If you’re reading this blog, you’re probably well aware of the FTX CryptocurrencyExchange implosion. Over a billion dollars worth of exchange customer investments are gone. Some individuals lost very significant portions of their net worth! Now-former CEO of FTX, Sam Bankman-Fried, is catching a lot of the blame — and potentially criminal charges — for being the architect of the exchange’s collapse.
FTX’s downfall was largely due to risky money moves Bankman-Fried made with his customers’ money, including rerouting around $10 billion of customer funds to the high-risk hedge fund Alameda Research, a sister company of FTX. However, while it certainly appears Bankman-Fried deserves blame for this individual collapse, it can also be argued that such collapses are par for the course in the cryptocurrency investing space.
Crypto is Inherently Volatile
We’ve talked about money before in these blogs, discussing how money itself is valueless. You can’t eat a dollar bill or make anything useful with it. Yet we view that dollar as valuable. Why?
Money represents value. You know that if you have enough money, you can exchange it for things you really want and need, like cars or housing. In short, money is valuable because enough people see it as valuable. To understand why crypto is so volatile, it’s important to understand the mechanics underlying that belief.
For money to be valuable as a medium of exchange, it needs to meet two main criteria. It must be scarce and people must believe in its value. By controlling the money supply, the government makes money scarce. There’s an old saying, “money doesn’t grow on trees.” We don’t use leaves as money because it would be too easy for everyone to obtain as much money as they want; once everyone is a trillionaire, being a trillionaire holds no value.
Of equal, if not greater, importance is that people believe money is valuable. If everyone suddenly lost confidence that money has value, then the idea of using money as a medium of exchange would collapse. People believe money is valuable largely because the government not only says it is but also promises to uphold its value now and in the future. Because it’s backed by the government, we can be reasonably sure that having money today means we will be able to buy things with that money tomorrow.
That highlights the central problem with cryptocurrency volatility. Governments don’t back crypto — there’s no promise that a bitcoin worth thousands today will be worth anything at all tomorrow.
Without government backing, the only real factor lending value to crypto is its scarcity. Since cryptocurrency tokens are created by computers competing to solve complex math problems, scarcity is baked into the system. But many things that are scarce are also valueless, and on its surface, a bit of data on a hard drive would seem to fall into that category!
It’s only because enough people believe that cryptocurrency is valuable that it holds any value at all. But because it’s not backed by any entity capable of guaranteeing its usefulness as a medium of exchange, belief in that value fluctuates rapidly, which causes volatility.
Lack of Regulation Carries Risk
Regulation is simultaneously great and terrible. When Ralph Nader’s Unsafe atAny Speed was published over half a century ago, it prompted almost every state in the nation to pass seat belt laws. Many opposed those laws, feeling they were a significant intrusion on our freedom of choice. On the other hand, in the years since those laws were passed, seat belts have saved well over 350,000 lives. People can debate over whether or not the lives saved were worth the increased government regulation, but it’s inarguable that because of that regulation, hundreds of thousands of people didn’t die in car crashes.
A similar argument can be made about Crypto. Lack of government oversight in a financial space is great if you’re planning to launder money or do other illegal things. But it’s not so great if you’re one of FTX’s many victims who lost significant amounts of money
With that background in mind, how should you approach investing in crypto?
Remember It’s Volatile
Approach crypto investing with the idea that it is very possible you will lose your entire investment. One way to think about it is if you want to buy cryptocurrencies, use the money you’d otherwise have spent on lottery tickets!In other words, bet on crypto with money you’re comfortable losing. If you make a lot of money, that’s great. But as with any investment, always ask yourself how comfortable you are with the amount of risk you’re taking on.
Consider Who Holds Your Money
FTX’s collapse caused a lot of people to lose a lot of money and drew almost instant comparisons to the Bernie Madoff disaster. Both FTX and Madoff were relatively untested custodians of their clients’ finances. Because they had direct access to clients’ money, they were able to reroute that money into places their clients didn’t intend it to go.Once those unauthorized investments collapsed, so did the clients’ portfolios.
Compare that with a financial advisory firm like Asset Preservation Wealth &Tax. We don’t actually hold our clients’ money.We use custodial companies such as TD Ameritrade, Charles Schwab and Fidelity. Those are long-established, highly-trusted giants of the financial world. The likelihood that a Bernie Madoff or a Sam Bankman-Fried could play high-risk unethical and illegal games with clients’ accounts is quite small.
FTX is a Cautionary Tale
Above all, you should view FTX’s demise as an event that illustrates a hazard.Get-rich-quick ventures, from multi-level marketing scams to cryptocurrency, rarely work reliably and often carry extremely high risk.
Don’t let tales of skyrocketing values drive you to make hasty investment decisions you may come to regret later. You should always thoroughly evaluate any investment you’re considering. Make sure you truly understand the investment and the risks associated with it before sinking money into it.
StewartWillis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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