Echoes of past market bubbles in the FTX scandal
The world hailed Sam Bankman-Fried (SBF) as a genius, innovator and, according to many trusted members of the financial community, the “JP Morgan of cryptocurrency”. Why was that? Was it because of his financial innovations? Perhaps it was the prospect theory – investors were interested in the potential gains from SBF’s crypto derivatives on FTX, rather than considering the foreseeable losses. Whatever the reason, investors have been lied to, manipulated and left with little.
The story of FTX and SBF is all too similar to that of a man named John Law – a story of financial innovation, abusive manipulation and a market bubble.
early 18thth In the 19th century, France was in economic turmoil – spending during the reign of King Louis XIV resulted in numerous debts. In 1716, the French monarchy appointed John Law, a Scottish economist, to boost the French economy. He initiated several changes that transformed French society. First he wanted the authority to issue banknotes, so he opened Banque Générale. Next he founded the Mississippi Company, a trading company utilizing resources of the French Louisiana Territory of North America. Law walked all over France talking about the riches and fame the venture would promise. To invest in this “limitless potential,” Law issued shares in the company, which citizens bought with banknotes. French society fell under Law’s spell; poor citizens shopped and became millionaires simply because of the tremendous demand for stocks.
John Law’s promises amounted to nothing. With the liquidity (gold and silver) exchanged for banknotes to buy Mississippi Corporation stock, Law began spending money on his ventures. He acquired the right to collect French taxes, necessities for colonial development, the expansion of trade, and the national debt. However, he abused these ventures, issuing more and more shares to pay for mounting losses. Eventually, the low rate of return prompted some citizens to buy back gold—but there was far less gold than banknotes. This led to a bank run and a financial bubble. Banque Générale’s balance sheet was unbalanced; There were far more liabilities than assets.
This story is eerily similar to FTX’s. Sam Bankman-Fried became the face of cryptocurrency and crypto derivatives, producing marketing campaigns with trusted public figures, buying arena naming rights and penetrating every corner of modern social life. Investors dived in, eager to get involved in this “trusted” way to make seemingly easy money. With the invested capital on the assets side of FTX’s balance sheet, Sam Bankman-Fried used the funds on separate ventures – transferring to his quant research firm (Alameda Research), risky investments, acquiring some for himself and other failed operations. When Binance, the world’s largest crypto exchange, saw the balance sheets of Alameda and FTX, it questioned the exchange’s legitimacy and liquidated hundreds of millions in FTT shares, the trading token that represents the value of FTX.
Binance’s pullback triggered a bank run on FTX as most investors lost confidence and immediately sold their positions in hopes of more trusted assets (cash). Despite this, FTX did not have the liquidity to cover this; its balance sheet had a contagion on the investment side. Does that sound familiar to you?
Sam Bankman-Fried and John Law are two intertwined stories of financial history. Trusting and using false promises and lies, these men manipulated the markets and as a result created financial bubbles. Innovators in finance have an idea, but not always a plan after implementation.
When it comes to finance, quick decisions and a Game of Thrones-like winning mentality ignore the lessons of history. Investors need to be cautious and always look for past patterns.
Nick Diamond was born and raised in Southwest Florida. He is a sophomore studying finance and history at the Wharton School of Business at the University of Pennsylvania.