A few lessons from the FTX meltdown: Risk, Red flags, and a Risky Business

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1)  Beware of financial institutions headquartered in OFCs – there’s a reason that they’re avoiding the full scope of US law and regulation. And while Bahamas does well in the Transparency Intl. Corruption Perceptions Index, there are other red flags, including allegations of corruption about the island as indicated in a US State Dept. report on investment climate, see https://lnkd.in/gGdrVaUr            As stated in that report (emphasis added): “Negative aspects include . . . internet connectivity issues, and high energy costs. The price of electricity averages four times higher than in the United States and is driven by antiquated generation systems . . . .” In other words, a crypto firm that is highly dependent on the internet places its HQ on an island without reliable internet connectivity and very expensive electric power. Really? 2)  What about other risk factors, including cryptocurrency as an asset class and FTX as a company? All I can say is that when movie stars and celebrity athletes start to recommend an investment, it’s time to sell. As an American financier was reputed to have said before the 1929 crash, when the guy who shines your shoes is giving you stock tips, it’s time to get out of the market. Matt Damon makes great movies and Tom Brady is a great football player –  let’s leave it at that. 3)  Overly complex corporate structures with far flung subsidiaries and affiliates, often in OFCs or other jurisdictions with weak regulation, can be a harbinger of bad things to come. Examples include the collapses of Enron, AIG, and Stanford International Bank in Antigua. 4)  Using any asset as collateral for a loan, as was done when Alameda borrowed from FTX, is always high risk; when that collateral is the FTT coin issued by one of the parties, FTX, and the coin is collateral for loans made to FTX by Alameda, a commonly owned affiliate, the risk goes off the charts. (For more about FTT, see https://lnkd.in/gzps8Kw3.) 5)  The absence of a reputable outside auditor is another red flag that was present in FTX as well as Madoff, Stanford International Bank and other large fraud schemes. 6)  Excessive growth in revenue and/or assets is another feature of fraudulent and/or mismanaged firms. FTX grew at an astonishing rate – unsustainable in the long term. 7)  Beware of illiquidity: Frauds and mismanagement often unravel as a result of a liquidity crisis such as the Great Recession of 2008, the S&L Crisis of 1988, and the recent crypto crash. Investors become illiquid, needing cash (yes, that means fiat). When they go to redeem their investments, they discover that there’s no there, there.

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