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The Fallout of FTX in the Cryptocurrency Universe

Warren Buffet warned us: “A rising tide floats all boats.  Only when the tide goes out do you discover who has been swimming naked.”


The Oracle of Omaha made this comment in 1992, in the aftermath of Hurricane Andrew, regarding the insurance business, and how “good times” can mask excessive risk-taking until they inevitably end.  Category 5 hurricanes hitting landfall in the U.S. are a rare event; only four have ever happened in recorded history.  Before Andrew, the last massive hurricane to make landfall was way back in 1935.  The lull led to many insurance companies developing a false sense of security about the risks posed by these storms.  When Andrew hit South Florida, the estimated $27 billion (in 1992 dollars) dwarfed the monetary damages caused by any previous hurricane.  At least 16 insurance companies were caught “swimming naked,” and became insolvent from their Andrew-related losses.


When conditions go south, whether caused by natural disasters or other factors, those who behaved recklessly often find themselves exposed to financial trouble.  This year has been notable for the monetary policy tightening adopted by the Federal Reserve to fight inflation.  As painful as they may be for legitimate investors, sharply higher interest rates have been flushing excesses in the market and the bad actors that are involved.  The tide is going out again.


Massive volatility has hit the digital asset (cryptocurrency) market this week.  At the heart of the meltdown is FTX, the second-largest exchange for crypto trading.  FTX is led by founder Sam Bankman-Fried and has enjoyed a rather clean reputation as one of the stronger players in crypto.  A frequent visitor to Capitol Hill testifying before Congress, Bankman-Fried established himself as one of the most prominent representatives of the industry.  Over the summer, as several major industry players collapsed, it was Bankman-Fried who stepped in and saved many crypto projects with large, last-minute investments.


Unfortunately, it appears that Bankman-Fried has not been wearing his swim trunks. The past few days have seen Bahamas-based FTX suffering the equivalent of a bank run, after information surfaced revealing that the balance sheet of market maker Alameda Research, a sister firm also founded by Bankman-Fried, was largely comprised of FTT, a relatively illiquid digital token created and issued by FTX. A major conflict of interest was obvious.


Significant anxiety surfaced among crypto investors over the extent and nature of the fraternal dealings between the two firms.  In a bid to prop up his trading firm, Sam Bankman-Fried reportedly loaned it billions of dollars from his FTX platform, compromising the value of FTX account holders.  The price of FTT collapsed, prompting a massive exodus of assets at FTX, as customers raced to withdraw funds from the exchange amid speculation that the company faced trouble from mounting losses at Alameda.


The resulting liquidity crush has created solvency risk for FTX.  The fallout is also attracting investigations from the Securities and Exchange Commission and Department of Justice.  Hopes of a rescue by industry rival Binance – announced Tuesday – all but faded after that company said it is pulling out of any rescue acquisition after just one day of due diligence.


This latest knock to crypto’s stability hit an industry that was already struggling.  This is not the first crypto firm or currency to fail, and it will not be the last.  FTX was long considered as one of the stronger players in the space, and they collapsed in less than a week, revealing just how fragile and unpredictable the crypto ecosystem remains.


Unlike other assets traded on the public market, digital currency does not adhere to any rules established by government authorities.  Indeed, crypto’s “freedom” from regulation and oversight is one of its prime appeals to its believers. The absence of regulation and the lack of transparency means that the legitimacy of cryptocurrencies as an investable asset remains deeply problematic. Crypto has proved itself to be neither an inflation hedge, store of value, nor uncorrelated asset to public market securities, while the collapse of FTX as an exchange serves as the latest reminder of the “Wild West” nature of the overall crypto market.


At Ascent, we owe a fiduciary duty to our clients to invest in what we know and believe in, while placing our clients’ interests first—always. We invest in securities with established track records that are subject to laws and regulations meant to safeguard investors.  We will never invest in mere “shiny objects,” of which crypto is simply one of the latest in a story as old as humanity itself.