Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Extraordinary popular delusions, 2022 edition: FTX

“Money, again, has often been a cause of the delusion of the multitudes. Sober nations have all at once become desperate gamblers and risked almost their existence upon the turn of a piece of paper.” – Charles MacKay, Extraordinary Delusions and the Madness of Crowds, 1841

The spectacular implosion of the FTX cryptocurrency exchange adds one more case study to the extensive library of investment bubbles and human psychology. Sam Bankman-Fried, a quirky 30-year-old wunderkind from Berkely, caught a wave and rode it to a $20 billion fortune before inevitably crashing on the rocks and possibly facing jail time. It turns out mom was right: if it sounds too good to be true…

Mr. Bankman-Fried, son of two Stanford University law professors, started a hedge fund called Alameda Research in 2017 to make risky bets on cryptocurrency. He moved the firm to Hong Kong in 2019 to avoid US regulation and then founded a cryptocurrency exchange named FTX. 

Although Alameda and FTX were supposedly separate entities, they were far from independent. The firms moved to the Bahamas in 2021 seeking an even more permissive regulatory climate. Both occupied headquarters in the same $40 million waterfront penthouse, and the person Mr. Bankman-Fried hired as CEO of Alameda, Caroline Ellison, shared his residence as well as a romantic relationship. But the ties went much deeper. 

Alameda traded heavily on the FTX platform but was not subject to the same rules as every other customer. The hedge fund had a secret exemption from risk controls like margin calls, allowing it to place exceedingly risky trades. And while most borrowers would be required to post legitimate collateral, Alameda borrowed against home-made Monopoly money: FTX’s own cryptocurrency called FTT, the value of which was essentially determined by FTX decree. Imagine writing “$500 thousand” on a cocktail napkin and handing it to your banker as collateral for your mortgage. Only works if you also own the bank.

Inevitably, Alameda’s risky bets blew up, and SBF absconded with billions of dollars in FTX customer’s money to prop up the failing firm. A November 8 exposé in a trade publication blew the lid off the scam and triggered mass customer exodus, leaving an $8 billion hole in the balance sheet. A November 11 bankruptcy filing tied a ribbon on the biggest fraud since Bernie Madoff. Barely a week into his role as court-appointed receiver, new CEO John J. Ray discovered purchases of homes for employees, emails that automatically self-delete, and approval of corporate expenditures by text emojis. “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information” he declared. Mr. Ray’s lengthy resume includes cleaning up the Enron mess.

How did the disheveled frat boy sucker so many sophisticated investors into backing his ephemeral empire? This is an uncomfortable question several institutions are currently struggling to answer and a reminder that that even professionals fall victim to the same emotional and psychological biases that plague individual investors. SBF carefully cultivated a bogus image as an ascetic visionary whose life mission was philanthropy. His countercultural eccentricities and cryptically oracular pronouncements were accepted as evidence of his inscrutable genius. Media outlets gushed fawning publicity, comparing him to J.P. Morgan and other legendary financiers. Fortune magazine published a cover story declaring SBF the next Warren Buffet.

One fund, Sequoia Capital, invested over $200 million even though Bankman-Fried fiddled with a fidget spinner and played video games during his Zoom call with investors, but they were hardly alone. SoftBank, BlackRock, and the sovereign wealth fund of Singapore fell victim as did the Ontario Teachers’ Pension Fund, which sank $95 billion into FTX. Perhaps most embarrassing, investor Kevin O’Leary of Shark Tank fame was both an investor in FTX and a paid spokesman for the scheme and cleverly insisted on being compensated in cryptocurrency. After an exhaustive search, he says, FTX was the only exchange that “met my own rigorous standards of compliance.” Still, hope springs eternal as O’Leary still considers SBF to be “a savant” and insists he would invest with him again.

But these embarrassing lapses in due diligence represent relatively small proportionate losses to big institutions. More troubling is the extent to which FTX enticed over a million individuals with little or no understanding into funding SBF’s Bahamian paradise. The company lavished a fortune on promotion, including naming rights and PR deals with major league sports, generous political contributions, and friendly media coverage. Celebrity endorsements from Tom Brady, Stephen Curry, and David Ortiz likely breached securities laws against dispensing investment advice without proper registration and are likely to provide holiday cheer for a host of lawyers. And predictably, many of the most vociferous opponents of regulation are now demanding to know why the government didn’t step in to rescue them.

Authorities from the US Justice Department, SEC, and CFTC, as well as the Bahamas and Turkey are now investigating potential fraud. The US has an extradition treaty with the Bahamas so the video game savant should eventually find his way into the US justice system. But the most fascinating aspect of the entire charade is just how immutable human nature proves to be. “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.” – Charles MacKay

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