5 lessons to learn from the collapse of FTX

5 lessons to learn from the collapse of FTX

March 29, 2023 | By Dean Sevin Yeltekin

In November 2022, the world was captivated by the swift downfall of FTX (short for “Futures Exchange”), a three-year-old company that operated a cryptocurrency exchange and crypto hedge fund. Overnight, FTX co-founder Sam Bankman-Fried (popularly known as “SBF”) went from magazine cover story to pariah in the way of other fallen stars like Bernie Madoff and Elizabeth Holmes.

At its zenith in mid-2021, FTX boasted more than one million users and was the third-largest cryptocurrency exchange by volume. Now, less than two years later, it is a cautionary tale.

What went wrong?

On February 23, I co-hosted a webinar entitled “Crypto Markets, Regulatory Environments, and the Collapse of FTX” alongside my Simon colleague, Jim Brickley, where we addressed this question from several angles.

At the event, I set the stage for Jim’s presentation by providing insights into the inherent instability of cryptocurrency. Then, Jim leveraged his expertise in agency-related and corporate governance issues to delve into the specifics of FTX’s descent into bankruptcy and the resulting fallout.

Below, I condense our presentation into five key lessons we can derive from the collapse of FTX:

1)    Cryptocurrency has always been vulnerable to collapse.

“I don’t think FTX would freak out in the slightest anyone who understands the fundamental investment case of bitcoin.” –Christopher Bendiksen, Bitcoin Research Lead at CoinShare.

I began my presentation with the above quote from a bitcoin researcher because it points to fundamental flaws in the hype surrounding cryptocurrency. Cryptocurrency is not designed or operated to function as an alternative financial system or substitute monetary system.

To understand why, we must return to the basic purposes of any currency:

• Make transactions efficient (medium of exchange)
• Unit of account (measure market value of activities)
• Store of value (does not get destroyed, is “ownable”)
• Replaces trust (cash does not need a transaction history, owned by bearer)

The crypto financial system is a fascinating blend of game theory, economic incentives, cryptography, and information systems—but creating a shiny new currency and uploading it onto an app doesn’t make it viable. As I discussed in a recent blog post, the problem with cryptocurrency is that it fails to fulfill the basic functions of currency—or, at least, fulfill them well. Bitcoin, for example, is not widely traded. People want to store it, not use or spend it—which is the opposite of what we see in a healthy economy. The idea that its value will plummet to zero is quite plausible, making it a questionable investment.

FTX was vulnerable to collapse, in part, because cryptocurrency is vulnerable to collapse. Any crypto investor must walk into an investment with eyes wide open to the risks they are taking on.

2)    Never underestimate the importance of sound corporate governance.

It may sound cliché to say that investors should only invest in companies with good governance, but in the case of FTX, it made all the difference. As Jim described in our webinar, we can think of corporate governance as the ways in which a corporation helps ensure that its capital is wisely managed and that investors will receive a return on their investment. A healthy board of directors, internal controls and processes, outside auditors, and other watchdogs all form guardrails that are intended to prevent mismanagement.

John J. Ray III, the newly installed CEO of FTX, stated publicly that in his 40 years of legal and restructuring experience, he has never witnessed such a flagrant failure of corporate governance as in the case of FTX. The company’s Board of Directors consisted of only two members, SBF and an attorney from Antigua (where the company is chartered), who approved major transactions without keeping any record of meeting minutes. The company also failed to maintain a complete record of bank accounts or employee records—to the point that at the time of bankruptcy, it was unclear where all the company’s assets were located and who was an in-house employee versus an outside contractor. The corporate structure was incredibly complex, consisting of about 100 affiliated companies with countless conflicts of interest. Outside auditors seemed to act more as cheerleaders than referees, producing unreliable financial statements.

In every possible way, FTX’s failure of corporate governance expedited its downfall.

3)    Large investors are more susceptible to bad investments than we might think. Due diligence is crucial.

FTX’s list of major shareholders is a who’s who of powerful, well-known investment firms: Sequoia Capital, Dan Loeb’s Third Point, Paradigm, Thoma Bravo, Softbank, Tiger Global Management, New Enterprise Associates (NEA), and others invested a combined $2 billion in the company.

Many observers have wondered how so many experienced investors made the decision to bet on FTX in the first place. Even a perfunctory review of the company’s financial statements and corporate structures reveals a sea of red flags. One response from investors centers on the idea of risk. Investors are, after all, in the business of taking risky bets on a small amount of their portfolio. Investments fail all the time.

But we might be missing a basic truth of human behavior: Even the most sophisticated investor can fall prey to the bandwagon effect. They don’t want to miss out on the next big thing, which they thought was crypto—especially when their primary competitors were getting in on the action. There is also a tendency to idolize a founder, like we witnessed with Adam Neumann at WeWork. SBF seemed like a reasonable gamble to investors. The son of Stanford law professors, his shorts-wearing, video-game-playing persona was exactly what investors expected of someone in his position.

Sequoia Capital, which lost $150 million, issued a rare apology to its fund investors and pledged to improve its due diligence process in the future. But the damage to its reputation, and the reputation of its competitors, has already been done.

4)    Individual investors/customers should be careful not to blindly follow the lead of more “sophisticated” investors.

Plenty of individual customers who invested in FTX by depositing money in exchange-held accounts lost money in the collapse as well. A key lesson for them in this debacle is to avoid following the herd off a cliff. Individual investors don’t typically have the same-sized parachute as their larger, more well-heeled counterparts, which they must factor heavily into their decision-making process. Large investors have made poor bets in the past, and they will make poor bets in the future. Neither size nor celebrity should be a determining factor in deciding whom to follow. Take their market signals with a grain of salt.

5)    More predictable regulation could help stabilize the crypto industry, but investors should not rely too heavily on regulators.

There is a debate raging about whether the U.S. Securities and Exchange Commission (SEC) or other federal regulators should regulate the cryptocurrency industry more stringently. While too much regulation can backfire, the optimal amount is certainly above zero. A certain amount of regulation benefits cryptocurrency firms because it helps them manage risk. In a stable, predictable regulatory environment, they will be able to act with more confidence knowing what will and will not be legal in the future.

But regardless of the degree of industry regulation, it is unrealistic to think that regulators will form a front-line defense against fraud and misdeeds. There are simply too many companies to regulate and not enough resources to go around. In the case of most scandals, it is usually an auditor, investigative journalist, internal whistleblower, or outside watchdog who first sounds the alarm. To a large degree, investors and customers will need to rely on these sources to gauge the soundness of potential investments and protect themselves from loss.

To watch the full webinar, click here.

Sevin Yeltekin is the Dean of Simon Business School. 

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