The Good News Behind the FTX Implosion…

Now comes the good part…

Since the crypto scam exchange known as FTX has officially taken its place in the record books beside the likes of Bernie Madoff and MF Global, the rest of the juicy details can start coming out.

Now, in the aftermath, we’ll start hearing all the really “surprising” stuff. For instance…

Stanford University law professors Joseph Bankman and Barbara Fried (SBF’s parents) were listed as signatories on a home in Old Fort Bay (the Bahamas) that was said to be used as a “vacation home”. Reuters was able to contact a spokesperson for the professors, who said they had “been trying to return the property to FTX”.

Of course the other stuff we’ll hear will be the usual predictable crap out of Washington’s collective mouth, like their immediate call for more…

Crypto Regulations — Please No!

As soon as the $#!% hit the fan and it was time to go into CYA mode (my emphasis)…

Maxine Waters – Chair of the House Financial Services Committee – wasted no time in demanding ‘more’ regulation…

“For four years, under my leadership as Chairwoman, the Committee on Financial Sendees [sic] has led the way in examining and investigating the cryptocurrency marketplace. This includes the Committee’s formation of Congress’ first-ever Task Forces on Financial Technology and Artificial Intelligence, along with the working group on digital assets. In addition, for several months, I’ve been working around the clock with Ranking Member Patrick McHenry to craft bipartisan legislation that establishes a federal framework for stablecoins in order to begin building the safeguards needed to protect customers’ assets and insulate our financial markets from contagion.

This week’s news further highlights the urgent need for legislation.”

Working around the clock… blah blah blah… to craft bipartisan… blah blah…  to establish a framework… blah blah blah…  to begin building… and so on.

Nevermind that the committee had called none other than SBF in to help craft regulations…

Here’s the problem with the whole government regulation thing. Either the Congresspeople responsible for writing regulatory legislation don’t understand how markets work, or they just don’t really care — until they have to point a finger that is. (It’s just easier to demand more regulations when the regulations they don’t enforce lead to some kind of disaster.)

Understanding How Markets Work…

If bonafide pros like Sequoia Capital got sucked in… what chance do mere politicians have at picking out financial scam artists? 

One guy who apparently had no problem was Terry Duffy, the Chairman and CEO of the Chicago Mercantile Exchange. In a recent interview he explained that he saw through the SBF charade long before his crypto exchange went belly up…

“Right away I said to him ‘You’re a fraud. you’re an absolute fraud.'”

What prompted that?

Duffy says he was approached by SBF at a conference who told him he wanted to compete with CME in crypto. Instead, Duffy says he offered to give SBF his crypto franchises in exchange for working together. “Let me be your risk manager. I’ll clear it so that I know it’s done properly,” Duffy says he told SBF.

Terry Duffy is a guy with decades of experience both in the futures industry generally as well as running the biggest futures exchange in the world. 

When SBF asked if Duffy would deploy his model, Duffy told him “Your model is crap. Why would I deploy a model that introduces risk into the system? Of course I’m not going to deploy your model!”

Exchanges are also known as “clearinghouses.” A clearinghouse/exchange’s job is to make sure every buyer of every contract on their exchange matches with a seller, and every trade is properly settled. That, at the end of the day, all the money made or lost is properly credited to proper clients’ accounts. The CME clears tens of millions of trades every day. 

Customers trade on exchanges through member clearinghouses. These entities are formally known as Futures Commission Merchants or FCMs (you know them as your broker). Their job is to safeguard their client’s funds. 

This combination of responsibilities has allowed the industry to weather some of the most dramatic financial upheavals ever.

Terry Duffy’s a guy who understands this — how the trading business has to work if you are going to keep doing business. 

Apparently he knew enough about FTX’s business to call SBF out — in front of Congress no less…

CME chief executive Terry Duffy’s claims that cryptocurrency exchange FTX has set aside insufficient financial resources to back its proposed direct clearing model for crypto derivatives – made at a US congressional hearing on May 12 – are raising eyebrows in the industry. 

FTX’s proposed direct clearing service would see customers post margin directly to the exchange without going through a futures commission merchant (FCM).

During his testimony, Congressman Ro Khanna (obviously a big fan of FTX) did his best to make Duffy seem incompetent in the areas of blockchain and crypto and raked him over the coals for purportedly suggesting that “FTX had zero capital requirements for participants.” 

Duffy 1. Khanna 0.

It’s a lack of understanding (or possibly willful blindness) of exactly how markets operate that inevitably makes Washington incapable of effectively policing things like FTX. (Especially when, ahem, FTX turns out to be a major democrat donor.)

The Real Reason the G Can’t Regulate…

Washington is the home of some massive regulatory failures.

Just look at 2008! 

I’m not being hyperbolic. Despite all their “regulation,” the entire global financial system nearly went down in flames.

There were plenty of agencies — from the comptroller of the currency, to the SEC, all the way to the Federal Reserve — that should have reined in anyone in the industry who got way too far out over their skis. And there were plenty of them.

You could start with the mortgage originators who were cashing in writing “liar loans.” You could question the clearing firms who were doing derivatives trades without any proper documentation. Or you could point a finger at the ratings agencies who gave AAA ratings to all that garbage debt they created. 

There is absolutely no shortage of regulatory-failure blame to go around. And thanks to it all, the financial world as we know it came to the precipice of collapse. 

Why?

There’s a great scene in the movie Too Big to Fail where Treasury Chief Hank Paulson (who happened to be a former Goldman Sachs CEO) and his inner circle — facing financial Armageddon — are contemplating the unprecedented financial bailout they’re going to have to justify. The communications secretary in the room asks what she’s going to tell the press. The others in the room lay out how the contagion gained momentum and metastasized into the imminent disaster the financial system was facing.

Looking at them in stunned disbelief, the press secretary asks, “And what do I say when they ask me why it wasn’t regulated?”

Hank Paulson replied, “No one wanted to. We were making too much money.”

I highly doubt that conversation actually happened. But it could have. Because it’s 100% true.

There’s a flow of money that often occurs between government regulatory agencies and the groups they’re supposed to regulate that is nothing short of massive. It can turn a lot of blind eyes to a lot of “minor” indiscretions.

So given either the ineptitude or the graft that prevents actual regulation from taking place, what are we supposed to do?

Leave Them Alone…

Last week I pointed out a couple other scam artists who took hopeful investors for millions billions. And they were just two of many. 

But the truth is, this kind of action is nothing new. Where there is a new, “breakthrough” money making opportunity, there will be people, fueled by FOMO, running to blindly jump on board.

Some years back, the consulting firm Gartner identified something they call the “Hype Cycle” in relation to technological innovations. You might have seen it before:

The Gartner Hype Cycle

It’s frighteningly accurate. Consider the dotcom fiasco of 2000…

Back in the late 90s, when the tech bubble was rapidly inflating, investors were paying insane multiples for almost any company remotely related to the blooming internet industry. Any non-tech company that announced an “internet initiative” could see their stock get boosted by as much as 50% in a single day.

Then…

When they could no longer justify the outright stupid valuations people were placing on companies that didn’t even have a business plan, they switched from talking about future sales to “eyes on the page.” 

I kid you not! People were literally justifying ridiculous valuations based on the number of visitors the company in question’s website was getting.  

Once this bubble reached the peak of inflated expectations, the market plunged into a nearly decade-long bear market…

Nasdaq Composite

Source: Barchart.com

(The chart is almost identical to the Gartner graph!)

Now the dotcom bubble wasn’t necessarily a failure in the government’s regulatory efforts. What it does show is the natural reaction to new opportunities. That people will be stupid. And greedy. And that this pattern of hype will always happen around new, potentially profitable things. 

And while the boom, bust and ensuing years was definitely a rough time for investors, something definitely positive came out of the whole fiasco.

And I’d argue, that’s the best news…

The Market Could Be the Ultimate Regulator (If They’d Let It)

I say this over and over. This is how free markets work.  Free markets and capitalism are responsible for every advancement – every bit of modern living we enjoy today. No centrally managed (government) economy has ever even come close.

Are free markets “equitable”? Hell no. Are they painless? Absolutely not. But no one ever said they were either of these things.

But are they efficient? You bet!  

Markets can take out the garbage faster and more effectively than any government regulatory agency… Even better than Maxine Waters working 24/7.

The dotcom crash washed out all the weak “pretender” tech companies and ultimately gave us companies that offered real value.  The Amazons. The Alphabets. The Nvidias. And the Apples…

The same thing will happen with “crypto” companies, if they’d just let it. 

Scams like FTX, other worthless tokens (I promise you there are more out there) and the like will all be washed out. Hopefully any bad actors involved will be in jail for a nice long stretch as well. People will lose money. And learn valuable lessons. 

But the real potential in the market will come out.

Ultimately it’ll be good for the entire industry. Like every new idea that’s come before it, it’ll work its way through the hype cycle, and the real winners will come out on top.

Now… I’m not saying turn a blind eye to fraud. The government should absolutely protect investors from fraud. They should prosecute fraudsters like they’d prosecute serial killers. 

But the problem is the regulatory mentality believes it can protect people from themselves. 

And because it does, ultimately government meddling usually lets the bad stuff go on until, well, it usually reaches a level of “holy crap.” 

The good news/bad news behind the FTX collapse is that now it’s going to be more and more difficult for the crypto-related universe to expand.

Not because the G has regulated them into line…  Rather because tens (maybe hundreds) of thousands of investors got burned — bad.  And they’ll be way more careful the next time someone offers a too good to be true opportunity. 

Make the trend your friend,

Bob Byrne
Editor, Streetlight Confidential