Incentives are the strongest force in the world. They explain why good people do awful things, why smart people do stupid things, and why ordinary people do amazing things. Nearly everyone underestimates how much their own beliefs and actions are influenced by their incentives, many of which are designed to fulfill someone else’s goals. – Morgan Housel

For a 21 year old, he gets it. He seems to have a grasp on monetary policy, gold to fiat history and the place that Bitcoin has in the world and it’s future. Plus he has the guy in the middle frame speechless the whole time, not sure if that’s good or bad but, interesting as I kept waiting to see if he was going to jump in the conversation at some point.

Additional thoughts on FTX

Incentives for fraud

The FTX implosion looks to be likely fraud or some kind of massive oversight and/or just some bad incentives. With the wrong incentives people can just plain behave badly. Morgan Housel has a short blog post on incentives that covers this topic better than I can here. But, basically once you create incentives that are tempting, too tempting, people can behave badly. People that normally would not steal or commit fraud start to bargain with themselves and wind up slowly dipping into bad behavior, if they don’t get caught, it keeps going. There are many cases of embezzlement that start as innocent “borrowing” from petty cash. Once no one notices that the cash is going out and not coming back ,over time there is an incentive to dip in more. And then you have these news stories of let’s say, because I remember this happening in a town near where I live, I’ll go with this following. Example: You have a town clerk that gets busted for being on the take to the tune of $30K, it all started slowly with small dips and grows to a big number.

Misjudgement and/or Incompetence

Or is FTX/Alameda more about a big misjudgement or incompetence. After all there are precedents for this. Smart people losing boat loads of money as they have not counted on some kind of fat tail event happening. This even occurred with Nobel Prize winners, freshly minted in 1997, Myron Shoales ( Of the Black-Scholes option pricing formula fame ) and Robert Merton ( also part of the  the same famous formula as a contributor ) when in 1998 John Merriweather’s LTCM, Long Term Capital Management imploded as they were seriously over-betting. They were heavily leveraged at the time, which is OK to a point, but they didn’t diversify enough so when things went wrong, the leverage actually went up, when they should have manually dialed it down. What happened at the time was that in 1998 Russia defaulted on it’s debt which LTCM was invested in but they also were invested in the same way with other foreign debt. Well, once one country defaults, it casts a shadow on the rest of the foreign debt as people start to get a bit paranoid as to who might default next. So if you are LTCM and you have a bunch of positions in this same kind of sovereign bonds all over the world, you are certainly not diversified  enough ( they might have thought this all sovereign bond debt was uncorrelated somehow, that bonds would never fall in unison) and if this chunk is a big part of your portfolio and it tanks guess what, bad news fast.

Death Spiral

With LTCM and others,  you get a situation where you have to liquidate something before a margin call happens, usally it’s good stuff that you might want to hold otherwise. This can depress prices of those assets. Soon a firm can get in a situation where the best description would be a reverse hedge and the losses mount on both sides of the trade. With leverage, large leverage 30,60X, it quickly consumes the real capital available. If you try to ask for more capital at this point, nervous lenders may sense panic and then the gig is up. Once lending banks or any other credit line smells something ‘funny’ in the air, panic calls for more capital, through price movements, insider info, whatever, they and other competitors will start to work against a firm like LTCM. They can trade against it and bleed it dry even faster, or they might start dumping the same assets pushing price down more and dry up any liquidity for a firm like LTCM to sell into. Then the problem grows so big that Fed has an emergency meeting and either puts other banks up to the challenge, the creditors, to carve up the carcass and potentially hold the assets until a better time to unload, or worst of all like in Lehman Brothers and etc, the taxpayer gets the bill, or QE happens, which generates inflation, just another tax.

LTCM could have taken the market down much like what happened 10 years later. A excellent course on how the economic collapse of 2008 played out is available at Khan Academy for free as all the material there is, Current Economics

Something like this could have happened at FTX, to much leverage and some fraud with users money, over-betting on the market as it was going into a down-cycle and they couldn’t get out of the dive. If this was a bull market, this kind of stunt might have worked out. Worst of all seems like they used their own FTT token as collateral. It seems like a real conflict of interest, if not just a bad idea as you have created what could be best described as a type of recursive risk. A risk that becomes riskier and you take on more risk. A few more anecdotes from LTCM thanks to one of my favorite books, William Poundstone’s Fortune’s Formula….

• LTCM lost $4.4B from it’s peak, the partners aloe had dropped about $1.8B. The entire fund had shriveled to $28M in weeks.
• Robert Merton (1997 Nobel Prize Winner) lost as much as $100M.
• Larry Hilibrand took out a $24M loan to increase his stake in the fund, leverage on top of leverage. His net worth went from $100M to $20M in debt thanks to the loan. He requested a bailout from the banks carving up LTCM known as the consortium, they said no.

More Interesting FTX Reads

https://www.coindesk.com/layer2/2022/12/02/sam-bankman-frieds-self-incrimination-tour/

https://www.coindesk.com/layer2/2022/11/30/ftxs-collapse-was-a-crime-not-an-accident/

FTX Contagion Slowly Being Revealed

A good interview on this FTX issue is one between C.J Wilson and Josh Olszewicz. It’s well worth seeing them pick this FTX issue apart further.