Investing compass: Does crypto matter for all investors?
In this episode, we explore what happened with FTX, and the lessons investors should take and apply to their own portfolios.
Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. Should we get right into the episode?
Lamonica: We should. We apologize to Will in advance for what we're going to talk about today, but we are going to talk about FTX. And we're going to try to take some lessons from the implosion of this crypto exchange and apply it to investing. And we'll preface this whole thing by saying that this obviously not a crypto podcast, and neither of us invest in crypto. And of course, if you do invest in crypto, that's fine. But it's just not our thing. The other thing we wanted to say is that it's pretty easy to dump on crypto right now when the price of Bitcoin has fallen from a high of over $82,000 Aussie to less than $25,000 Aussie. And deciding that crypto is a crappy thing to buy when it's fallen so much really doesn't take a lot of guts.
Jayamanne: And we did actually do an episode on crypto which we released on February 14, 2021.
Lamonica: That's Valentine's Day, right?
Jayamanne: It is that. But not because we love crypto.
Lamonica: Yeah. No, certainly not. But it just happened to be Valentine's Day.
Jayamanne: All right. So, before getting into FTX, we're going to do what we always do on Investing Compass and that is getting back to the basics of how you value something. The value of all traditional investments come from the cash flows that they generate in the future. Full stop, that's it. All the noise we hear and all the commentary we hear is just making this very simple concept seem more complicated.
Lamonica: And figuring out what the value of an asset is involves, of course, a lot of complexity, but the value is based on these future cash flows. So, let's walk through some examples. You buy a bond. You do that in anticipation that you will receive interest payments and your principal back. It is a loan after all. If you don't think the company you've loaned your money to will pay you back, then of course the price will go down and the value will be less because those cash flows are less certain.
Jayamanne: And if you buy an ownership stake in a company, whether that is a share, or you're funding a startup, or if you buy a small business, you're doing this because you expect those businesses to generate cash flows at some point in the future. It could be years from now if you're investing in a startup, or it could be immediately if you're buying a share in an established company. But the value that any of those businesses is based on the fact that you think that they will generate cash flows in the future.
Lamonica: And changes in opinions on the timing and amount of those cash flows will cause the value to fluctuate. But nevertheless, the value comes from those cash flows. You buy an investment property; you are expecting cash flows to come from rent. You buy a toll road; you are expecting cash flows to come from future tolls. You buy an office building; you expect there will be tenants. Cash flow, of course, is king. Now, Shani, what kind of cash flows does crypto generate?
Lamonica: So, does that mean it has no value?
Jayamanne: Not exactly.
Lamonica: But you told me if cash flows are where value comes from and in crypto has no cash flows, then where does its value come from?
Jayamanne: Well, when we say crypto, we are really referring to cryptocurrencies. And a currency is a store of value. We hold currency because we believe it will hold its value, so we exchange it for something in the future, just like we walk around with $20 in our wallet because we believe in the future, we can exchange that piece of paper for something we want.
Lamonica: And that line, piece of paper, is important because that's all that it is. And what makes that piece of paper more valuable than the notebook I have that's also filled with paper is confidence. So, nothing else. It is confidence that this paper will retain value and confidence that when it comes time to buy something that the person I want to buy it from will take that piece of paper and then just give me what I want.
Jayamanne: And confidence is a fragile thing. The confidence we have in the Aussie dollar is based on faith in the government and central banks, and that they won't erode the value of their currency by letting inflation get out of control. Confidence that the laws in place that require the Aussie dollar to be accepted by businesses and other people will be enforced, but ultimately it is all confidence.
Lamonica: And there used to be less confidence in governments. And in order for people to accept that a dollar is going to hold its value used to require the government to have gold sitting in a vault to back up those dollars. And before that, banks issued their own currencies, which was truly a confusing time because each town had a different bank and was hard to figure out who to trust and if the bank could survive a run. It was hard to gain that confidence that this currency would hold value.
Jayamanne: And all of these, all of these developments in currencies were simply to make it easier to trade our labor for other people's labor, so that if I raised sheep and wanted wine, I didn't have to show up at the wine maker with the sheep to trade for wine.
Lamonica: Yeah, because it's easier to carry paper around, Shani, than it is a sheep.
Jayamanne: I imagine so.
Lamonica: Yes. So, if it wasn't for currency, you and I would have to go around and ask people if they wanted to listen to this podcast and then try to figure out what they would give us for it.
Jayamanne: Yeah, I guess, it's similar to the sheep story but would probably involve the wine part.
Lamonica: What do you think the chances are that someone would give us a bottle of wine for listening to this podcast?
Jayamanne: I think it's pretty slim.
Lamonica: Yeah, probably. But the point of this whole brief trip through the history of currency is just to show the importance of confidence in the ability of a currency to retain its value. So, let's turn our attention to FTX, Shani. For those that don't know what happened, why don't you give us a brief summary?
Jayamanne: All right. So, a bunch of private equity firms and venture capitalists gave a 30-year-old named Sam Bankman-Fried billions of dollars which he used to fund an amphetamine fueled sleepaway camp for his friends in the Bahamas. And he funneled money from his customers to another company run by his ex-girlfriend which was promptly lost trading crypto.
Lamonica: That's very concise, Shani.
Jayamanne: Thank you.
Lamonica: Yeah, I hope that all of our listeners have learned a lot today. So, why don't we go into a bit more of a detailed explanation of what happened. So, let's start with what FTX is or was. So, FTX was a crypto exchange. So, for a fee it connected buyers and sellers of various currencies – crypto and of course, government issued currencies, so they could exchange the two on agreed upon price. It was a marketplace.
Jayamanne: It was an institution that took a cut of a transaction, and this happens all the time. Banks do this with currencies all the time. When we go to the Bahamas, we'll have to exchange Aussie dollars for Bahamian dollars, and we will not get the exact exchange rate because the bank will take a cut.
Lamonica: So, did you know, Shani, that one of the central tenants of Bitcoin is at a new type of currency was needed to stop financial institutions from taking a cut on transactions.
Jayamanne: I did know.
Lamonica: Yeah. Well, so the irony here is that a parallel set of financial institutions have been set up that are taking cuts from crypto transactions. And to add to this irony, the fees are really hard to figure out and quite high. For instance, transaction and trading costs on Coinbase, which is a really large crypto exchange, range from 0.4% to 4.5%, which of course is outrageous.
Jayamanne: So, what you're saying is that these crypto exchanges are basically just banks that charge really high fees for you to exchange one currency for another.
Lamonica: Well, no, because they aren't just like banks because banks are regulated, and banks have deposit insurance and banks can't take customer deposits and then use them to trade. So, banks are safe.
Jayamanne: And This is why we started talking about the evolution of the banking system earlier. What is happening in crypto right now is a lot like the old banking system before national currencies and before regulations.
Lamonica: And right down to the fact that FTX created their own cryptocurrency, a coin called FTT. And this is how the run on the bank started with FTX. An article appeared on a website named CoinDesk that revealed that Alameda Research, which was a partner firm that was trying to trade crypto for a profit, had a significant portion of their assets with FTX in FTT.
Jayamanne: And this is where the craziness started. FTX apparently took US$10 billion of customer assets and lent them to Alameda so that Alameda could pay back loans they had taken to trade crypto using FTX as an exchange. The only assets that Alameda had with FTX were in FTX's own cryptocurrency, FTT. That is what FTX was holding as collateral for the trading that Alameda was doing.
Lamonica: And as we said before, the value of any currency is derived from the confidence that users have that it has value. Well, this article on the CoinDesk website started to erode this confidence. It was further eroded when another firm called Binance said they were going to sell their holdings in FTT. So, there was an old-fashioned bank run on FTX where customers started pulling funds out because they lost confidence, and it's estimated that US$6 billion was pulled out.
Jayamanne: So, FTX was about to go under when Binance stepped up and said they would buy FTX. But very quickly the due diligence they performed turned up the fact that FTX was not handling customer funds appropriately and they pulled out. And that was the death of FTX.
Lamonica: And there's obviously a lot more to this story and a lot more to play out. Investigations have already started, and there will undoubtedly be lawsuits, and I'm sure countless books and docos and movies. But the question is what we can take from this episode as investors. And let's start if you're a crypto investor. The lesson to me is to think long and hard about the source of value for crypto. In our view, it's just like any currency and the value is derived from confidence. And think about how we get confidence in other currencies through government backing, through laws and then by having institutions like banks that support currency go through regulations and have insurance and independent audits and boards with independent directors and industry organizations that impose standards.
Jayamanne: It takes a lot of structure and a lot of faith to support currencies. And then, we have crypto, occurrences like these erode confidence and show that none of this structure applies to crypto. There is no regulation of these financial organizations that support crypto There is no insurance. There are no investor safeguards. FTX never even had to show anyone their balance sheet, which is shocking – nobody, not their investors, and certainly, not the public. FTX had no internal audit function, no outside audit, no governance committees, no management structures, and no board. Sam Bankman-Fried was allowed to do basically whatever he wanted.
Lamonica: So, if you don't think that regulation is coming to the crypto world to shore up this confidence gap, you might be on more drugs than our listeners are going to give to Shani and I for Christmas. So, I don't know what form it's coming in. I don't know when it's coming. But it seems like it is definitely coming.
Jayamanne: And with regulation will come more confidence, but also with more regulation and more structure in the industry there could be some questions. What exactly is the purpose of all these cryptocurrencies? Do they have any other use other than speculation? If nobody is actually using them as a way to purchase and sell goods and services, do they need to exist? Time, of course, will tell.
Lamonica: And if you are not a crypto investor, it is a reminder to think about where the value comes from for the investments you have. When will your assets deliver cash flows? How much would those cash flows be? You better be able to answer those questions.
Jayamanne: And if you are invested in something solely because you believe it will go up, you need to understand that while that is the outcome you want, it is not a legitimate rationale for an investment.
Lamonica: Another lesson here is something that I've been frequently made fun of by you, Shani, the notion that cash flows matter not just for the investments you own but also your personal finances. FTX went bankrupt because of a liquidity squeeze. They didn't have the cash and the cash flow to cover client withdrawals and liabilities. What they did have was a bunch of hugely volatile assets that made it seem like they were doing really well, just like lots of people have taken on a ton of debt to buy assets which make their net worth go up but puts them in more and more financial peril. So, of course, you purchased a home and that's a good thing. But can you cover those cash flows to pay off the loans? In what scenarios could you not cover those cash flows – if your income goes down, if interest rates go up.
Jayamanne: And this is why you need an emergency fund. You need to be able to cover events without selling assets, because you just might have to do that in a scenario where those assets have to be sold quickly and may not be worth as much. The question is, can you handle a run on your own bank?
Lamonica: And another big lesson for all investors is the faith that was put in Sam Bankman-Fried. In the crypto world, we don't have the structure we have in traditional finance, and with a lack of structure the crypto community is forced to rely in many ways on confidence men. People didn't have a system that gave them confidence. They had a person – this tech genius who checked every box. He dedicated a lot of his time to try and make money by facilitating the trading of something that served no useful purpose. But he was doing it so he could donate that money to charity. He seemingly didn't care about things that most people either care about or are forced to care about. He dressed however he liked. He didn't bother to put in place any structure in his companies or share any details about his companies, and he famously played a video game while giving a presentation to investors at a major venture capital firm. And he got away with all of it because he was a "tech genius."
Jayamanne: And while there are certainly more safeguards in place in traditional finance that prevents someone from stealing your money, that doesn't mean that we don't anoint people as investing geniuses that we blindly follow. That could be a star fund manager, or it could be a financial advisor. The point is not that there aren't good fund managers, or that there aren't really good financial advisors. The point is that it's up to you. It's your life and you need to be in control of your future.
Lamonica: Yeah, I couldn't agree more, Shani. Some of the largest venture capitalists in the world turned over money blindly to Sam Bankman-Fried and a company that never had audited financial statements. Why did they do that? Greed. They knew better, and they had a responsibility to their investors to do better, but their actions weren't any different than investors in ARK Innovation who saw strong returns and a fund manager celebrated by the press. Those investors didn't think they had to do any due diligence because they were getting access to the great Cathie Wood.
Jayamanne: And we believe passionately that the person best placed to ensure that you achieve your goals is looking right back at you at the mirror. Get help, find a good advisor if that is what you want to do, invest your money with fund managers if you think they have an edge, but remember it is on you to educate yourself about investing. It's on you to define your goal and define a plan to achieve it. A financial advisor can help with the process, but it's really your goal and your plan. It's you that's going to be the key to achieving it.
Lamonica: And we'll end this thing where we started it. Successful investing is about finding an approach that works for you. Shani and I are the first people to tell you that crypto isn't for us. That doesn't mean we are right, but we both know we shouldn't invest in things that we don't believe in. So, Shani, I think we've exhausted our crypto quota for a while now.
Jayamanne: Yeah, unless you find another major crypto company that collapses.
Lamonica: So, maybe next week we'll be back doing this again.
Jayamanne: You're slowly killing Will. I don't even think he recorded this episode to be honest.
Lamonica: Yeah. No, I think he's at least pretending not to listen. But anyway. Yeah, we really don't want to pile, of course, on what happened to FTX, because it is in the news everywhere, but it is a time that we can step back and think about as investors, as we said, what are some of the lessons we can take from this.