If you weren’t already wary about investing in cryptocurrencies, following the story of the FTX fiasco should help you acquire this skill. You’ll see a recap about FTX below.
As family wealth advisors, we pay little attention to the cryptocurrency (“crypto”) markets in general. By their nature, their level of volatility far exceeds the comfort zone of our long-term investing strategy. But the headlines about FTX, Alameda Research, and the now ex-CEO of both firms—Sam Bankman-Fried—have been hard to ignore. From our perspective, this makes for a good “teaching moment” regarding the checks and balances that help advisors proceed with caution in their work on behalf of clients.
But first, here’s a briefing on the FTX debacle to date.
An FTX Primer
You know it’s bad when they tap John Ray III to act as the Debtor’s CEO at FTX Group, which filed for Chapter 11 bankruptcy on November 11. Ray, who managed to distribute $7.2 billion to Enron creditors in a similar role,1 describes the task before him at FTX: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” 2 But let’s go back to the beginning.
Sam Bankman-Fried started Alameda Research (a trading firm) in 2017 and then FTX Group (a cryptocurrency derivatives exchange) in 2019. FTX created its own cryptocurrency (the FTX token or FTT). As recently as January, FTX was valued at $32 billion after additional investments from major VCs and institutional investors.3 But by early November, it was discovered that FTX was “loaning” billions to its partner company, Alameda, to keep it afloat. Much of this was in cryptocurrency and holdings that actually belonged to FTX account holders. Over the course of three days, FTX users withdrew $6 billion in crypto tokens and lost confidence in FTT in particular.4 Within days, FTX and Alameda collapsed, with side effects rippling throughout the cryptocurrency world.
FTX: Red Flags Galore
So, what does the implosion of FTX have to do with the world of financial advisors? After all, you could never buy shares in FTX, as it wasn’t a publicly traded company. What is relevant is the red flags that investors should always look out for, and a few aspects of a financial advisor’s business that help to buffer their clients from FTX-style disasters. First, let’s look at two sides of the same coin that work together to keep advisors on the straight and narrow: oversight and compliance.
Oversight and Compliance
In the case of securities traded on exchanges such as NASDAQ and the New York Stock Exchange, the U.S. Securities and Exchange Commission (SEC) helps protect investors by overseeing the activities of publicly traded firms and enforcing securities laws.5 Without such oversight, investors and advisors could be misled by inaccurate or even false reporting by companies, for example. It’s solid controls and oversight that build the necessary level of trust for managing wealth.
The flip side of oversight is compliance. Even well-educated investors can be charmed by promises of large gains and seemingly risk-free bets on investments. And that’s exactly why the SEC’s system of strict rules is designed to protect investors by insisting that advisors stick to the facts and not the future when helping clients with their financial planning and portfolios.
Now let’s turn to the concept of a fiduciary to explore another reason why advisors would not be fans of FTX. A Registered Investment Advisor firm (RIA) manages investment portfolios on behalf of its clients. To qualify as an RIA, a firm must register with the SEC as soon as they manage more than $100 million in client assets.6 There are, of course, many additional requirements, but one of the key responsibilities of SEC registered advisors is that they serve as fiduciaries. In other words, first and foremost, they must act in the best interest of their clients. FTX, on the other hand, was acting on behalf of itself, exactly opposite to the best interest of its investors and customers.
Two More Red Flags
In the case of FTX, there are two other red flags that would be all too obvious to a good financial advisor: lack of clarity in the FTX business model, and poor management.
Lack of Understanding
A reputable financial advisor would avoid recommending going anywhere near a company like FTX, because they simply wouldn’t buy into how it made money and could sustain growth going forward. When it comes to investing, if you don’t understand something, or if its business model is far from traditional, it’s usually best to stay away. This red flag seemed to elude the many VC firms and institutional investors who did put money into FTX. But while wealth advisors tend toward caution, these players have a very large tolerance for risk.
Another reason financial advisors would not recommend FTX as an investment: the company’s poor management.
When it comes to investing, you need to have confidence in the management team leading the company. Recently, what became obvious included FTX’s lack of transparency, questionable ethics, and apparent disregard for basic accounting principles. Due diligence should have exposed these red flags to the VC firms who did invest, but clearly didn’t discourage the multiple rounds of funding that fueled FTX until its downfall. Even though VC firms are more interested in the occasional big win among their many “also rans,” and non-public firms aren’t obligated to be as transparent as publicly traded firms, sketchy management is to be avoided whenever possible.
We could have used any high-profile scandal like Enron or Lehman Brothers to spotlight the positives of a more cautious investment approach. Since FTX is still in the headlines, it seemed like a more helpful example right now. For the time being, let’s hope that the disaster at FTX and its partner firm, Alameda, doesn’t have substantial negative effects beyond the cryptocurrency markets. One thing is for sure: financial advisors should be watching this from a safe distance, from the sidelines!
Disclosure: This information is for educational and informative purposes and shall not be considered a specific recommendation. Readers are advised to speak with their advisor at JL Bainbridge to determine their specific recommendations that meet their investment objectives and to review their portfolios. The material being provided is thought to be accurate. However, the information is compiled from multiple resources and may become outdated or otherwise rendered incorrect by new research or corrections without notice. J.L. Bainbridge & Co., Inc., is not a broker dealer and does not offer tax or legal advice. Please consult your tax or legal advisor for assistance regarding your individual situation. It should neither be assumed that future results will be as profitable or that a loss could not be incurred. For more information related to our firm, please see our disclosure brochures at jlbainbridge.com and https://adviserinfo.sec.gov/firm/summary/108058.
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