How easy money led to the fall of the FTX cryptocurrency

The collapse of the cryptocurrency exchange FTX could be a sign that the crypto bubbles fueled by easy money are about to burst. The collapse of FTX has shown that investors don't really do their research. Instead, they seem willing to put a lot of money into whatever looks like the hottest new thing and promises big returns without good evidence.

In fact, FTX seems to be a textbook example of how easy it is for the media to trick investors with stories about the latest investment genius who has magically found a new way to make returns that have never been seen before.

Sam Bankman-Fried (SBF), a thirty-year-old MIT graduate who ran FTX into the ground and gave control of his clients' money to a small group of friends who had almost no experience, knowledge, or morals about how to manage funds responsibly, is the "genius" in this case. At best, the company didn't keep good financial records or report on them.

Even though the numbers won't be clear for a while, it looks like FTX has "lost" at least $1 billion to $2 billion in client funds and billions more in investments in the company. It's likely that a lot of it was just stolen. But it's hard to say right now because FTX didn't bother to set up an accounting department. The new CEO of FTX says that the way the company handles its money is worse than what Enron did.

Still, hundreds of thousands or even more than a million clients were willing to put money into the exchange. Some put in almost everything they had. Much more money is put in by institutional investors. Sequoia Capital is well-known for putting $210 million into FTX. As part of "due diligence," Bankman-Fried and he had a "last-minute Zoom call" during which Bankman-Fried played video games. All of that money is now "lost."

Why were so many people willing to give a big chunk of their life savings to a business run by a man-child in short pants who didn't have to answer to anyone? The answer lies in the fact that speculative manias and decades of easy money from central banks create a world where FOMO and a desperate search for yield lead to disaster. The FTX implosion is exactly what we should expect to see as our bubble economy deals with rising interest rates, less easy money, and a coming recession.

Slowing Monetary Inflation Creates a Problem for Leveraged Crypto

As I showed earlier this week, as the cost of borrowing (interest rates) goes up, the tech industry as a whole will lose money and have to cut costs.

Up until this year, this inevitable economic decline kept getting put off. This is because many problems and inefficiencies in a business can be covered up when it's always possible to just borrow more and pay off old debts with new, cheaper debt. The plan works when interest rates keep going down, which is what has been happening for the past forty years. That is, until recently, it was easy to do so. Now that companies can't always count on more cheap money coming down the road, losses and expenses that are out of control are a problem.

When the cost of borrowing money goes up, it's harder for companies to hide their losses and lack of income. This is a big problem for highly leveraged companies that have to pay off a lot of debt, play around with their finances, and invest in high-risk things like derivatives.

In the past few months, we've seen a lot of crypto exchanges get into trouble for the same kinds of reasons. FTX is just the most famous recent example, but FTX could have kept its problems hidden for longer if the easy money kept coming in as usual.

What happened was that FTX, as a crypto exchange, worked in some ways like a bank. Clients put money into the exchange to make it easier for them to invest, and they use their cryptocurrency to both invest and spend. A lot of this also had to do with FTX's crypto token, which is called FTT. In a way, clients were "depositors." But, like a bank, FTX also tried to make money by making its own investments through a sister company called Alameda Research, which traded in cryptocurrencies. FTX was almost like a fractional-reserve bank because it used "deposits" from clients to make risky investments through Alameda.

But this year, when the Federal Reserve raised interest rates and stopped quantitative easing, the easy-money economy became a little less easy (QE). This caused the prices of many cryptocurrencies, including FTT, to go down. Investors, both small-time crypto buyers and large institutions, started selling their crypto or not buying any more to get cash to use elsewhere. Because of this, regular clients at FTX started to take their money out. At the same time, Binance, a large cryptocurrency exchange, started to sell its own large amount of FTT. Suddenly, FTX had to give money back to a lot of clients who were leaving. But FTX had already put most of its money elsewhere. Alameda and FTX, like many other investors, were making riskier bets to stay ahead of inflation in a world where yields are very low because of the Fed.

Then, FTX found out that it didn't have enough cash to meet its clients' needs. Also, asset prices stopped going up as the Fed cut back on QE and the economy slowed down. This meant that FTX's collateral was losing value and could not be easily sold to cover client withdrawals. All of it fell apart on November 11.

If easy money was still coming in, this wouldn't have happened, at least not right now. Clients wouldn't have lost as much interest in FTT tokens, and FTX probably could have gotten some new loans to cover any rising costs. The problem would have been pushed off again.

But as things stood, there just wasn't enough money for the scam to go on.

So, we find that crypto with leverage has many of the same problems as other high-risk ventures with a lot of leverage. Once the easy money runs out, people still have to pay their bills, but it's hard to get new loans to cover up the problems. Caitlin Long, a bitcoin consultant at Custodia Bank, pointed out this problem months ago. She was against using leveraged crypto, or "savings" that aren't backed by anything, as a form of circulation credit.

From Yield Famine to Collapse

Even though SBF's business practices were clearly dishonest and his accounting was a mess, he was able to keep up the ruse for years.

But the truth is that many investors fall for scams like the ones SBF is pushing because they want to believe them. Investors are desperate to find a hero who can promise big returns, even if the risks seem high, because of years of financial repression that has caused "yield starvation." Economist Brendan Brown has said that there will always be manias and stories based on speculation. But when the need to make money is very strong, things get much worse.

Then, the financial world falls in love with financial stars like SBF. SBF was on the cover of Fortune magazine. SBF was featured on a lot of news shows as a young expert on the new economy. This was made worse by the fact that a lot of the client money SBF mismanaged—that is, stole—was spent on huge PR campaigns to boost his image and power. He gave a lot of money to the Democratic Party and used some of that money to win over a lot of media elites. Even after SBF's fraud was found out, the New York Times and the Washington Post still ran stories about how SBF and its members are just good people who are misunderstood. SBF himself said that his whole image was a trick.

The PR worked, and people looking for easy money kept putting money into FTX without doing much or any real research. Many investors forget that when money is easy to make, even frauds or people who aren't very good with money can make themselves look like real geniuses. Unfortunately, sometimes all it takes is a small change in money to show up the scam, and then the party is over.