You may have recently heard about the dramatic downfall of the FTX cryptocurrency exchange, or possibly even been impacted yourself. While obviously tragic for customers that lost money, these events serve as a good reminder of the importance of doing your due diligence before making an investment. Here’s some questions you should ask before investing your hard-earned money.
Do you understand what you’re investing in?
Founded in 2019 by 27-year-old Sam Bankman-Fried, FTX was the third-largest cryptocurrency exchange where over one million users would buy and sell crypto along with other digital assets. At its peak, the business was reportedly valued at US$32b, attracting many of the world's top venture capitalists, making Bankman-Fried one of the world's wealthiest people.
In December, Bankman-Fried was arrested for 8 criminal charges including fraud following the bankruptcy and collapse of the FTX exchange. The exact amount of customer funds lost in the collapse is still unclear, however, regulators estimate it could be as high as US$8b. The failure of FTX and the corresponding collapse of Bitcoin and other cryptocurrencies has brought to light the importance of truly understanding what you are investing in and where its value stems from.
Many users of the platform owned FTT tokens, FTX’s own exchange token that essentially acted like loyalty points by providing users with discounts on trading fees and other benefits on FTX. FTT tokens could also be bought and sold like any other cryptocurrency. The value of the FTT token has fallen dramatically since last year. At its peak, one FTT token was worth around US$84 but is now essentially worthless with its price hovering around US$1.
This huge loss in the value of FTT, underlines the importance of truly understanding what you are investing in and what underpins its intrinsic, or true, value. For example, the true value of stocks may be the dividends they generate, or for commodities their industrial use. When investments have no underlying intrinsic value, they are only worth what others are willing to pay for them, making them particularly volatile and risky.
How is your money being used?
Another lesson to learn from FTX’s collapse is the importance of understanding what a cryptocurrency exchange or trading platform is actually doing with your money. FTX’s fall occurred when it came to light that FTX had mishandled customer funds, lending them to a sister company, Alameda Research, which then used those funds to make risky bets on speculative investments. This mishandling of customer’s money meant that many were unable to withdraw their investment from FTX, eventually leading to the exchange’s bankruptcy.
Are there regulations in place to protect you?
The biggest issue with FTX was that a lack of regulation meant that the exchange was not subject to requirements that govern banks and other financial services organisations.
Traditional stock exchanges and banks are heavily regulated so even if they were to collapse, customers would still be able to withdraw their funds thanks to the capital requirements in place.
These regulations and processes include:
Capital requirements to protect financial institutions’ depositors and policy holders. For example, banks are required to maintain capital reserves to ensure that they have enough cash to handle unexpected losses while still honoring customers’ withdrawal requests.
Regulations to prevent financial institutions from taking on too much risk and mismanaging customers’ money, and disclosure requirements which provide transparency, allowing customers to find out what an institution is doing with their money.
Auditing requirements to ensure that banks and exchanges are using customers’ money safely and following government regulations.
Custodial arrangements which mean the underlying fund or exchange does not have direct access to customers’ money which is instead controlled by a third-party independent custodian. For example, in the case of KiwiSaver, fund managers do not have direct access to customer funds as they are held independently by a third-party custodian. These third parties also often play an additional supervisory role to ensure the investments made by a KiwiSaver manager comply with the investment mandate or policies.
So, what are the biggest lessons we can learn from this?
The collapse of FTX teaches us important, timeless lessons when it comes to investing. Do your due diligence. Understand what it is that you are investing in, how your money is being used, and the regulations that are in place to protect you. If you need help understanding an investment, or deciding on the best investment for you, speaking with a financial adviser can be a great place to start.
