Friday, February 23, 2024

Technology may change, but not the importance of history

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Echoes of past market bubbles in FTX scandal

The world hailed Sam Bankman-Fried (SBF) as a genius, innovator, and, according to many trusted members of the finance community, the “JP Morgan of cryptocurrency.” Why was this? Was it because of his financial innovations? Perhaps it was the prospect theory — investors were keen on the potential winnings from SBF’s crypto derivatives on FTX rather than considering the foreseeable losses. Whatever the reason, investors were lied to, manipulated, and left with hardly anything.

The story of FTX and SBF is all too similar to one of a man named John Law — a tale of financial innovation, mishandled manipulation, and a market bubble.

In the early 18th Century, France was in economic turmoil — spending during the reign of King Louis XIV created numerous debts. In 1716, the French monarchy appointed John Law, a Scottish economist, to jumpstart the French economy. He instituted several changes that altered French society. First, he wanted authority to issue bank notes, so he opened Banque Générale. Next, he created the Mississippi company, a trading company utilizing resources of France’s Louisiana Territory in North America. Law went across France, discoursing the riches and glory that the company would promise. To invest in this “limitless potential,” Law issued shares of the company, which citizens bought with bank notes. French society fell under Law’s spell; poor citizens bought in and became millionaires purely because of the tremendous demand for shares.

John Law’s promises amounted to nothing. With the liquidity (gold and silver) traded for bank notes to buy Mississippi company shares, Law began spending on his ventures. He purchased the right to collect French taxes, necessities for colonial development, expanding trade and government debt. However, he mishandled these ventures and issued more and more shares to pay for increasing losses. Eventually, little return led some citizens to buy back gold — but there was far less gold than bank notes. Thus, a bank run and financial bubble occurred. Banque Générale’s balance sheet was unbalanced; there were far more liabilities than assets.

This story is eerily similar to that of FTX. Sam Bankman-Fried became the face of cryptocurrency and crypto derivatives, producing marketing campaigns with trusted public figures, buying arena naming rights, and pushing into every corner of modern societal life. Investors dove in, eager to join in on this “trusted” method to make seemingly easy money. With the invested capital in FTX’s asset side of the balance sheet, Sam Bankman-Fried used the funds for separate ventures — underwriting it to his quant research firm (Alameda Research), risky investments, taking some for his own, and more mishandled operations. When Binance, the world’s largest crypto exchange, saw Alameda and FTX’s balance sheets, it questioned the exchange’s legitimacy and liquidated hundreds of millions in FTT shares, the trading token representing FTX’s worth.

Binance’s withdrawal triggered a bank run on FTX as most investors lost confidence, immediately selling their positions in hopes of more trusted assets (cash). Nonetheless, FTX didn’t have the liquidity to cover this; its balance sheet had an asset-site contagion. Does this sound familiar?

Sam Bankman-Fried and John Law are two intertwined stories of financial history. Trusted and spewing false promises and lies, these men manipulated markets and, as a result, created financial bubbles. Innovators in finance have an idea, but not always do they have a plan after implementation.

In the realm of finance, fast-paced decision-making and the “Game-of-Thrones”-like winning attitudes omit the lessons of history. Investors must be prudent, always looking for patterns of the past.

Nick Diamond was born and raised in Southwest Florida. He is a sophomore studying Finance and History through the Wharton School of Business at the University of Pennsylvania.

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