CRYPTO: LESSONS FOR INVESTORS

If we don’t change direction soon, we’ll end up where we’re going.

–Professor Irwin Corey

With the arrest of Sam Bankman-Fried, the crypto king, cryptocurrency critics are having a field day. Billions of dollars of investors’ money have evaporated overnight at Bankman-Fried’s crypto exchange. And critics believe everyone should have known the risks.

So, in this post, we will explore that issue more thoroughly. Were the critics right, or was the situation not so clear? Is the problem with cryptocurrency, the exchanges, or both?

After all, luminaries like Elon Musk were touting various cryptocurrency products not so long ago. And several sophisticated hedge funds appear to have had significant investments in FTX too. So some of the most intelligent people on the planet have taken the plunge.

It has not always worked out well.

I am not criticizing these investors but instead will try to point out the warning signs that were there. In addition, I will use some of the lessons learned from this situation to help readers identify warning signs when they invest in the future.

Readers should also know that the situation is still evolving. Since my last post, a second crypto exchange has failed, not just Bankman-Fried’s FTX. Celebrity endorsers are being sued. And major holders of crypto, including, oddly, the government of North Korea, are suddenly finding the value of their assets reduced.

To understand where this situation is going, we will first look at what kind of asset crypto is and how the situation arose in the first place.

SOME CRYPTO BACKGROUND

The idea of electronic money exchange is not new or revolutionary. If you do ordinary electronic banking, you know that money is usually held in electronic form. It is not all held somewhere in the back of your bank in paper money and coins.

Cryptocurrency takes the simple idea of currency in an electronic form a step further. Not only is crypto in a digital format, but it is also encrypted and protected by blockchain technology so that it can be safely transferred between anonymous holders.

The whole process is decentralized.  

No organization, like a business or government, backs cryptocurrency. So the risks are higher than with many conventional investments.

SOME DIFFERENCES AMONG ASSET CLASSES—AND WHERE CRYPTO FITS

Before we go further, it is vital to discuss the primary ways that various asset classes differ. To oversimplify a complex subject, I feel three primary asset types exist. They are:

• Assets that directly make money include farmland, real estate, and businesses/stocks. In each case, these assets can directly make their owner money. For example, with farmland, you can grow crops to be sold; with real estate, you can rent it for income; and with businesses, you can sell or make goods. The primary point of owning these assets is to get income.
• Assets that make money because they are backed by a government or business organization earn interest—these can be corporate or government bonds, for instance. The income earned is on the interest charged and paid to the bondholder.
• Assets that have value because others want them—this category can include collectibles, fine art, gold, and cryptocurrency. Their value rises or falls based only on the perceived value to others. For instance, gold has little industrial or other use. It is valuable because, throughout history, it has been considered a haven when the world is uncertain and because of its scarcity. During periods of stability, its price goes down.

This third class of assets is potentially riskiest because you only get money from them by borrowing against their perceived value or upon sale. And the price people are willing to pay can fluctuate wildly.

That makes them hard to value and subject to constant change. Moreover, crypto rises and falls with popularity, societal trends, etc., and its value is in the eye of the beholder since no government or company backs it.

MORE ABOUT CRYPTOCURRENCY

It turns out that there is an additional complication to cryptocurrency. Storing it is not like holding a physical object. Instead, the currency exists in a digital electronic form. I will spare you the various ways it can be stored and kept safe, but you can read about that issue here.

For many, the solution to storing cryptocurrency is simply using an exchange. Once in an exchange, you can conveniently keep it and trade it with others. That includes exchanges like FTX.

So, now that you know the basics, what follows is a list of risks and warning signs that apply to any investment, not just cryptocurrency.  

To illustrate the point, I have included parallels between the current situation and the conditions that led to the Great Recession in 2009.

RISK 1: THE RISK OF INVESTING IN THINGS YOU DON’T UNDERSTAND

Investing in cryptocurrency must include learning about a highly complex asset class first. Like any investment, you must do your due diligence and know how things work and the risks and potential rewards. Unfortunately, however, many people jumped in without knowing much about it.

At first, some people made fortunes, mainly when the idea was new. And for some readers, if you were fortunate enough to buy and sell at the right time, you have done well too. But lately, more people have lost everything. That includes some very sophisticated investors who invested in the failed exchanges.

2009 Crisis: investing in real estate did not involve understanding a complex asset class like cryptocurrency. But the context of purchase was complex and maybe just as problematic. Many people did not do their homework. Read on to see how individuals, investors, and corporations failed to understand the risk and context.

RISK 2: THE RISK OF FAILING TO DETERMINE WEAK POINTS OF INVESTMENTS–AND THE ODDS OF FAILURE

Any time an asset where the value is entirely in the eye of the beholder, there will be price volatility. And when an asset is entirely digital, and you cannot touch or feel it (Like gold), some people will have the additional concern of seeing crypto as an abstract concept, not real.

That makes the potential for volatility much higher. And sometimes, it complicates the ability to define and confirm the value at all.

So, right now, many cryptocurrency exchanges are aiming for transparency. But there are doubters. For instance, Michael Burry correctly forecasted the economic catastrophe in 2009 and pointed out that the methods used to verify crypto exchange reserves are not meaningful.

2009 crisis: risk was masked because the value of underlying assets was hard to determine. Many banks were making unsound loans to people who could not afford them, but they also took those same loans and packaged them using Credit Default Swaps: CDS. These packaged risky and non-risky loans together and marketed them as being safe. Again, this happened because neither auditors nor rating agencies fully understood those products.

RISK 3: LACK OF OVERSIGHT

There is no such thing as a risk-free investment. However, when there is no solid framework to hold, provide transparency for, or fully audit and disclose how money is spent or used by holding institutions, the lack of regulatory oversight can increase the possibility of error and misuse of funds. It is a bit like the wild west

2009 crisis: lenders were offering sub-prime and no documentation loans. That is pretty much what it sounds like: lenders lent to people who could not repay loans. And other people could borrow by claiming an income–but not proving it. If that sounds like a lack of oversight, it is.

RISK 4: THE INCREASED LIKELIHOOD OF FRAUD WHEN YOU USE UNREGULATED FIRMS TO HOLD YOUR MONEY

First, let’s get this straight: Unregulated organizations cannot commit fraud. The allegation against FTX’s management is that they used client funds without permission. That is a crime whether the entity holding them is regulated or not.

But apart from that issue, the failure of Congress to provide some regulatory framework for exchanges is hard to understand. More than a few people have noted Congress itself may have a built-in conflict of interest.

2009 crisis: in the years preceding the crisis, deregulation was king. Lax oversight was a byproduct of that mindset. That is why very few people were prosecuted, despite billions of dollars in losses, the cost of government bailouts, and the aftermath. Failure to provide oversight or a framework of oversight nearly toppled our financial system.

HINDSIGHT IS 20/20

You may be asking yourself how intelligent people lost so much money. Or how, if experts could not ferret out risk, you, as a private investor, can figure out what they cannot.

It is not always easy. But, hopefully, these four warning signs will give some guidance. When you see more than one of these risk factors, it is time to take a second look. But mostly, use your common sense. If something does not seem logical, or if you must take a leap of faith, be careful.

When speculators make a lot of money in a short period, it is essential not to park your common sense at the door.

Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.

Photo Credit: Michael Fortcsh

License: Unsplash