FTX WTF — What Next?

OK. Wow. I’m not going to take too long to rehash what’s already been well-reported in so many places across all forms of media. In sum, it appears that one of the largest crypto exchanges was using customer funds to shore up their hedge fund, which took on massive losses by originating their own coin. The specifics of what they did and how they did it were quite interesting. If you haven’t followed, you should read Matt Levine here. Here are some primary sources like The Alameda Research 2018 Pitch Deck, FTX Secondary Pitch Deck from Sept, and the memo from Sequoia that they took down but is now archived.

Sequoia: "After my interview with SBF, I was convinced: I was talking to a future trillionaire.”

Cringe. Squared. In retrospect, the signs were all there.

What am I taking away from this week? Stay the course to the tried and true.

I often say that higher education is over-rated and not everyone should go to university. However, it does often feel incongruent with how important and influential my university education has been for me. My career and knowledge as an investor sits on a bedrock of important reading and reflection from my time at Duke, particularly those lessons learned from two professors who I both regularly email with and who subscribe to this newsletter: Ed Tower and Emma Rasiel.

All of their advice and thinking about financial markets and investing has been TIMELESS. I read books as assigned during 2006-2008 (sadly, about 15 years ago), and the lessons are all the same. When I was in Emma’s class, we read When Genius Failed: The Rise and Fall of Long-Term Capital Management, which reminds me to this day how markets can stay irrational longer than we can stay solvent and how leverage can create massive losses.

We also read a book, which strangely, I don’t seem to be able to find anywhere on the Internet, entirely devoted to how full of shit Jim Cramer from Mad Money is/was, as written by a guy who worked for him. I remember reading this book in 2007 and then being amazed as Jim Cramer continued to be on TV. It’s so important to learn the lessons that much of media - particularly financial media - is entertainment and entirely not credible. And to learn them early so that they can only be reinforced and cemented by experience.

With Ed Tower, I read Stocks For the Long Run (a new edition is out, and Ed emailed me to recommend it highly just last week). But more importantly, with Ed, I spent a year writing a senior honors thesis on Time Zone Arbitrage in Vanguard Mutual Funds. I spoke about, thought about, and internalized all the lessons of Vanguard and John Bogle over the course of a year.

What does that have to do with this week and FTX? I have seven takeaways.

1) The power of “Reputation Ponzi Schemes.”

We don’t yet know exactly went down at FTX/Alemeda. It does seem to have elements of a Ponzi scheme. The aspect that I’m most interested in is a term coined by a close investor-friend who I’ve spent years discussing a phenomenon with - the nature of the “reputation ponzi scheme.” The idea that someone is credible because they are affiliated with someone who seems even more credible, which continues to bolster their story into a furor. Clearly, SBR was proficient at that, in the way Elizabeth Holmes also.

Every great fraud at the end has the human element of reputation. Maybe it was from his Stanford Law School parents. It’s the same behavior behind the mania in venture of outsourcing your due diligence to other “Tier 1” firms like Sequoia or Tiger. Still today, one of the most important slides for investment managers raising capital is the ‘reputation’ of the follow-on capital for being credible investors. There were probably many venture capital rounds raised last year when other investors took that FTX Ventures investing was a credible sign. Those companies probably have significant exposure.

Of all Ponzis to fall, the reputation one is most difficult. We will see more dominos fall and fall hard in this ecosystem.

I’ve been in countless conversations that go round and round about utility vs security tokens, how to create money out of the air (it’s a playbook many have been running: invest a token related to a community with some reputation ponzi scheme elements, do a swap of your token with another token (different reputation Ponzi scheme), mark your token to that valuation, sell as fast as you can). In these conversations, I’m usually the person being like, “But where is the cash coming from? What stream of cashflows underpin the token?” That’s always a problematic question.

Also, remember that if Accounting Ponzis get off easy, Reputation Ponzis get punished much less, if not at all.

2) The Ownership Economy and decentralized mission behind web3 remains.

This week doesn’t discredit all of crypto and web3. FTX doesn’t represent the entirety of web3 or crypto. It was a centralized exchange linked with a proprietary investment arm. It did not adhere to any of the values of decentralization and open governance that are core to web3. Eric Lavin and I wrote Web3: It’s all still happening in August, and I stand by everything we wrote.

A decentralized web can be powerful and is likely a big part of the future. Getting the technology to work and the UX/UI to be optimized is going to take years. Founders that build ownership incentives that are real will drive behavior and be successful.

Digital money is the future. Most money is already digital. Fraud is still fraud.

3) Think independently.

Tom Brady, Matt Damon, Sequoia, Tiger. Always think for yourself. People and institutions always have different and likely non-transparent motivations, so you have to do your best with the information you have. And, if you don’t have good information, don’t play the game.

4) Think long-term in a short-term world.

It always struck me as notable how quickly FTX rose to prominence. They were founded in 2019 and suddenly emerged as a massive market leader. How? Some people on Twitter have theories with how FTX was able to allow so many traders to be profitable, almost like the game was easy. This should have raised alarm bells about why it was such easy money. But, as the thread points out, everyone wants to believe they are smart, not that something is amiss with the system.

Someone on Twitter shared this short fiction called Slow Tuesday Night about the culture of such accelerated cycles from boom to bust with companies, financial markets, and relationships.

5) Invest in and/or build good businesses.

The only way to grow wealth is to own good businesses with high integrity people. It’s that simple. That’s what Stocks For The Long Run will tell you. That’s what Warren Buffett and Charlie Munger have practiced.

What’s a good business? Cash-efficient growth. Products that customers love. An enduring moat and competitive advantage. Competent and ethical management. A large and growing market.

Yes, it’s that simple.

6) Align capital with a contribution.

It’s been clear over the past ten years - and definitely in 2020 and 2021 - that you were rewarded for moving fast and growing at all costs. This included and was perhaps fueled by the investment industry. Managers that pumped up their investments and completed investments without diligence or conditions (e.g., pesky governance) were rewarded handsomely.

I was in a group chat with an investor in FTX and Luna. He said he wouldn’t do anything differently. Same message from Sequoia in their public letter to their LPs. My takeaway is this is the attitude that seems to impress. Never admit your mistakes. Our process works, even if this error lost money. It’s better to be invested with people who are insiders to the game than those who didn’t play.

A way to get around this, potentially, is to change the game to align capital with the contributions that are being made to a company. Less party rounds. Less YOLO-ing. Get back to the days where people were accountable for the outcome of their capital allocation on the micro-level. It’s impossible to do this at these mega funds.

7) Jack Bogle remains entirely unmatched. Who is the next Jack Bogle?

Who is the greatest philanthropist and most transformative entrepreneur of our time? Someone who re-wrote the rules of the financial system? Jack Bogle, the founder of Vanguard.

Discussing Vanguard and Jack Bogle deserved much more space but here’s the gist. Jack Bogle has saved the common American investor over $1 Trillion dollars by lowering fees on investment assets. He did that by force of his vision and also by the way he set up his company. Vanguard is a mutual, which means it is owned by its customers and clients and thus has a reinforcing incentive to keep fees low to non-existent. The rest of the industry has to compete against them.

In my time in and around the cyrpto industry, I’ve never heard a crypto-venturist discuss Jack Bogle. I found that odd, given he’s the OG of the ownership model in the finance and investment sector. I get that the cryptography and smart contract technical apparatus is interesting and, in a sense, defining of ‘crypto’. But, when advancing a technical innovation leap to try to transform the financial sector, it would have been nice to see leaders who actually walked the walk and paid any attention to those who had come before them.

The culture of ‘wen token moon?’ has always been disgusting and irresponsible. Raising a round of financing of $420, 690,000 isn’t funny. It’s juvenile. There are some things - like managing other people’s money - that deserve to be taken seriously. May our next generation of leaders be the stewards that our system deserves.

What is effective altruism? One of these philosophies popularized by SBF was ‘earn to give’, e.g., you should earn as much money and accumulate as much wealth as possible and then give it away. I can’t think of anything more system-destroying. And that’s before committing massive fraud. Jack Bogle had about $80M net worth at the time of his death a few years back. He didn’t need to give it all away because he had never taken so much from others; instead, he had spent decades giving it all back, bit by bit, to the American retiree.

Finding and helping the next Jack Bogle is one of the greatest opportunities of our time.