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        Faculty, Finance

        Harbert eminent scholar comments on FTX collapse and lessons learned in cryptocurrency

        November 29, 2022 By Michael Ares

        All News


        The failure of FTX, one of the largest cryptocurrency exchanges in the world, reminds us of something we’ve known all along—information, and timely and accurate information at that—is the most important component of every decision we make. Or, at least, we should have known that, according to James Barth, Lowder Eminent Scholar in Finance at Auburn University’s Harbert College of Business, a senior fellow at the Milken Institute, and a fellow at the Wharton Financial Institution Center.

        FTX filed for bankruptcy on November 11, followed quickly by its estimated 100-plus owned and tightly intertwined corporate entities. With reverberations still spreading across the globe, the full impact of this collapse on the cryptocurrency market has yet to be tallied. But to be sure, significant damage has been done to both the perceived and the actual value of this still quite new financial instrument available in the marketplace.

        In the wake of the FTX collapse, fundamental questions arise: How did this happen? What went wrong? Does this spell the demise of cryptocurrency itself? And if so, what are the consequences on a global financial basis?


        Harbert sat down with Professor Barth to tap into his world-renowned financial industry experience and regulatory expertise to find out just what happened to FTX—and why. His insight offers a critical reminder of the value of timely and accurate information when it comes to the investment decisions we make.


        Let’s address the elephant in the room: Is the failure of FTX an isolated incident or does it signal the coming end of cryptocurrencies? And where were regulators in all this?


        To begin with, reports of the death of cryptocurrency are “an exaggeration”—to quote what Mark Twain wrote back in 1897 about rampant rumors that he had died when he was, in fact, still very much alive.

        So, is this the death knell for the crypto market? While this less than 15-year-old financial market has taken a shot across the bow, the short answer is “No.” Cryptocurrency is simply too new and offers too many potential benefits to conclude that the demise of a poorly managed crypto exchange—one of the world’s largest—foretells the collapse of an entire market.

        One might ask whether this represents a systemic failure of the Securities and Exchange Commission (SEC) since it was established in the 1930s to ensure all material information is disclosed when firms seek to solicit funds from the public.

        Again, the short answer is “No.”


        Why not? Isn’t the SEC supposed to shield investors from this kind of failure?


        Not necessarily. The SEC was created not to shield investors but to ensure the public is informed about companies before investing in the stocks and bonds issued by them. We should realize—at the end of the day—with the disclosure of timely and accurate information to investors they are responsible for the results, whether it be gains or losses.

        Allow me to explain. The premise on which the SEC operates is that the public should receive material information to make informed decisions about whether or not to invest in securities issued by firms. The term “material” refers to the amount and kind of information—financial, operational, strategic, etc.— an investor needs to properly assess the prospects in terms of risk and expected return of an investment opportunity before deciding to invest or not.  

        So, if a company wants to raise equity (shares) or debt (bonds) from the public, it is required to disclose all material information about ongoing operations and report regularly on its financial health. As long as firms are transparent and forthcoming in terms of gathering and releasing all material information, they are free to raise money from the general public.

        However, in the case of the crypto market, it is reported that “the SEC believes crypto firms are illegally operating outside of U.S. securities laws and instead lean on other licenses that provide minimal consumer protection” according to Reuters.

        This indicates the SEC was quite concerned about crypto and expressed its view about the riskiness of this market to investors. It turns out that even while interest and participation in crypto grew, the total amount invested in cryptocurrencies reached a little less than a trillion dollars at its peak. By comparison, the total value of all the money, stocks, and bonds around the world is more than $400 trillion. Given the potential downside risk to the world economy from such a small percentage—far less than 1%—of the global financial marketplace failing perhaps wasn’t considered sufficient enough for more aggressive action on the part of governments or even a financial regulatory agency like the SEC.

        Recent events, however, are likely to bring about a change in behavior on the part of governments, regulators, and investors regarding the tradeoff of acting vs. not acting.


        What “tradeoff” are you talking about?


        The tradeoff—as it always is when it comes to the role of the government in the financial system—is between how much regulation and oversight is warranted and how much would be too much. It’s about balancing the costs and benefits. Too much intervention can stifle innovation and too little can contribute to financial instability.

        An analogy that may be helpful here is the Food and Drug Administration (FDA) labeling requirements that detail the ingredients that go into the food we buy—the nutritional data required by law to be prominently displayed on the packaging of most foodstuffs. But do consumers read and understand that info? And if so, how much does it affect their decisions about what to buy? Moreover, do people know how their decisions about what is bought affect their health?

        We don’t have to look too hard to notice that even with this level of mandated transparency, many people still fail to value that nutritional information as much as they might. We’ve all seen overweight people in the grocery store load up on ice cream, cookies, or potato chips when experts agree that eating those foods could negatively impact their health if the same eating habits continue over time. One might argue, then, that the FDA isn’t doing enough to protect us.

        But what would the alternative be—restricting access to certain foods based on one’s weight or other health conditions? How would that even work? Scales at the check-out line? Empowering grocery store cashiers to tell heavy-set individuals “No, you can’t buy that box of glazed donuts” while the person in line behind them can?

        Of course not. It’s hard to argue that regulators should do more than prohibit the sale of downright harmful foods and require transparency about the ingredients of other foods. Where does personal responsibility come into play when deciding what to eat?


        That sounds a lot like “buyer beware.” Is it really that simple?


        Simple, yes. Easy? Not quite. In the case of FTX, it appears that there was a lot that went wrong. Reports from James Bromley, a partner at the law firm Sullivan & Cromwell who is representing FTX at a bankruptcy hearing in federal court in Delaware, indicate that “a substantial amount of assets have either been stolen or are missing,” according to the New York Times. Bromley’s initial observation after a week on the case is that Sam Bankman-Fried, founder and former CEO of FTX, so poorly managed the company that lawyers are left with limited, and still searching for more, information about the firm’s finances. This seems to suggest that investors did not have, or demand, timely and accurate information about FTX at the time of their investments or thereafter until its pending bankruptcy.

        This didn’t have to happen. The warning signs were there—many, many signs. Most of them appear to have been ignored. Perhaps the most powerful warning was the “limited” information released by the company—always a red flag. It may turn out that timely and appropriately verified information was never gathered, let alone publicly disclosed, something now being pursued to determine whether inappropriate behavior was involved in what happened. Even due diligence by an investor may not uncover inappropriate behavior that occurs after an investment in a firm.


        If sufficient material information about the company wasn’t provided to investors, why did they invest in FTX?


        According to the Wall Street Journal, Sam Bankman-Fried said he wanted to prevent nuclear war and stop future pandemics, and he very publicly pledged to use his vast and growing wealth to do so. It appears that these and other lofty claims and the prominent persons with whom he appeared on occasion, participation in Congressional Hearings, and meetings with regulators may have been “misleading” signals to investors that the source of Bankman-Fried’s wealth was real—his ownership in the company he was allegedly running—rather than conducting their own due diligence on the financial condition of FTX.

        You might say investors did indeed rely on information in making their investments—just not the right information. This brings to mind the saying “trust but verify.”


        So, what lessons can be learned from all this?


        The most valuable lesson here concerns the value of information—not just any information, but the right kind of information and its timeliness. It might be difficult to fully understand the inner workings of a given company based on the information available and disclosed, but the amount and extent of such information is fairly easy to gauge. When material information isn’t provided to allow one to assess the risk and return of an investment, or is provided but not understood, it’s perhaps time to walk away.

        Of course, if an investment is a small portion of an investor’s wealth, such an investor might be willing to take the risk even without material information being provided, perhaps simply viewing the investment as similar to buying a lottery ticket, with a loss that is quite bearable but with a low probability of a huge gain.

        In the end, the consequences of not looking before we leapt into cryptocurrencies fall on us.


        James R. Barth is the Lowder Eminent Scholar in Finance at Auburn University's Harbert College of Business, a Senior Fellow at the Milken Institute and a Fellow at the Wharton Financial Institution Center. He was consistently recognized by SSRN as among the top 10% of authors as measured by all-time downloads. SSRN is devoted to the rapid worldwide dissemination of research and is composed of many specialized research networks. Barth has also been a visiting scholar at the U.S. Congressional Budget Office, Federal Reserve Bank of Atlanta, Office of the Comptroller of the Currency and the World Bank.