What equity investors can learn from the collapse of FTX

"You don't get into a situation like I got in if you make all the right decisions." - Sam Bankman-Fried, founder and CEO of FTX.

While schadenfreude is an unappealing trait, I can’t help but feel some as the crypto world collapses. The past few months have been highly entertaining, including quotes like the above from Sam Bankman-Fried (colloquially known as SBF).

But there are important lessons for all investors in the collapse of the SBF cult. Some of them us traditional finance types learned many decades ago.

If you are unfamiliar with the FTX saga, it is important first to understand what FTX is, or was. FTX acted as custodian, broker and hedge fund for cryptocurrency “investors”. It was as if the New York Stock Exchange, a Goldman Sachs hedge fund and JP Morgan Custody were wrapped into one. The saga unfolded when customers holding their crypto assets with the custodian wanted to retrieve their "assets" back from FTX. Customers discovered that FTX had lent billions of dollars worth of crypto assets to Alameda Research, a related quantitative cryptocurrency trading firm, and Alameda had lost it. As a consequence, FTX, and its $10 bn 'worth' of crypto assets, fell apart.

Don't succumb to FOMO

The first lesson is, don’t blindly follow anyone, no matter how well-regarded they are. FTX’s own investors included a number of high-profile venture capital firms - including Sequoia, perhaps the most successful venture capital manager in the world. Politicians sang the praises of the exchange and the inexperienced 20-something-year-olds running the show.

It is all easy with the benefit of hindsight, of course, but it is hard to comprehend the confidence when you watch old interviews with key personnel.

"You absolutely could pull it off without my maths degree. I use a lot of elementary school maths." - Caroline Ellison, CEO of Alameda Research

It shows that even some of the best and most experienced investors in the world can succumb to the phenomenon of FOMO. And there appears to be a domino effect, where it only takes one prominent investor to come on board, and everyone else follows suit.

Americans seem to have a particular penchant for non-conforming superstars. Most notably, Elizabeth Holmes, the founder of Theranos and Adam Neuman, the co-founder of WeWork. Plenty of outrageously successful businesses have been built by misfits but so, too, are many of the frauds.

Unregulated is dangerous for the average investor

The second lesson is that many of the frictions and frustrations with traditional financial markets are there for a reason - your protection.

Segregation of assets, regulation of key players, capital requirements. All of these things are frustrating, can stifle innovation and be expensive, but they are there because exactly the same thing that happened to FTX happened to the traditional finance system decades ago. And much of the trust essential to a functioning financial system is a direct result of the regulation in place.

Some crypto advocates will argue that FTX being a centralised exchange goes against the principles of the crypto world and should, therefore, not be a criticism of crypto. The reality is that the widespread adoption of any technology requires ease of accessibility and simplicity. Expecting the average mom-and-dad investor to store their BHP shares on a USB stick severely restricts the number of people who will use the technology. In many use cases, centralised exchanges are far more useful than a decentralised alternative.

As a side note, it is still essential that investors do not blindly trust that the traditional finance system works. Even small risks are worth checking on. Before making any investment or signing up with an online broker, it is worth checking if the fund you are investing in is registered with ASIC, if your advisor has the licence they claim to have and that your assets are appropriately segregated with a reputable custodian.

Recognising that the rules are there for a reason is important, but this does not mean that everyone follows them.

Instruments of speculation

The final lesson is simply a reiteration of what I have been saying for years: these digital tokens are not investments. You can buy shares in a business that pays you dividends over time. You can buy government bonds that pay you interest. You can own an investment property that pays you rent. Those are all investments.

Buying some digital token that you are hoping to flip for a higher price is gambling, plain and simple. The whole crypto space is one giant casino and there are plenty of SBFs out there willing to take your real money off your hands.

If that’s what you want to do with your money, go for it. Just don’t pretend it is “investing”.

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