InvestMacro

By Amy Froide, University of Maryland, Baltimore County 

Enron. Bernie Madoff. FTX.

In modern capitalism, it seems as if stories of companies and managers who engage in fraud and swindle their investors occur like the changing of the seasons.

In fact, these scandals can be traced back to the origins of publicly traded companies, when the first stockbrokers bought and sold company shares and government securities in the coffee houses of London’s Exchange Alley during the 1700s.

As a historian of 18th century finance, I am struck by the similarities between what’s known as the Charitable Corporation Scandal and the recent collapse of FTX.

A noble cause

The Charitable Corporation was established in London in 1707 with the noble mission of providing “relief of the industrious poor by assisting them with small sums at legal interest.”

Essentially, it sought to provide low-interest loans to poor tradesmen, shielding them from predatory pawnbrokers who charged as much as 30% interest. The corporation made loans available at the rate of 5% in return for a pledge of property for security.

The Charitable Corporation was modeled on Monti di Pietà, a charitable institution of credit established in Catholic countries during the Renaissance era to combat usury, or high rates of interest.

Unlike the Monti di Pietà, however, the British version – despite its name – wasn’t a nonprofit. Instead, it was a business venture. The enterprise was funded by offering shares to investors who, in return, would make money while doing good. Under its original mission, it was like an 18th century version of today’s socially responsible investing, or “sustainable investment funds.”

Raiding the fund

In 1725, the Charitable Corporation diverted from its original mission when a new board of directors took over.

These men turned the corporation into their own piggy bank, taking money from it to buy shares and prop up their other companies. At the same time, the company’s employees began to engage in fraud: Safety checks ceased, books were kept irregularly and pledges went unrecorded.

Investigators would ultimately find that £400,000 or more in capital was missing – roughly $108 million in today’s U.S. dollars.

In the autumn of 1731, rumors began to circulate about the solvency of the Charitable Corporation. The warehouse keeper at the time, John Thomson, who was in charge of all loans and pledges but also in league with the five fraudulent directors, hid the company’s books and fled the country.

At the shareholders’ quarterly meeting, they found that money, pledges and accounts had all gone missing. At this point, the proprietors of the Charitable Corporation stock appealed to the British Parliament for redress. One-third of those who petitioned were women, a proportion that equaled the percentage of women who held shares in the Charitable Corporation.

Many women were drawn to the corporation because of its public mission in providing small loans to working people. It’s also possible that they had been intentionally targeted for fraud.

The parliamentary investigation led to various charges being leveled against both managers and employees of the Charitable Corporation. Many of them were forced to appear before Parliament and were arrested if they did not. The managers and employees deemed most responsible for the 1732 fraud, such as William Burroughs, had their assets seized and inventoried in order to help pay back the shareholder losses.

Bankruptcy proceedings were started against the banker and broker, George Robinson, and the warehouse keeper, Thomson. Both Sir Robert Sutton and Sir Archibald Grant were expelled as members of the House of Commons, with Grant being prevented from leaving the country and Sutton ultimately prosecuted in several courts.

In the end, the shareholders received a partial government bailout – Parliament authorized a lottery that reimbursed only 40% of what the corporation’s creditors had lost.

The risks of concentrated power

There are several key characteristics that stand out in the collapses of both the Charitable Corporation and FTX. Both companies were offering something new or venturing into a new sector. In the former’s case, it was microloans. In FTX’s case, it was cryptocurrency.

Meanwhile, the management of both ventures was centralized in the hands of just a few people. The Charitable Corporation got into trouble when it reduced its directors from 12 to five and when it consolidated most of its loan business in the hands of one employee – namely, Thomson. FTX’s example is even more extreme, with founder Sam Bankman-Fried calling all the shots.

In both cases, the key fraud was using the assets of one company to prop up another company managed by the same people. For example, in 1732, the corporation’s directors bought stock in the York Buildings Company, in which many of them were also involved. They hoped to juice stock prices. When that didn’t happen, they realized they couldn’t cover what they had taken out of the Charitable Corporation’s funds.

Fast forward nearly 300 years, and a similar story seems to have played out. Bankman-Fried allegedly took money out his customer accounts in FTX to cover his cryptocurrency trading firm, Alameda Research.

News of both frauds also came as a surprise, with little advance warning. Part of this is due to the ways in which managers were well respected and well connected to both politicians and the financial world. Few public figures mistrusted them, and this proved to be a useful screen for deceit.

I would also argue that in both cases the company’s connection to philanthropy lent it another level of cover. The Charitable Corporation’s very name announced its altruism. And even after the scandal subsided, commentators pointed out that the original business of microlending was useful. FTX’s founder Bankman-Fried is an advocate of effective altruism and has argued that it was useful for him and his companies to make lots of money so he could give it away to what he deemed effective causes.

After the Charitable Corporation’s collapse in 1732, Parliament didn’t institute any regulation that would prevent such a fraud from happening again.

A tradition of loose oversight and regulations has been the hallmark of Anglo-American capitalism. If the response to the 2008 financial crash is any indication of what will come in the wake of FTX’s collapse, it’s possible that some bad actors, like Bankman-Fried, will be punished. But any regulation will be undone at the first opportunity – or never put in place to begin with.

About the Author:

Amy Froide, Professor of History, University of Maryland, Baltimore County

This article is republished from The Conversation under a Creative Commons license. Read the original article.

By D. Brian Blank, Mississippi State University and Brandy Hadley, Appalachian State University 

In the fast-paced world of cryptocurrency, vast sums of money can be made or lost in the blink of an eye. In early November 2022, the second-largest cryptocurrency exchange, FTX, was valued at more than US$30 billion. By Nov. 14, FTX was in bankruptcy proceedings along with more than 100 companies connected to it. D. Brian Blank and Brandy Hadley are professors who study finance, investing and fintech. They explain how and why this incredible collapse happened, what effect it might have on the traditional financial sector and whether you need to care if you don’t own any cryptocurrency.

1. What happened?

In 2019, Sam Bankman-Fried founded FTX, a company that ran one of the largest cryptocurrency exchanges.

FTX is where many crypto investors trade and hold their cryptocurrency, similar to the New York Stock Exchange for stocks. Bankman-Fried is also the founder of Alameda Research, a hedge fund that trades and invests in cryptocurrencies and crypto companies.

Within the traditional financial sector, these two companies would be separate firms entirely or at least have divisions and firewalls in place between them. But in early November 2022, news outlets reported that a significant proportion of Alameda’s assets were a type of cryptocurrency released by FTX itself.

A few days later, news broke that FTX had allegedly been loaning customer assets to Alameda for risky trades without the consent of the customers and also issuing its own FTX cryptocurrency for Alameda to use as collateral. As a result, criminal and regulatory investigators began scrutinizing FTX for potentially violating securities law.

These two pieces of news basically led to a bank run on FTX.

Large crypto investors, like FTX’s competitor Binance, as well as individuals, began to sell off cryptocurrency held on FTX’s exchange. FTX quickly lost its ability to meet customer withdrawals and halted trading. On Nov. 14, FTX was also hit by an apparent insider hack and lost $600 million worth of cryptocurrency.

That same day, FTX, Alameda Research and 130 other affiliated companies founded by Bankman-Fried filed for bankruptcy. This action may leave more than a million suppliers, employees and investors who bought cryptocurrencies through the exchange or invested in these companies with no way to get their money back.

Among the groups and individuals who held currency on the FTX platform were many of the normal players in the crypto world, but a number of more traditional investment firms also held assets within FTX. Sequoia Capital, a venture capital firm, as well as the Ontario Teacher’s Pension, are estimated to have held millions of dollars of their investment portfolios in ownership stake of FTX. They have both already written off these investments with FTX as lost.

2. Did a lack of oversight play a role?

In traditional markets, corporations generally limit the risk they expose themselves to by maintaining liquidity and solvency. Liquidity is the ability of a firm to sell assets quickly without those assets losing much value. Solvency is the idea that a company’s assets are worth more than what that company owes to debtors and customers.

But the crypto world has generally operated with much less caution than the traditional financial sector, and FTX is no exception. About two-thirds of the money that FTX owed to the people who held cryptocurrency on its exchange – roughly $11.3 billion of $16 billion owed – was backed by illiquid coins created by FTX. FTX was taking its customers’ money, giving it to Alameda to make risky investments and then creating its own currency, known as FTT, as a replacement – cryptocurrency that it was unable to sell at a high enough price when it needed to.

In addition, nearly 40% of Alameda’s assets were in FTX’s own cryptocurrency – and remember, both companies were founded by the same person.

This all came to a head when investors decided to sell their coins on the exchange. FTX did not have enough liquid assets to meet those demands. This in turn drove the value of FTT from over $26 a coin at the beginning of November to under $2 by Nov. 13. By this point, FTX owed more money to its customers than it was worth.

In regulated exchanges, investing with customer funds is illegal. Additionally, auditors validate financial statements, and firms must publish the amount of money they hold in reserve that is available to fund customer withdrawals. And even if things go wrong, the Securities Investor Protection Corporation – or SIPC – protects depositors against the loss of investments from an exchange failure or financially troubled brokerage firm. None of these guardrails are in place within the crypto world.

3. Why is this a big deal in crypto?

As a result of this meltdown, the company Binance is now considering creating an industry recovery fund – akin to a private version of SIPC insurance – to avoid future failures of crypto exchanges.

But while the collapse of FTX and Alameda – valued at more than $30 billion and now essentially worth nothing – is dramatic, the bigger implication is simply the potential lost trust in crypto. Bank runs are rare in traditional financial institutions, but they are increasingly common in the crypto space. Given that Bankman-Fried and FTX were seen as some of the biggest, most trusted figures in crypto, these events may lead more investors to think twice about putting money in crypto.

4. If I don’t own crypto, should I care?

Though investment in cryptocurrencies has grown rapidly, the entire crypto market – valued at over $3 trillion at its peak – is much smaller than the $120 trillion traditional stock market.

While investors and regulators are still evaluating the consequences of this fall, the impact on any person who doesn’t personally own crypto will be minuscule. It is true that many larger investment funds, like BlackRock and the Ontario Teachers Pension, held investments in FTX, but the estimated $95 million the Ontario Teachers Pension lost through the collapse of FTX is just 0.05% of the entire fund’s investments.

The takeaway for most individuals is not to invest in unregulated markets without understanding the risks. In high-risk environments like crypto, it’s possible to lose everything – a lesson investors in FTX are learning the hard way.

About the Author:

D. Brian Blank, Assistant Professor of Finance, Mississippi State University and Brandy Hadley, Associate Professor of Finance and the David A. Thompson Professor in Applied Investments, Appalachian State University

This article is republished from The Conversation under a Creative Commons license. Read the original article.

By D. Brian Blank, Mississippi State University and Brandy Hadley, Appalachian State University 

In the fast-paced world of cryptocurrency, vast sums of money can be made or lost in the blink of an eye. In early November 2022, the second-largest cryptocurrency exchange, FTX, was valued at more than US$30 billion. By Nov. 14, FTX was in bankruptcy proceedings along with more than 100 companies connected to it. D. Brian Blank and Brandy Hadley are professors who study finance, investing and fintech. They explain how and why this incredible collapse happened, what effect it might have on the traditional financial sector and whether you need to care if you don’t own any cryptocurrency.

1. What happened?

In 2019, Sam Bankman-Fried founded FTX, a company that ran one of the largest cryptocurrency exchanges.

FTX is where many crypto investors trade and hold their cryptocurrency, similar to the New York Stock Exchange for stocks. Bankman-Fried is also the founder of Alameda Research, a hedge fund that trades and invests in cryptocurrencies and crypto companies.

Within the traditional financial sector, these two companies would be separate firms entirely or at least have divisions and firewalls in place between them. But in early November 2022, news outlets reported that a significant proportion of Alameda’s assets were a type of cryptocurrency released by FTX itself.

A few days later, news broke that FTX had allegedly been loaning customer assets to Alameda for risky trades without the consent of the customers and also issuing its own FTX cryptocurrency for Alameda to use as collateral. As a result, criminal and regulatory investigators began scrutinizing FTX for potentially violating securities law.

These two pieces of news basically led to a bank run on FTX.

Large crypto investors, like FTX’s competitor Binance, as well as individuals, began to sell off cryptocurrency held on FTX’s exchange. FTX quickly lost its ability to meet customer withdrawals and halted trading. On Nov. 14, FTX was also hit by an apparent insider hack and lost $600 million worth of cryptocurrency.

That same day, FTX, Alameda Research and 130 other affiliated companies founded by Bankman-Fried filed for bankruptcy. This action may leave more than a million suppliers, employees and investors who bought cryptocurrencies through the exchange or invested in these companies with no way to get their money back.

Among the groups and individuals who held currency on the FTX platform were many of the normal players in the crypto world, but a number of more traditional investment firms also held assets within FTX. Sequoia Capital, a venture capital firm, as well as the Ontario Teacher’s Pension, are estimated to have held millions of dollars of their investment portfolios in ownership stake of FTX. They have both already written off these investments with FTX as lost.

2. Did a lack of oversight play a role?

In traditional markets, corporations generally limit the risk they expose themselves to by maintaining liquidity and solvency. Liquidity is the ability of a firm to sell assets quickly without those assets losing much value. Solvency is the idea that a company’s assets are worth more than what that company owes to debtors and customers.

But the crypto world has generally operated with much less caution than the traditional financial sector, and FTX is no exception. About two-thirds of the money that FTX owed to the people who held cryptocurrency on its exchange – roughly $11.3 billion of $16 billion owed – was backed by illiquid coins created by FTX. FTX was taking its customers’ money, giving it to Alameda to make risky investments and then creating its own currency, known as FTT, as a replacement – cryptocurrency that it was unable to sell at a high enough price when it needed to.

In addition, nearly 40% of Alameda’s assets were in FTX’s own cryptocurrency – and remember, both companies were founded by the same person.

This all came to a head when investors decided to sell their coins on the exchange. FTX did not have enough liquid assets to meet those demands. This in turn drove the value of FTT from over $26 a coin at the beginning of November to under $2 by Nov. 13. By this point, FTX owed more money to its customers than it was worth.

In regulated exchanges, investing with customer funds is illegal. Additionally, auditors validate financial statements, and firms must publish the amount of money they hold in reserve that is available to fund customer withdrawals. And even if things go wrong, the Securities Investor Protection Corporation – or SIPC – protects depositors against the loss of investments from an exchange failure or financially troubled brokerage firm. None of these guardrails are in place within the crypto world.

3. Why is this a big deal in crypto?

As a result of this meltdown, the company Binance is now considering creating an industry recovery fund – akin to a private version of SIPC insurance – to avoid future failures of crypto exchanges.

But while the collapse of FTX and Alameda – valued at more than $30 billion and now essentially worth nothing – is dramatic, the bigger implication is simply the potential lost trust in crypto. Bank runs are rare in traditional financial institutions, but they are increasingly common in the crypto space. Given that Bankman-Fried and FTX were seen as some of the biggest, most trusted figures in crypto, these events may lead more investors to think twice about putting money in crypto.

4. If I don’t own crypto, should I care?

Though investment in cryptocurrencies has grown rapidly, the entire crypto market – valued at over $3 trillion at its peak – is much smaller than the $120 trillion traditional stock market.

While investors and regulators are still evaluating the consequences of this fall, the impact on any person who doesn’t personally own crypto will be minuscule. It is true that many larger investment funds, like BlackRock and the Ontario Teachers Pension, held investments in FTX, but the estimated $95 million the Ontario Teachers Pension lost through the collapse of FTX is just 0.05% of the entire fund’s investments.

The takeaway for most individuals is not to invest in unregulated markets without understanding the risks. In high-risk environments like crypto, it’s possible to lose everything – a lesson investors in FTX are learning the hard way.

About the Author:

D. Brian Blank, Assistant Professor of Finance, Mississippi State University and Brandy Hadley, Associate Professor of Finance and the David A. Thompson Professor in Applied Investments, Appalachian State University

This article is republished from The Conversation under a Creative Commons license. Read the original article.