What Happened with FTX?

12/20/2022 - By Mark Hemby, CFA

Recently, my wife was scrolling through an online news site and asked me: “What happened to bitcoin?” She showed me a headline that read, “Crypto exchange FTX files for bankruptcy.” I told her that the bankruptcy of FTX ultimately amounted to a simple explanation: FRAUD. While this answer may have been sufficient for my wife’s question, this answer doesn’t fully address the important questions that many investors have on the topic. Questions such as:

What was FTX?
What caused their downfall?
Should investors be concerned?
How does this effect my investments?
What is bitcoin?

What was FTX?

FTX was a cryptocurrency exchange that allowed users to exchange fiat currency to buy and sell the estimated 21,000 different cryptocurrencies that have been created in the past 14 years. FTX was founded by Sam Bankman-Fried in 2019. In addition to FTX, Mr. Bankman-Fried also founded the trading firm Alameda Research, along with a slew of other related companies. FTX was not the largest crypto exchange, but it was quite possibly the best known, as hundreds of millions of dollars were spent on celebrity endorsements, Super Bowl commercials, and various sports team naming rights.

So, what caused FTX’s downfall?

FTX created a native token called FTX Token (FTT for short) as a means to incentivize trades and reduce trading fees. Investors could convert any token or currency to FTT and use those tokens to purchase cryptocurrencies. On November 2, 2022, CoinDesk revealed that Alameda Research held a $5 billion position in FTT, a fairly illiquid holding. Immediate concerns began to surface about the relationship between the two Bankman-Fried-owned companies. A few days later, Binance (a separate Crypto exchange) announced that it would liquidate all their FTT tokens, valued at $529 million. This redemption request, along with thousands of others, created a liquidity crisis as FTX was unable to meet customer withdrawal requests. On November 11, 2022, FTX filed for Chapter 11 Bankruptcy as it’s founder stepped down. While many of the details are still being sorted out, it’s become increasingly clear that FTX and Alameda Research were using customer deposits from FTX in an unauthorized and illegal manner.

“But is this relevant to the average investor? What is cryptocurrency and how does it affect me?”, you might ask. Bitcoin was the first cryptocurrency. It was conceived in 2008 in the wake of the Global Financial Crisis and was born in 2009. After its creation, many new cryptocurrencies were created based on the original bitcoin blueprint but added more bells and whistles. The SEC, including its head, Gary Gensler, have stated that bitcoin is a commodity.

What about the rest of crypto? Well, that has yet to be determined. Many argue that all other cryptocurrencies are unregistered securities, and therefore out of compliance with U.S. securities laws. The Howey Test is used to evaluate whether a transaction is a security or not and asks two questions:

Was money invested with a reasonable expectation of return?
Is this investment dependent on the efforts of others?

If the answer to both questions is yes, then the transaction is an investment contract and is subject to the registration requirements of the Securities Act of 1933. In most cases, the crypto ‘projects’ have a group of people actively managing them on behalf of others. Arguably, based on the Howey Test, they are unregistered securities.

At Saltmarsh, we help plan our client’s financial needs with diversified portfolios of stocks and bonds using an asset allocation that best suits an investor’s risk tolerance, goals, and stage in life. Most of the Crypto industry is similar to the day trading dot com boom of the late 1990s. It is a sophisticated form of gambling. If you like to gamble, go to Vegas or Biloxi. See a show, have some drinks, go to the Grand Buffet, and most importantly gamble responsibly. Crypto is not the place to gamble.

Bitcoin has as much to do with FTX as U.S. Dollars has to do with Bernie Madoff. Yes, bitcoin was involved in the FTX fraud, but it was not the reason FTX failed.

From an investment perspective, bitcoin can best be thought of as digital savings. However, given its volatility, bitcoin is not suitable for all investors. Only those with longer time horizons and high-risk tolerance should ever consider it. If you’d like to hear more about constructing a well-diversified portfolio that best suits your needs, please contact us.

Questions?

If you have any questions regarding your investments, Bitcoin or the FTX failure, please contact our Investment Management team!

About the Author| Mark Hemby, CFA

Mark is a financial advisor for Saltmarsh Financial Advisors, LLC, an affiliate of Saltmarsh, Cleaveland & Gund. He holds a Chartered Financial Analyst (CFA®) designation and as part of our investment advisory group, he works with clients to develop and implement investment strategies to achieve financial freedom while also ensuring their goals and objectives are aligned. Mark has over 15 years of experience in investment banking working with individuals and organizations to manage their portfolios and coordinate investment activities. In addition to his experience with fixed-income trading and sales, Mark owned and operated his own business in Alabama.