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Is your 401k Exposed to the Crypto Carnage and the Collapse of FTX?

crypto current events ftx risk Nov 21, 2022

What Crypto Carnage and the FTX Collapse Mean for Your Money

  • Once an industry stalwart, now a defamed relic of arrogance, FTX declared bankruptcy following a series of poor decisions by its founder.
  • Unfortunate events and even crimes in the investment world are nothing new and are driven by greed, opportunity, pressure, and rationalization.
  • Your retirement must be protected and diversified so that your long-term goals can be achieved.

They say in financial markets that, “risk happens fast.”

We saw that no clearer than in the crypto and FTX debacle that took place the week of November 7. The high-profile company filed for bankruptcy following $6 billion of requested customer withdrawals in just 72 hours earlier this month.

The U.S. Justice Department, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission (CFTC) are now all investigating how FTX handled customer funds, according to Reuters.[i]

Crypto turmoil is actually nothing new.

Earlier this year, major crypto firms such as Celsius and Voyager Digital effectively went belly up as old-fashioned runs on the banks took place.[ii] Once doubt begins to creep into the psyche of depositors, they almost in unison withdraw funds. Making matters worse among some of these cryptocurrency institutions is that they were lending out customer funds for extremely risky proprietary bets and using leverage.

On November 13, FTX, a major crypto exchange, which had become a household name following its Super Bowl commercials and numerous sports sponsorship deals, swiftly declared bankruptcy after a supposed deal that was in the works with Binance, the largest crypto exchange, fell through.[iii]

What Happened with FTX?

Taking a step back, FTX went from being a white knight to a canary in the coal mine. Its founder Sam Bankman-Fried (SBF) gained the trust and admiration of Wall Street with his work in advocating the case for regulation in the risky crypto space over the last year or two.

FTX grew to become a $32 billion company, and Mr. Bankman-Fried even spent hundreds of millions of dollars propping up other struggling crypto firms in the last year, as reported by The New York Times.[iv] Bear in mind that Bitcoin peaked in November of 2021 near $69,000 but then plummeted to under $20,000 by mid-June of this year. Many smaller tokens endured steeper percentage losses.

That sharp decline in value – from roughly $3 trillion to under $1 trillion across all coins – led to turmoil among crypto companies, exchanges, and lenders. There were also nefarious actions behind the scenes among those outfits. It was thought that FTX was among the safest firms out there, but recent developments proved otherwise.

It has now been revealed that FTX used customer funds to support Sam Bankman-Fried's trading firm Alameda Research through a large “margin position” on FTX – meaning that the founder was buying FTX stock with client money.[v] That’s a major no-no in the banking and brokerage world. A comparable situation took place more than a decade ago with the once-respected, now tarnished, MF Global’s practice of commingling client assets with its own wagers.[vi]

Why All The Crypto Bankruptcies?

So, what’s the deal with all these crypto companies going bankrupt?

Think of it like a combination of the 1929 stock market crash, a lack of regulatory oversight that was also seen back then, the so-called co-mingling of funds and raising cash just to pay off existing accountholders (not unlike Bernie Madoff’s scheme), and just overall excessive risk and leverage (like with Lehman Brothers in 2008).

Greed and FOMO Drove Poor Decision Making

An added feature, perhaps unique to the market environment of 2020-2022, was extreme “fear of missing out” (FOMO) as the bitcoin and Ethereum craze kicked into high gear in 2021.

Retail investors plowed cash into coins hoping to make a big score despite not knowing the inner workings of the investments. They also bought risky stablecoins to earn high yields without grasping all the risks.

This FOMO was not limited to retail investors, this includes big names like Kevin O’Leary from Shark Tank, BlackRock, and other institutional investors who dumped billions into FTX in an effort to get in on the next big thing.

Holders of cryptocurrencies are left wondering what to do now and how they got duped – that includes big hedge funds and the so-called “smart money” investors. In a word – greed. It is the same old tragic story on Wall Street (as long-time investors can certainly understand).

Not a New Story on Wall Street

Recall almost a quarter-century ago, in 1998, when a consortium of the smartest minds in finance collaborated to form a hedge fund called Long-term Capital Management (LTCM). For background, its partners included some of the savviest traders, money managers, and academics. LTCM was initially successful. From 1995 through 1997, it garnered impressive annual returns, net of its high fees.[vii] In its fourth full year, however, the fund lost nearly $5 billion in less than four months. How’d that happen? Simply put, Hubris, leverage, and the fact that the market is made up of people and not machines, and people don’t always make rational decisions.

As the saying on Wall Street goes, “the markets can remain irrational longer than you can remain solvent.” In reality, LTCM’s bets all panned out and made people billions, but the founders of LTCM had so overextended themselves that they were unable to remain solvent long enough to see their bets realized. In the end, LTCM then had to be bailed out in September 1998 to avoid a global financial crisis.

What happened to FTX has shades of LTCM in that Sam Bankman-Fried played institutional investors against each other. Sam played on their fear of missing out on the stratospheric rise of FTX and Crypto, and used his position to rack up extreme amounts of leverage that threaten to bring down the entire system.

In the case of Long Term Capital Management, the Federal Reserve had to step in to facilitate a bailout by the major banks and counterparties. Crypto has no such “central” figure to turn to, to stop the “contagion” or “domino” effect, as one institution causes the next to fail, undoing nearly a decade of hard-won growth.

No Safety

The Crypto world and Sam Bankman-Fried seemed to believe they were above the traditional problems that have plagued finance for centuries. Specifically, SBF thought he could leverage his money, and indeed client funds, with the goal of earning big-time returns or, at a minimum, earning back their losses. As the value of cryptocurrencies sank, and depositors and lenders (summing to more than 100,000 (perhaps around one million per the latest reports), according to The Wall Street Journal) demanded the return of their money, the house of cards unraveled.

FTX’s high risky balance sheet and lack of discipline among its management team sunk the exchange in a matter of days, maybe even hours. It is now reported that some $370 million of customer assets appear to be missing, according to the risk-management firm Elliptic. In all, FTX faces a shortfall of up to $8 billion between what it owes and the assets it holds.[viii]

As investors who are part-market historians, it’s easy to see the warning signs in retrospect. With FTX specifically, there was reportedly a very sparse finance department with no Board of Directors or even a CFO. Additionally, their “Compliance Officer” was the same person who was responsible for compliance at an online betting company where its employees would look at player cards and bet against them, in short, they were stealing clients' money. This lack of oversight helped SBF get off with such unscrupulous financial activities. It is said that for financial fraud to take place, there is a triangle of opportunity, pressure, and rationalization.

SBF Hailed As The Modern Day JP Morgan

Arguably, the FTX founder had the opportunity due to a lack of company-level and industry-wide oversight and felt pressured to continue to gain the esteem of traditional bankers and regulators.

SBF donned the cover of investment magazines as the second coming of Warren Buffett, or JP Morgan just months ago. Finally, perhaps he could rationalize the behavior since all the moves Bankman-Fried had made previously seemed to work out well for both him and the crypto world. Consider that Bankman-Fried's net worth swelled to just shy of $30 billion. He’s now estimated to be worth zero, according to Bloomberg.[ix]

Aside from some of the specifics of the FTX saga, we all know that being blinded by greed ultimately leads to financial peril. Like your mother said, “if it’s too good to be true, it probably is.” Moreover, there was very little intrinsic value in FTX’s assets, so leveraging those assets makes it all the more likely that it will result in turmoil for investors and creditors. Of course, when the value of crypto rises, no harm, no foul. Like Buffett says, “it's only when the tide goes out that you learn who has been swimming without trunks.” With no real diversification and extraordinarily light oversight, FTX was able to operate with virtually no transparency.

Could This Happen To Your 401k?

Seems scary, right? You might be wondering if this sort of thing can (or will) happen again, but with big, established banking companies or brokerage firms that handle YOUR cash and retirement money. The answer is yes. But don’t let that cause you anxiety.

There are protections in place and due diligence that goes into owning stocks, bonds, money market mutual funds, and other assets within IRAs, 401(k)s, and so many other regulated account types. While we cannot dismiss the chance of another Bernie Madoff, or “Lehman Brothers moment,” and a major bailout being needed, as was seen more than 14 years ago during the 2007 market crisis.

The financial industry has investor protection and oversight built in. Here are some of the ways the regulated system is set up to protect investors.

#1 – Insurance

Did you know your investment account is backstopped with insurance? It’s true. Now, it is not insurance that protects you from market losses, but on the off chance that some financial fraudster snatches your brokerage account assets. The Securities Protection Insurance Corporation (SPIC) is there to make account holders whole up to $500,000 and up to $250,000 in cash. You might already be familiar with the Federal Deposit Insurance Corporation (FDIC) that insures your checking and savings accounts.

#2 – Tight Regulation

At a bigger level, though, there are tight regulations that provide guardrails in the investment world. The U.S. SEC, accounting boards, investors, audited financials, and a massive amount of transparency and public scrutiny an monitor the goings-on at banks and brokerage houses.

#3 – Central Banks and The Ability to Print Money

If worse comes to worst, a central bank or government will likely be there to bail out some of those big financial companies, too. One of the major criticisms of the Federal Reserve is that in 1929 they didn’t step in and bailout failing firms, which then led to the greatest depression in history, and ultimately the unpegging of the US dollar from Gold.

Crypto Rejected All The “Traditional” Protections

Crypto decided to shun all of those layers of investor protection in the high effort to be “decentralized.” That simply means the criminals are supposed to police themselves. “How’s that workin for ya?,” as Dr. Phil is wont to ask.

But seriously, what did we think was going to happen? If you leave the door to the hen house open, and the fox gets in, whose fault is it really?

Is this the end of crypto?

Is this the end of crypto? No. Are the wild, wild west days of trading altcoins and leveraging client assets numbered? Probably so. I expect more of those firms, albeit smaller ventures, to go bust in the days, weeks, months, and years ahead. Or they will simply close up shop or be acquired by big banks for pennies on the dollar. New “regulated” players might emerge and the old way of doing business will go the way of the dinosaurs.

All of this is why we do not take on individual company risk with your investment money.

The crypto market is here to stay, but the players are not. That’s a key difference. And we still don’t know who will be left standing when all the dust settles.

As with prior financial crisis, who the winners and losers are will be tough to call. But in hindsight, it is usually obvious. Of course, as investors, we don’t have the benefit of hindsight…this is why as retirees and investors, we have to work extra hard to protect our life savings, ensure that the decisions we are making are sound and based on a reasonable expectation of the future – and that we aren’t taking on excess risk.

And risk comes in many forms, it could be assuming that the winners of today will be the winners of tomorrow (anchoring and survivorship bias) or it could be accidentally tying our future to the success of a few companies or a single outcome.

The Bottom Line

As retirees, the one thing we can count on is that the future will not look like the past. The question we need to ask ourselves, is do we have a strategy designed for the next 20 years? Or one stuck in the past?

Is your portfolio built on gimmicks, marketing, and false expectations?

Are you making sound decisions or are we acting out of fear/greed? Is our advisor acting out of fear or greed? Just because we hire a professional doesn't make them immune to human nature. The only way to ensure long-term success is to have an investment strategy that is based on rules and logic, and the ability to adapt to changing market conditions.

Now is an ideal time to take stock and re-evaluate. Fortunes will be made or lost in this market…which side of the equation will you be on?

To learn more about how we protect our clients and help protect them from volatile markets, check out our private wealth management strategies here.

Or if you would like our team to do a full risk review of your portfolio and help you discover ways to reduce your risk, pay less taxes and make your money last money in retirement, click here to book your free no-obligation consultation.

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