Why the FTX-collapse resembles Lehman more than other fallen unicorns
The parallels between FTX and Theranos are striking except in one regard and this is what makes the FTX-downfall so catastrophic.
The implosion of the world’s third largest crypto-exchange FTX continues to roil the financial industry. Not only that FTX and its affiliated investment firm Alameda Research have filed for bankruptcy, but so have other crypto firms such as BlockFi that had a high exposure to the two companies, mainly by giving them loans backed by collateral not worth the hard drives it was recorded on. According to the lawsuit against FTX the exchange’s American customers alone have lost $11bn. And the already crippled cryptocurrency prices – more than $1.3 trillion of value has been slashed so far in 2022 – have been sent into free-fall once more.
Through top-notch reporting and not least through an interview FTX-founder Sam Bankman-Fried (SBF) gave to the New York Times (you can watch it here) we are learning more shocking news every day. What struck me in particular was the same pattern that we saw with Elizabeth Holmes, the equally hyped founder of Theranos. Her company was a Silicon Valley biotech darling that promised to do all kinds of blood tests at a fraction of the costs and only with a single drop of blood.
First there is the obvious. There are themes such as fraud or the fall from wunderkind to potential prison inmate that feature prominently in the countless memes comparing the two founders. But what I found more surprising is how easily all stakeholders – large and small investors, regulators, politicians, celebrities, corporate partners, and the media – fell once more for the very same pattern. There seems to have been very little progress in terms of due diligence in all of the involved parties despite both companies operating in highly regulated industries.
FOMO succeeded over due diligence
The Financial Times looked at the mind-boggling shortcomings in decision making and risk management amongst some blue chip investors. FTX was launched only in 2019 but within three years it had raised $1.8bn and reached a valuation of $32bn. Among those giving capital were the world’s leading asset managers and hedge fund managers including Sequoia Capital, BlackRock, and SoftBank. None of them demanded a board seat at FTX, which is standard procedure for deals this size. Top-investors speaking to the FT claim that there was insufficient focus on governance and financial controls. Also, investors failed to see the high amount of leverage in the business because the end of quarter balance sheets did not show them.
The business model and the underlying assets were highly speculative but that was accepted by the investors. FOMO – fear of missing out – was blinding them to the potentially catastrophic downsides. The same principle worked in Theranos’ favor. For years one flimsy study kept opening doors for the company and none of the investors or partners challenged this evidence for the effectiveness of the company’s blood testing technique. Instead, everybody was relying on others. The rationale went like this: If another reputable corporation was partnering or investing, then they must have checked it. So why lose time? BTW: If you are interested in the incredible Theranos-story, you should read Bad Blood, a book written by the Wall Street Journal reporter who was at the core of Theranos’ dissolution.
The instrumental role of a unique founder
Both SBF and Elizabeth Holmes were masters of self-branding. He wore white socks and spoke in a frail voice, she imitated Steve Jobs’ turtlenecks and talked as deep as a robot. Both were unusual. He was a nerd that allegedly played videogames while pitching million-dollar investments; she was a young female founder in a stale and slow industry. Also, both had grand visions. He wanted to re-invent the nature of money, she wanted to rid the world of needles. And they were never modest about their aspiration. Just last year SBF said he did not rule out that FTX will buy Goldman Sachs if it ever manages to become the largest crypto-exchange in the world.
He wanted to bring financial services to those that couldn’t afford it; she wanted to do something similar with blood diagnostics. SBF even preached an approach known as “effective altruism,” a stream of philanthropy that he himself helped to popularize. If, the theory goes, you earn as much money as possible and give it away for charitable couses it will grant the maximum positive impact to the world. That is why SBF was building FTX and all of his other ventures.
And the media bought it. Actually, all these things made for excellent media stories, whether it was SBF’s altruism, his baggy short pants, or the grand visions uttered as a matter of course. SBF and Holmes both made the covers of the leading business magazines, were regular guests in TV-talk shows, and spoke at the most important events. To spice things up, SBF opened his wallet in media-effective deals such as when he invested heavily in the football club Miami Heat.
The same mechanism that wooed the media also worked for celebrities. Both founders were hobnobbing with A-listers from all walks of life, sharing stages with former presidents and world leaders. Some of them were actively part of FTX and Theranos. While the top-names of SBF’s endorsers included Tom Brady, Gisele Bündchen, and Kevin O’Leary, Theranos was supported by political heavyweights such as Henry Kissinger, George Shultz, Jim Mattis, and Betsy DeVos. SBF too was seeking to be close to politics, and he never shied away from pouring money into it. He pumped $40m into Democrat’s 2022-mid-term campaigns, making him the second largest donor to the Democratic Party. In Washington he was seen as the friendly face in the midst of a crypto-Wild West. And SBF even lobbied for his industry to be regulated. Never mind his company was based in the Bahamas.
The crucial difference
With all the credibility that SBF and FTX were getting through celebrities, seasoned investors, politicians, and the media it is no wonder then that customers who simply wanted to invest their money at a big exchange ended up entrusting their money to FTX. They are the least to blame but stand to lose the most. And herein lies the major difference to Theranos. While Holmes’ blood testing startup has caused huge harm to direct investors and even worse has yielded numerous diagnostic errors that have resulted in wrong treatment or no treatment of serious diseases, the impact has largely stayed contained to those people and companies directly in contact with Theranos.
The FTX unravelling, on the other hand, had crippling effects across the entire industry. It has wiped out billions of investments of the exchange’s users and indirectly impacted the wealth of hundreds of millions of people that are now suffering from the sliding prices of basically every cryptocurrency in the market. But it doesn’t stop there. Questions now abound as to whether FTX’s downfall could be just the first step that set off a chain reaction. The financial world is holding its breath as other (large) exchanges are rushing to prove that they have the adequate liquidity and that they will not be the next FTX.
What is ahead for the crypto-industry?
With the exception of Coinbase, which is a publicly-listed company in the US and thus regularly audited, exchanges are publishing so-called Proof-of-Reserves (PoR). Most PoRs are built on Merkle-trees. Those are a basic concept in all cryptocurrencies and can best be described as a hash of hashes. Hashing is a one-way cryptographic function that transforms input variables, i.e. transaction data, into an alphanumeric-code of fixed length. The codes of multiple encrypted transactions are run through this encryption mechanism until only one value is left. In the case of PoR it gives a cryptographic snapshot of all of an exchange’s reserves without actually opening the books to external auditors. For many this is not good enough.
The most heated debate is currently led by the CEOs of Binance and Kraken. Binance is by far the world’s largest exchange and has published a PoR in order to calm jittery markets. Yet Kraken CEO Jesse Powell tweeted that the “statement of assets is pointless without liabilities.” Without it you can’t really know which assets belong to the exchange and which to customers. The fact that Kraken, gate.io, and OKX are among the very few exchanges that have provided such a Proof-of-Liabilities is very concerning. If another giant keels over, it might deal an almost fatal blow to the industry. To be sure, the failure of FTX has nothing to do with any shortcomings of the technology or the big cryptocurrencies, but those types of digital assets work only as long as money is pouring in due to investor confidence.
In the end, it is the fatal industry-contagion that makes the FTX-downfall more like that of Lehman-Brothers than that of Theranos. It is so much more than just the undoing of a promising startup. The next days and weeks will show how interconnected FTX was and how resilient the crypto-industry really is.