The fall of FTX (Futures Exchange) serves as a cautionary tale. From its meteoric rise to its swift descent into insolvency, FTX’s journey offers us valuable insights into the world of cryptocurrency, corporate governance, and investment decision-making. The lessons learned can be applied to broker-dealers, RIAs, and any regulated entity. As history has taught us, sometimes the blocking and tackling involved in creating appropriate risk controls is what sets firms apart.
The Rise and Fall of FTX
Founded in 2019 by Sam Bankman-Fried, a former Wall Street trader, and Gary Wang, a former Google programmer, FTX rapidly grew to become one of the largest cryptocurrency exchanges. By 2021, FTX had more than one million users and was the third-largest cryptocurrency exchange by volume. Alongside the exchange, FTX also operated a crypto hedge fund, which appeared prosperous even amid a bear market.
During its prime, FTX attracted significant funding from high-profile investors like Sequoia Capital, Dan Loeb’s Third Point, Paradigm, Thoma Bravo, Softbank, Tiger Global Management, and New Enterprise Associates. In 2021, FTX raised a $900 million funding round and was valued at $18 billion. However, the seemingly invincible financial titan was soon to face an unprecedented downfall.
In November 2022, a news article was published that raised public concern about FTX’s financial stability. This article referred to FTX’s sister hedge fund, Alameda Research, possessing an excessive amount of FTT (tokens issued by FTX). This revelation triggered a mass withdrawal from FTX, and within three days, traders had withdrawn $6 billion from the platform. Unable to meet this demand, FTX filed for bankruptcy on November 11, 2022. Bankman-Fried was later arrested, and criminal and civil complaints were filed by the U.S. Department of Justice, the SEC, and the CFTC.
Key Lessons from the FTX Collapse
The collapse of FTX offers several crucial lessons.
Advertising and Marketing
Crypto firms’ extensive marketing and advertising efforts, including high-profile placements such as Super Bowl ads and stadium sponsorships, attracted the intertest of regulators. FINRA recently conducted a sweep examination of crypto firms’ advertising practices, revealing potential violations of FINRA Rule 2210 in over 70% of the 500 advertisements reviewed. These violations encompass several key areas:
- Failure to clearly distinguish between crypto assets
- False Statements Regarding Functionality
- General Misleading Statements
- Unclear Explanations of Crypto Assets
- Omission of Clear Explanations
- Misrepresentation of Protections
- Misleading Statements About Protections.
These findings raise concerns about the accuracy and transparency of crypto-related advertising, prompting firms to consider revising their communication practices to ensure compliance with regulatory obligations.
The Inherent Volatility of Cryptocurrency
The hype surrounding cryptocurrencies often overlooks their inherent flaws. Although cryptocurrencies integrate game theory, economic incentives, cryptography, and information systems, they frequently fail to fulfill the basic functions of currency effectively. Any investor in the crypto market must be aware of the risks involved. While FTX dealt with crypto, an asset class known to by highly volatile, there are many “traditional” financial products that can certainly be as volatile as crypto. The key here is to ensure that your due diligence process thoroughly reviews the risks of any products being considered.
The Significance of Good Corporate Governance. Proper corporate governance is vital in ensuring that a corporation’s capital is wisely managed and that investors receive a return on their investment. In the case of FTX, the failure of sound corporate governance expedited its downfall. The company’s board of directors consisted of only two members, and it failed to maintain complete records of bank accounts or employee records. Consequently, at the time of bankruptcy, it was unclear where all the company’s assets were located and who was an employee versus an outside contractor.
Compliance is all about the tone from the top. Frequent and transparent dialogue with a firm’s business leaders helps ensure that the firm is reviewing its risks from multiple perspectives.
The Importance of Due Diligence for Large Investors
Despite the apparent red flags, many experienced investors invested in FTX. This scenario underscores the importance of due diligence. Even sophisticated investors can fall prey to the bandwagon effect, where they fear missing out on the next big thing. However, as demonstrated by FTX’s collapse, following the herd can lead to bad investments.
The Need for Individual Investor Caution
Many FTX customers lost money in the collapse. Individual investors must understand that large investors have made poor bets in the past, and they will do so in the future. Firm size or celebrity should not be a determining factor in deciding whom to follow.
The Role of Regulation in the Crypto Industry
There is an ongoing debate about whether federal regulators should regulate the cryptocurrency industry more stringently. While too much regulation can backfire, some degree of regulation can benefit cryptocurrency firms by helping them with risk management. However, investors should not rely too heavily on regulators, as there are simply too many companies to regulate and not enough resources. It is often an auditor, investigative journalist, internal whistleblower, or outside watchdog who first sounds the alarm.
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