FTX goes bankrupt

Between 8 and 11 November 2022 the FTX platform, one of the world’s largest in crypto-assets, declared bankruptcy after it emerged that it had used customer funds. Its founder would later be convicted. For those who had their money on the platform, the episode meant losing access to their funds and enormous uncertainty about how much they could recover. It is worth remembering that behind the figures are real customers whose savings were put at risk.

The case is relevant beyond the crypto world because it is an extreme example of a very old problem in finance: entrusting money to an intermediary without really knowing how it is managed. That the firm was large and well known did not prevent the fall. That is why the episode should be taken as a general lesson about custody, transparency and supervision, applicable to any type of investment.

A fall within days

Within barely a few days, one of the largest platforms in the world went from operating normally to declaring bankruptcy. The speed of the fall shows that, when a financial institution loses its customers’ confidence, everyone tries to withdraw their money at once and problems that were hidden come to light.

This kind of dynamic, in which a loss of confidence feeds on itself, is what has historically given rise to so-called bank runs. In the traditional financial system there are safeguards to limit their impact, such as supervision and guarantee funds. In a less regulated market, those protections may be missing and the effect on customers more severe. Regulated institutions are subject to rules on segregating funds and on disclosure, precisely to prevent situations of this kind.

Management and custody

FTX did not fail because of technology, but because of management and custody. It emerged that it had used customer funds, something that is prohibited in a regulated institution, and that its founder would later be convicted. In other words, the problem was not in the asset, but in who held it and how it was managed. It is not a question of technology but of corporate governance: who decides, who controls and who is accountable.

This distinction is essential. An asset can be legitimate and well designed and at the same time badly held by an unreliable intermediary. That is why, when assessing an investment, two questions must be separated: what is being bought and who holds it. Both matter, and a good answer to the first does not compensate for a poor answer to the second. Although an asset can be held on one’s own account, doing so requires technical knowledge and security measures that not everyone can take on; each option carries different risks.

The key question

For any investor, the key question is who really holds the assets and under what rules. Before entrusting funds to a platform, it is wise to know whether customers’ assets are segregated from the firm’s own, what supervision exists and how the money would be recovered if something failed.

Other useful questions are whether independent audits exist, what public information the firm provides about its accounts, what happens in the event of bankruptcy and what rights the customer has. If the answers are vague or cannot be verified, it is a warning sign. And, as always, it is wise not to put with a single intermediary more than could be lost without serious consequences. This note is general information, not a recommendation. Diversifying across intermediaries, and not only across assets, is a way to limit the damage if one of them fails.

In investing, trust without checking is a risk.

This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.