for years but no one is listening.

Anthony
November 25, 2022

You were correct to point out that the climate has always been changing. Were it to continue to change as it has always done, there would be time for humans to adapt to gradual climate change. The only adaptation we can do now is to quickly transition away from our use of fossil fuels.

Models of our climate from when the science was in its infancy have still been remarkably good at predicting our present climate. With many decades of improvement, vastly larger quantities of data and an exponential increase in computing power over the last 50 years or so, there is no reason to doubt that modelling of our future climate and the effect of changes in concentrations of greenhouse gases in our atmosphere would be anything short of remarkably accurate.

You seem to appreciate many of the complexities of modelling our climate. It's natural to be sceptic too, as even meteorology can be fallible sometimes, yet it's a brave man who plans a company picnic for a day when an 80% chance of hail storms is predicted.

Climate modelling is related to meteorology in some respects. Both rely on collection of vast amounts of information about the past to predict the future. Once sufficient data is available, it's actually simpler to predict climate than weather, particularly over a longer term and when the models don't attempt to predict localised conditions.

One of the most challenging issues in climate modelling is not so much the prediction of how changes in the composition of atmospheric greenhouse gases would impact our climate, but in identifying the sources of those gases and how those sources might vary over time.

You also pointed out that we understand the climate has always been changing. We have an incredible amount of data on historical climate change, collected and tallied over the past century through methods such as drilling and analysing ice cores from the Antarctic. The science of climate modelling has been matured and been refined. As more data and more processing power becomes available, exponential increases in computing power and the constant accumulation of new data have not only seen climate models become remarkably accurate but they will continue to become even more accurate over time.

If the climate were changing at a historical rate, most would accept your argument that we might better spend money on adapting to gradual climate change as required. Sadly, our is changing at a much faster rathe than ever before, accelerating so much that merely adapting is akin to waiting until an accident is about to occur before putting on a seatbelt. There just isn't time.

I think everyone agrees the climate is warming much faster than at any other period in the geographical historical record of our planet. What is disputed, now by an vanishingly small minority, is whether human fossil fuel usage is causing or exacerbating the vastly increased rate of change of our climate.

If we could, I expect we'd all insure against the possibility of a catastrophe loss, no matter how small the chance. If you believe there is even a small chance that our use of fossil fuels is causing or exacerbating the historically rapid warming of our climate, it would be madness not to insure against it. The cost of such insurance is a transition to green energy and the adoption of a healthier lifestyle.

Due diligence has been done on climate science, their predictions vetted and their books pored over by all.

The only scams are a long history of deliberate misinformation, campaigns by those with vested interests in the continued use of fossil fuels.

Trevor G
November 25, 2022

Hi Anthony,
Here is an interesting article about Climate modelling.

https://quadrant.org.au/opinion/doomed-planet/2022/10/garbage-in-climate-science-out/

Keith
November 23, 2022

Due diligence…..why some people can so easily be caught up in the latest “thing”. I suppose it’s the FOMO fear of missing out.
How often have you heard….. “ I should have bought Amazon , Apple , Alibaba, etc when they listed”. Bitcoin……could have bought for peanuts & sold for AUD$80k plus
We see stories of pimply faced nerds in hoodies & sandals becoming Billionaires overnight.
Greed & opportunism distort the judgement of supposedly well educated Wall Street cowboys who in their publications sprout their experience & integrity as investors.
Funny thing is……often the money you “might” get , you’ll probably never really need .

Jerome Lander
November 23, 2022

One of the lessons is that many venture capital and private equity and even pension fund investors are investing in stories and hype, hoping to catch the next big thing. One of these investors has even been reported as outsourcing their "due diligence" altogether to another firm (wasn't that their job?), another as being impressed that the CEO was playing video games when they met with him! This is a reflection of the easy money days created by central banks and prevailing over previous years, and quite obviously these investors are unlikely to do well in changed circumstances as the cycle unravels. As a general rule locking up your money for 10 years is simply too long and not a great idea and simply not worth the risk because even if you found out your manager was a drug addict through monitoring, it probably wouldn't help you much. There are many more frauds which will likely unravel in the coming year unfortunately as we move into a earnings recession in major economies and the free cash diminishes further. It helps to recognise this risk is real when investing and invest with those who are open about this risk and how to reduce it drastically damaging investment returns, including through diversification and reduced exposure to high risk areas such as venture capital and other known problematic investment arenas. The investment environment and world has changed and the potential reward for being a rampant risk taker and gambler - which may or may not work in a bull market - is no longer there to the same degree. Many have still not recognised this and are seeing their investors suffer for it heavily already in 2022 as they continue to sell hope and hype. You could argue it is much better to recognise this yourself and move away from the spin and unrealistic hope to something more conscious of the world's reality. Investing with meth addicted 20odd year olds and those who invest in them isn't the way to go!

Steven
November 23, 2022

FTX & FTT tokens were Ponzi schemes, brilliantly conceived aimed directly at idiots and the greedy. The FTT token had zero value, the value was created in the magical world of “value perception” starting @0.5c & running to $US85.00. Around $1.4 TRILLION has been lost in Crypto since the $US70k high of Bitcoin. Capital theory in similar form has been around for ever, so has stupidity & greed.

 

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