Investing Lessons from FTX Collapse
What key lessons can we take away from the collapse of the cryptocurrency exchange, FTX, and apply in the way that we select investments, manage our portfolios and approach personal finance in general?
Let’s start with some background
FTX is a Bahamas-based exchange for cryptocurrency. The company was founded in 2019, and CEO Sam Bankman-Friend was just 28 years old at the time. At its peak, it was the third large exchange in terms of volume traded with over one million users in 2021. The exchange provided volatility products, options, leveraged tokens, and a spot market for over 300 different trading pairs, including BTC / USD. It also had its own native token, FTT.
FTX was incorporated in Antigua and Barbuda and relocated its headquarters from Hong Kong to the Bahamas in 2021. FTT is the native token on the platform, and this was largely held by traders and investors to cover aspects such as transaction fees, and the platform offered discounts on trading fees based on the amount of FTT tokens that the account owner held.
The pathway to bankruptcy
For reasons that will be uncovered in the current investigations, FTX, in addition to a number of Sam Bankman-Fried’s other entities filed for Chapter 11 bankruptcy on 11 November 2022. This saw the then CEO, Sam’s, net worth plummet from approximately $16 billion to $0 based on reported figures.
There were a number of possible reasons already highlighted here, from a separate entity controlled by Sam Bankman-Friend, Alameda Research, which held over $5 billion in FTT tokens and had allegedly received a large quantum of funds from FTX to finance risky trades, to Binance announcing that they would liquidate approximately $529 million worth of FTT tokens, which they announced on 6 November. Ultimately, these announcements led to a liquidity crisis with investors seeking to pull billions of their funds out of their FTX accounts, which couldn’t be funded by the company as they did not hold enough cash on hand to cover the withdrawals.
What are the key takeaway lessons
Given the brief background of what transpired by Sam, FTX, and the cryptocurrency industry in general, what can we as investors take away as key lessons from this? Outlined below are our top insights:
- Stay in your circle of competence
A key lesson from a world-famous investor, Warren Buffett, is to stay within your circle of competence when it comes to investing. By this, he is referring to the fact that you should only invest in a business, industry, or market that you understand and could explain to someone else if asked. If you don’t understand what you’re investing in, then chances are you perhaps shouldn’t be exposing your personal finances to it.
This doesn’t mean that you need to understand the components of a Lithium-Ion battery, but you should understand their use and the basis that forms your investment hypothesis in the industry. If you were investing in the Australian banking sector, for example, it would be sensible to understand how a bank generates its revenue and the key risks that could impact its profitability.
- Be mindful of your asset allocation
When it comes to alternative assets, such as cryptocurrency, private equity, or other non-Mark to Market (MTM) assets, it’s a sensible idea to have a cap on the total amount of exposure that you wish to have to this area. This may be 5 – 10% of your personal balance sheet for example to allow for the added risk and reduced liquidity that you’re exposing yourself to.
This also highlights the fact that you should review your asset allocation on a regular basis, at least once or twice per year. As asset classes will perform differently over time, you may find that you’re taking on too much or too little risk over time based on your financial objectives.
- If it sounds too good to be true…RUN!
Any promise of excessive returns without commensurate risk should be a red flag to any investor, and any guarantee of similar should be where you decide to leave the conversation and walk away. This does not mean that excessive returns can not be generated, but rather that they come with a higher degree of risk, in most cases than lower expected return alternatives.
- Is the investment regulated, and if so, where..?
It’s important to review where the investment, or the Adviser for that matter, is regulated and authorised to provide advice. In some cases, such as is often the case with many cryptocurrency investments, there is no regulator to provide oversight for the speculative investments, and as such investors can wind up taking on far more risk than they may realise.
It’s also important to consider where the Financial Adviser is regulated, and ensure that you’re comfortable with that jurisdiction. In the case of Ally Wealth Management, we operate in the regulatory environment of Australia with the oversight of The Australian Securities and Investments Commission (ASIC), with a very robust regulatory framework.
In the case of FTX, being regulated in the Bahamas may not provide most investors with the same degree of comfort.
- Understand the true meaning of diversification
It’s important to recognise that diversification is much more than holding two or three different cryptocurrencies. This means spreading your investments across different asset classes, countries, regions, styles of investment, currencies, and as a result, risk factors. This approach has stood the test of time, and naturally reduces the investor’s exposure to such risks as changing regulations and tax rules, which can have a significant impact, particularly on Australian expats.
It’s sensible to review your diversification and asset allocation on a regular basis, to identify any shortfalls or ‘overweight’ exposures that you may not have been aware of.
We look forward to seeing the FTX / SBF story unfold, and the investigations reveal the many drivers behind the events of November 2022.
Ally Wealth Management is the trusted ally in finance for Australians at home and across the globe. As both Australian expats and residents, the founders of Ally have a unique understanding of the common personal financial challenges faced.
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General Advice Warning: The information contained herein is of a general nature only and does not constitute personal advice. You should not act on any recommendation without considering your personal needs, circumstances, and objectives. We recommend you obtain professional financial advice specific to your circumstances.
