The FTX downfall: A crypto problem, or a greed problem?

Signage for FTX Arena, home of the NBA's Miami Heat basketball team. Photo / AP

OPINION:

Two weeks ago, the investment world was shocked when FTX, one of the largest and supposedly most credible crypto exchanges in the world, effectively announced that it was insolvent and they were trying to piece together a rescue deal.

This was a massive fall from grace for the founder and previous CEO Sam Bankman-Fried, or SBF as he is referred to on Twitter. Only months earlier he was worth an estimated $17 billion, was a constant presence in Washington, and was being referred to as the modern-day equivalent of J Pierment Morgan – a saviour of the US Banking system in the early 1900′s. Now, SBF has lost much of his fortune and is under investigation by multiple regulators – there is a high chance he will end up facing criminal charges.

The past year has been annus horribilis for the global markets, rising interest rates have driven a repricing of risk across the board. The price of Bitcoin has fallen by over 75 per cent from its October highs. A sharp reversal of the past two years when prices rose almost 1700 per cent from the March 2020 lows and as the famous investor Warren Buffet is famous for saying, “When the tide goes out, you see who is swimming naked.”

The rapid fall in the price of Bitcoin has resulted in the spectacular collapse of a number of cryptocurrency-related businesses. All of the failures have one or more of the following red flags in common – excessive leverage, a complete lack of controls and/or a promise that had no way of being delivered. FTX was the latest, and arguably, most spectacular of these failures.

Over the past three to five years crypto trading has morphed from a relatively simple transactional world where the complexity was handled on the Blockchain to a highly complex transactional world dominated by derivatives and leverage. The new normal has included highly leveraged crypto hedge funds, margin trading, remarkable guaranteed returns on “safe investments” and the assurance of alternative coins that did not promise to do anything special. These can be great get-rich-quick products in a rising market but when the tide goes out chaos ensues as prices fall.

Cryptocurrencies were designed to be utility assets to enable payments, smart contracts rather than tools of financial speculation. And we have seen that with the development of smart contracts and Stable Coins using the Ethereum and Avalanche networks and payment systems emerging using Bitcoin. The blockchain technology that they were built upon was designed to make the financial system more transparent, less centralised, more resilient, and lower cost.

The trading systems for cryptocurrencies have become defined by greed and get-rich-quick schemes rather than the utility purposes that are at the core of the underlying cryptocurrencies. Rather than delivering an improved financial ecosystem they have focused on building highly speculative, unregulated and complex financial products most of which relied on the price of cryptocurrencies to keep on rising forever. All of this brings us back to FTX.

FTX was a crypto exchange founded in the Bahamas in May 2019 offering highly complex derivatives and margin products to retail investors without any systems or controls in place to manage those products. The exchange itself was created to enable the founder’s hedge fund, Alameda Research, to trade around the world and take advantage of arbitrage opportunities across different exchanges (a warning sign in itself).

What is clear is that this high-tech exchange run by a group of wonderkids on bean bags was instead a stack of cards being run by a group of kids with no adult supervision. It has been alleged that FTX was using client funds to funnel client cash to their own hedge fund and making loans worth hundreds of millions of dollars to its staff. It has been alleged FTX was spending billions of dollars a year on endorsements, sponsorship and stadium deals and political donations to win the credibility argument and conceal what was happening behind the scenes.

In a typical investment process, funds will do months of diligence and review processes and financials before investing in a company. It is difficult to see how this happened with FTX, as some of the largest and most reputable venture capital firms in the world were investing. In coming months difficult conversations will be had with their underlying investors.

Many commentators and cynics have called this the end of crypto. They see the FTX saga as the final nail in the coffin for crypto with rhetoric that trust has been broken. I hope this is not the case because these problems are not the problems of cryptocurrencies or the blockchain technologies that they have developed.

In my opinion, these crises are the result of a shoddy and unregulated financial system built on top of the cryptocurrencies that focused on greed and financial engineering rather than helping crypto currencies achieve their underlying objectives. This is very typical human behaviour, but regulators should never have let this happen and needed to step in.

The next generation of crypto businesses (and they will come) need to learn from these challenges and refocus on utility and away from greed and complex financial products. They will need to take learnings from the traditional finance world rather than thinking that the normal rules don’t apply to them. As catastrophic as it may seem, the crypto industry will also need to realise that cryptocurrencies need regulation to regain the trust and investment that will allow them to flourish.

• Rupert Carlyon is the managing director and founder of kōura Wealth Limited.

Disclaimer: kōura Wealth Limited is an innovative manager of the kōura Wealth KiwiSaver scheme, which launched New Zealand’s only Cryptocurrency KiwiSaver fund.