Empires of Illusion

The jackals in the government….and the running dogs in the press…are gnawing on the bones of poor Sam Bankman-Fried (SBF).

It’s a great carcass; the story has all the makings of a hit movie. In fact, Michael Lewis, who does that sort of thing (The Big Short, Moneyball…), is already on the case.

The markets’ roadkill attracts vultures, too. The political reporters think SBF offers yet more proof that unfettered capitalism doesn’t work. Instead, they say, everything needs to be regulated to protect the little guys.

Here’s Benzinga: ‘Elizabeth Warren Calls For “Aggressive Enforcement” Against “Smoke And Mirrors” Crypto Industry After FTX Fiasco’:

She says it “shows a dire need for stringent regulations to protect consumers.”

What Happened: Warren cited a Wall Street Journal report on the Security Exchange Commission launching a fresh probe into FTX. “The collapse of one of the largest crypto platforms shows how much of the industry appears to be smoke and mirrors,” she said in a tweet.

According to Warren, the cryptocurrency industry needs more “aggressive enforcement,” stating that she is going to keep pushing the SEC “to enforce the law to protect consumers and financial stability.”

The SEC had previously pointed out that FTX was in the Bahamas, not the US. Whether any US laws were broken or not, we don’t know. But, in our opinion, US investors are indebted to Mr Bankman-Fried. He gave us all valuable lessons on how money and markets really work.

Ivy League whiz kids

We all know that a fool and his money are soon parted. Today, we look at how they got together in the first place.

And there were so many of them! The list of FTX investors is exceptionally long…and unusually illustrious. It’s a lesson in itself. From Bloomberg:

FTX’s list of investors spans powerful and well-known investment firms: NEA, IVP, Iconiq Capital, Third Point Ventures, Tiger Global, Altimeter Capital Management, Lux Capital, Mayfield, Insight Partners, Sequoia Capital, SoftBank, Lightspeed Venture Partners, Ribbit Capital, Temasek Holdings, BlackRock and Thoma Bravo.

These are the smartest players in the room. They have lawyers. They have researchers. They have Ivy League, whiz-kid staff who carefully research each of their investments. And now that the tide has receded, we see that these Olympic swimmers were all naked.

To give you an idea of the depth of their due diligence, here’s Sequoia Capital explaining why it had chosen to put $150 million in FTX:

After my interview with SBF, I was convinced: I was talking to a future trillionaire. Whatever mojo he worked on the partners at Sequoia—who fell for him after one Zoom—had worked on me, too. For me, it was simply a gut feeling. I’ve been talking to founders and doing deep dives into technology companies for decades. It’s been my entire professional life as a writer. And because of that experience, there must be a pattern-matching algorithm churning away somewhere in my subconscious. I don’t know how I know, I just do. SBF is a winner.

A deep dive? Maybe not deep enough. Still, it’s hard to imagine how researchers could have missed this balance sheet item reported by the Financial Times (FT): a ‘hidden, poorly internally labeled “fiat@” account’.

Crypto Edisons

What was that? According to the FT, there was US$8 billion in it. And if that were in our business, we’d ask the question: US$8 billion of what? But FTX’s books are so deep and murky, it will take forensic divers a long time to get to the bottom of it.

For the benefit of readers who wish to scam investors, or simply know more about how markets work, here’s the gist of the program:

When crypto was hot, money rushed into FTX like molten lava to Pompeii. Hustlers could invent a new ‘coin’. They might, say, create 10 million of them. Then, they put a few of them up for sale…and maybe even buy a few for their own crypto fund. If they bought a single coin for US$1, the presumed market value of the whole coin supply would be US$10 million.

Of course, the real value was still zero, but you couldn’t find that out until you tried to sell the coins on the open market. Then, the price would quickly crash down to nothing.

But with a US$10 million market cap for your coin, you could begin to wheel and deal, trading your coins (at US$1 a pop) for other coins…and building a portfolio of them. It was like having a stock with a very small ‘float’. A little bit of trading could dramatically move the price, even though the real value of the company hadn’t changed. And if you were really cagey, you could do the trading yourself.

Each of these crypto Edisons was playing more or less the same game. The idea was to launch one…try to get a few sales, and then pretend that the whole lot of them were worth the same amount.

Dust in the wind

And thus, do markets teach us something that may be useful: the law of declining marginal utility of money. When you have a few dollars, they may be worth X each. Flood the world with them, and the price will fall to X minus Y. Keep printing and you soon run out of alphabet; the price will go to zero. The world will then have ‘too many’ of them.

In SBF’s case, he invented two coins — FTT and Serum — and held huge quantities of them in reserve, while allowing a few out in the semi-real world to establish a market price. On the books, as of last Thursday, its Serum coin, advertised as ‘a protocol for decentralized exchanges that brings unprecedented speed and low transaction costs to decentralized finance’, was worth US$2.2 billion. By the weekend, the value had vanished. The other coin, FTT, had previously been worth — at least according to the standards of accounting in the crypto world — US$5.7 billion. Likewise, by this past weekend, investors looking for their money found only a chemical trace of it.

These two coins were the primary ‘assets’ on the balance sheet…and could be used as credit to buy more assets of similar dubious value.

Thus was Bankman-Fried’s dazzling empire built, one fizzly illusion after another. Investors, including the hot shots at the aforementioned hedge funds, were convinced that SBF and others of his ilk ‘got it’. And they wanted some of it too.

And so, they put money in. And now, the big question is: where did it go? And there’s another money lesson for us. Easy come, easy go. In two days, SBF’s fortune, then at about US$15 billion, was reduced to zero. Suddenly, Sam Bankman-Fried didn’t ‘get it’ anymore.


Dan Denning Signature

Bill Bonner,
For The Daily Reckoning Australia

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