Market insights and analysis

By Will Hubbard

Last week was a wild ride in cryptocurrency land. On November 4, the largest and most well-known proxy for the cryptocurrency space, bitcoin, traded around $21,130 USD per bitcoin. By Monday morning, it was trading below $16,000, a drop of nearly 25%.

This drop came as the industry was in an uproar over the collapse of one of the largest crypto-trading exchanges in existence: FTX.

This week, we will review the timeline of events leading to FTX’s implosion, the warning signs, and why risk management is so critical to investment success in times like these. As Warren Buffet says, “Only when the tide goes out do you discover who’s been swimming naked.”

The rise of FTX

At the center of the fiasco is Sam Bankman-Fried, the co-founder of cryptocurrency exchange FTX and the crypto-trading hedge fund Alameda Research. Frustrated with the crypto exchanges available at the time, Bankman-Fried launched FTX in May 2019. FTX grew to become the third-largest crypto exchange in the world with nearly $16 billion of assets. The ascent of Bankman-Fried and the “crypto craze” helped the valuation of FTX skyrocket to $32 billion after raising $400 million from multinational conglomerate SoftBank earlier this year.

Bankman-Fried was a highly regarded and well-known proponent of the crypto community, regularly seen at different conferences speaking on behalf of the industry. He also donated and lobbied heavily in the political arena, donating over $35 million to liberals and $155,000 to conservatives in 2022 alone. This helped to cement his altruistic persona as one of the most prominent in the cryptocurrency world.

Last week, all of that changed in an instant when FTX suspended customer withdrawals.

Red flags

On November 8, Changpeng Zhao, CEO of the largest cryptocurrency exchange, Binance, posted on Twitter that FTX had asked for help and a letter of intent had been signed to acquire the firm after Bankman-Fried tweeted on November 7 that FTX’s assets were “fine.”

This was a huge “woah” moment for investors in the crypto community. As the acquisition was announced, bitcoin began to stumble, and people started to inquire about what was happening at FTX.

Looking back, there were warning signs.

In mid-October, Keith McCullough, CEO of HedgeEye, interviewed short-seller Marc Cohodes, who called FTX a scam that was “dirty and rotten to the core.” The associated video is a scathing summary of why. The language is not family-friendly, but it effectively conveys his concerns.

On November 2, CoinDesk published a report that cited concerns about the balance sheet of FTX’s sister company, the trading firm Alameda Research. The report revealed that a massive allocation of Alameda Research’s assets is in FTX’s digital token FTT. FTX was issuing cryptocurrency and sending it to its sister company. “It’s fascinating to see that the majority of the net equity in the Alameda business is actually FTX’s own centrally controlled and printed-out-of-thin-air token,” said Cory Klippsten, CEO of investment platform Swan Bitcoin via the CoinDesk report.  

“That was a red flag for investors, as the companies were, on paper at least, separate,” reports CNN. “On Sunday [November 6], the CEO of Binance, FTX’s much larger rival, said his company was liquidating $580 million worth of FTX holdings. That set off a firestorm of draw downs that FTX didn’t have the cash to facilitate.”

This triggered the events that led to FTX reaching out to Binance.

Countdown to the end

With the tweet from Binance on November 8, it seemed like FTX might avert a crisis.

But the following day, November 9, Binance tweeted, “As a result of corporate due diligence, as well as the latest news reports regarding mishandled customer funds and alleged US agency investigations, we have decided that we will not pursue the potential acquisition of FTX.com.”

The thread continues, “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.”

On November 10, the Securities Commission of the Bahamas froze FTX’s assets and appointed a provisional liquidator. On November 11, FTX filed for bankruptcy protection.

Bitcoin fell 25%, and some cryptocurrencies are much worse off. FTX, worth $32 billion in January, may now effectively be worth a goose egg. For those paying attention, it may have been possible for the crisis to have been averted. Reports from CoinDesk and Mr. Cohodes suggest to us that the tide was going out and it looked like someone was indeed found to be naked.

There will likely be lawsuits over how to divvy up whatever is left of FTX, but the big question being asked by many going forward is, “Will there be criminal charges against Bankman-Fried?” Only time will tell.

What’s the lesson? Always put risk management first.

So, what can investors learn from the story of the collapse of the third-largest cryptocurrency exchange?

The current environment reminds me of the 2007–2009 financial crisis. I remember getting my feet wet in the investment landscape, watching Jim Cramer on Mad Money explain why Bear Sterns was “fine” on March 11, 2008. Then on March 16, the media reported that the 85-year-old investment bank was sold to J.P. Morgan for $2 per share. I was confused. Why did this happen? How did someone who should have known better miss this?

This preceded the collapse of Lehman Brothers by six months (September 15), during which time the S&P 500 was essentially flat. The very public failure of Bear Stearns was followed by general complacency in the market. It wasn’t until Lehman fell that investors snapped to attention and realized the housing slowdown was a full-blown crisis.

Using the S&P 500, as represented by the SPY ETF, we can see that the 2008 “summer of complacency” was coming off the 2007 highs, and the market was trading in a “risk off” stance based on the old rule, “If the 50-day moving average (blue line) is below the 200-day moving average (red line), sell. If it’s above, be long.” In other words, a “death cross” pattern had already occurred.

The technical, or price action, was suggesting that investors should be more defensive going into the summer and fall. Much of the media at the time, however, made it sound like the issues with housing would be contained to the sector and not spill over.

Shortly after the collapse of Lehman, surprise! It was “risk off,” and the Great Recession ensued. A little risk management (like the 50-day/200-day moving-average momentum strategy) would have gone a long way in protecting investors in 2008.

In 2008, troubled banks were weeded out by regulation, bailouts, and acquisitions. The process of weeding out bad housing loans and bad banks was expected to be relatively contained. When it wasn’t, it was a disaster for the economy.

The world is vastly different than it was 14 years ago, but there is an eerie similarity about where we are. Sticking to a risk-managed investment plan can be hard, especially in volatile times when fear makes us want to act. But managing risk and the downside is the key to successful investing in the long run.

If weeding out the “bad eggs” in the crypto space requires some juggling and volatility, then that’s fine for now. Hopefully, the nascent industry is small enough that there is little potential for global contagion. I’m not sure, but we will approach the coming quarters with hope, optimism, and a focus on risk management. And when the tide inevitably goes out again, we’ll have our suits on!