It was a November to remember — at least in the markets. The S&P 500 ended the month up 5.8%, the Dow Jones Industrial Average up 6% (pulling itself out of a bear market), and the Nasdaq up 5.3%. That’s the second straight month that stocks have closed the month higher — a welcome reprieve that hasn’t happened since 2021.

What drove this month’s stock market gains?

Well, it helped that the midterm elections were less controversial than expected. (Something I think we can all be thankful for.) 

But also, October’s inflation report came in lower than expected. Consumer demand seems to be cooling, and the housing market is slowing — in truth, this latest report reflected a broad slow-down across most categories. Lower inflation could mean that higher interest rates are already working to slow the economy down, so many are hoping that the Federal Reserve may not have to do much more. In fact, big gains on the last day of the month were fueled by Fed Chair Jerome Powell’s indication that the Fed is eyeing a smaller rate hike this time around.

But that’s not all interest rates are doing

Many of the excesses that built up when interest rates were low — household savings, tech stock investments, meme-stock trading, etc — are now unwinding. Remember when interest rates were close to zero and T.I.N.A. was the investing mood of the moment? That hyperfocus on stocks over other asset classes led to lofty tech company valuations that are now coming back down to Earth. That, in turn, is fueling a series of layoffs across the industry — even from the once-seemingly untouchable Facebooks and Amazons of the world.

And last but certainly not least: the recent fall in crypto prices (“crypto winter”) and the resulting collapse of FTX — the second-biggest crypto exchange in the world. Even large, “sophisticated” investors got this one wrong, and pundits are calling its downfall a potential “watershed moment” for the crypto industry. 

Those are some grand claims, so let’s dig in and unravel all the chaos.

What happened with FTX in November 2022

What is (er, was) FTX, and where did it go wrong?

Just a few months ago, the crypto exchange FTX was valued at more than $32 billion. Many considered it to be a “safer” business in the crypto industry — one that merely brought buyers and sellers together, and earned a decent middle-man commission for doing so, similar to any other traditional exchange. 

It was founded by Sam Bankman-Fried (aka “SBF”), a 30-year-old MIT grad. He convinced everyone from prominent VC firms to celebrities that he was not a stereotypical “crypto bro,” but exactly the opposite (and maybe even the “savior” that the crypto world needed). He was also one of the Democratic party’s biggest donors during the recent midterms (as a big proponent of advancing regulation in the crypto space) and had expressed a desire to use his fortune for “effective altruism.”

At the same time, SBF also owned another company called Alameda Research. Its name made it sound like a consulting firm, or maybe a think tank, but in reality, it was a market-maker that was taking on risky bets. The thing is, the two companies were supposed to have nothing to do with one another … but that didn’t turn out to be the case. So here’s where it gets sticky. 

Alameda owned a lot of FTT, the crypto tokens (kind of like cryptocurrency vouchers) issued by FTX. It’s common for crypto exchanges to offer their own proprietary token, because it gives the company something tangible to offer early investors and provide as incentives to get traders to use the exchange. The value of a crypto token is essentially whatever the market says it is, so theoretically, it should get more valuable if the exchange does well and sees a lot of activity. But when crypto trading volume fell earlier this year, the price of FTT fell with it. 

The problem was, it turns out Alameda Research was using its FTT as collateral for the loans that financed its risky bets. Put this all together, and it's a recipe for disaster. Borrowing funds to make risky bets? We’ve seen this story before — the 2008 subprime crisis, or the meme stock mania of 2020, take your pick. It never ends well. 

FTX’s collapse

Fast forward to 2022, when higher interest rates led people to sell off their risky assets — the riskiest being cryptocurrency. Alameda lost money on its risky bets. But because its collateral — FTT — also lost money, it was a double whammy. 

And then, instead of letting Alameda fail, SBF quietly decided to move billions of dollars in customers’ funds from FTX over into Alameda to help offset its losses. (Big yikes.)

All of this was happening under the radar — until November 2, when Coindesk published a report showing that Alameda held a large amount of FTT. Changpeng Zhao (“CZ”), founder and CEO of Binance (the only crypto exchange larger than FTX), caught wind of it. And even though he owned a major competitor, he also happened to be an early investor in FTX who owned nearly $500 million worth of FTT. 

CZ threatened to dump his FTT holdings, which sent the token’s prices spiraling. That led to a “run on the bank” scenario, with FTX customers trying to withdraw funds — but they couldn’t, because SBF had moved them to Alameda (and where they went after that, we don’t yet know). 

CZ offered to buy the company to help save it — only to back out within 24 hours. (Of course, it wouldn’t be 2022 without most of the communication about all of this happening via Twitter.) FTX was ultimately forced into bankruptcy, and thousands of customers are unlikely to ever get their money back again. 

The post-collapse fallout

We aren’t very far out from the collapse yet. But what we know right now is that FTX’s new CEO has already found a ton of operational issues, from a lack of governance (no board of directors) to outright fraud (like purchasing homes for employees with corporate funds). The SEC & DOJ are actively investigating. 

And the contagion — the risk that this collapse will poison the crypto industry — is very real. FTX owes more than $3 billion to its creditors, which span the entire crypto industry. BlockFi, which took a line of credit from FTX earlier this year, is now preparing for bankruptcy. Meanwhile, Genesis Global, which had lent money to Alameda, is trying to raise funds after it received a rush of withdrawal requests. Both companies have paused customers’ ability to make withdrawals.

Crypto companies aren’t the only ones in hot water, either. Investing “experts” also got this one wrong — and not just firms that are known for taking on risky investments, like Softbank or Tiger Global. Prestigious VC firms like Sequoia, large asset managers like BlackRock, and even the Ontario Teachers Pension Plan fell for it, too. They all missed basic due diligence red flags — see: inaccurate accounting and no corporate governance, the president of FTX tweeting that customer funds were FDIC-insured when they weren’t, and (!?!) the fact that SBF was playing video games while pitching to Sequoia. 

So how will this change things in the long term? For starters, stricter regulations for the crypto industry seem all but certain. Still, investor confidence in the industry has taken a huge hit — one that it may not recover from (or at least for a long time). FTX isn’t the first crypto firm to go under this year, but in the words of its new counsel, this was “one of the most abrupt and difficult collapses in the history of corporate America and the history of corporate entities around the world.”

Sometimes, what you don’t invest in is just as important as what you do invest in

FTX lured a lot of customers to the exchange by offering hefty yields. But you know the saying: If it seems too good to be true, it usually is. 

The takeaway: Know what you own and how your potential sources of returns are expected to be earned. At Ellevest, our rigorous due diligence process — along with our core principles of diversification, minimizing costs, and focusing on our client’s goals — have helped us avoid a lot of these FOMO land mines for our clients these last few years. And we hope the same for you.

Disclosures