Broker Check

The Canary in The Coal Mine

April 19, 2024

In 2019, a small investment fund wanted to expand its cryptocurrency trading strategy. The fund was generating phenomenal returns, so raising capital was effortless. Pitches like these may have also helped1.

The fund’s name was Alameda Research. Soon after, it launched FTX and grew this crypto trading platform to the largest in the world by early 2022. Months later, the world learned that FTX was a total fraud.

FTX reportedly had billions on its platform, paid Tom Brady and Larry David handsomely for endorsements, and financed strong political connections in D.C. Few predicted FTX would become one of the largest financial frauds in history, but a closer look at the advertisement above was riddled with red flags.

Anytime anyone anywhere offers double-digit returns with zero risk, run. There’s no reason to dig any deeper. It’s that simple. However, some ancillary lessons can be learned from the red and yellow highlights.

First, the Securities and Exchange Commission (SEC) regulates investment funds so strictly that no legitimate compliance department would ever allow the word “guarantee” to be printed on any advertisement.

Second, the only loan with “no downside” is a U.S. Treasury bond. Every other form of investment has risk, especially those offering high returns. Third, fixed-rate loans with no lockups and interest paid in either U.S. dollars or highly volatile crypto are recipes for disaster. It just takes a little volatility or an exogenous event to wipe everything out (as we saw more than once in 2022).

Defying gravity

Fairfield Greenwich Group is an investment firm that started in 1983 in New York City. They launched the Fairfield Sentry Fund in 1990, and the chart below shows the cumulative performance of $1 invested was worth $6.75 by late 20082. That’s an annualized return of over 11% for 18 years.

The only problem is that this fund was a conduit to Bernie Madoff. The performance was fake, and his Ponzi scheme failed shortly before this chart was publicized. The media frenzy around this story was like no other financial fraud, but not everyone was surprised.

Harry Markopolos spent years trying to persuade the SEC to investigate Madoff. The story goes that it only took Markopolos five minutes to determine that Madoff was running a scam. Here are his words3:

“It was a 45-degree angle without any variation," he said. "It went in only one direction: up. It never had variation like the market does, like this. And that was the key tip-off.”

Charts like these may look desirable, but straight 45-degree angles don’t exist in investing. There’s only one way to defy the laws of financial gravity, and that is to cheat.

The bottom line

It’s been estimated the increase in road deaths in the three months following September 11th, 2001, was 353. This estimate exceeded the total number of passengers killed on the four hijacked airplanes. Another study reported an increase of 1,595 in traffic fatalities over the twelve months following the attacks4.

According to researchers at Cornell University, the aftershock of Madoff's crimes caused $363 billion in withdrawals from investment funds unrelated to him. The withdrawals were so hefty that some investment firms went out of business5.

This happened despite the immaterial impact on most investors and markets. He stole a few billion from the $40 trillion in investable assets in the U.S.6, which is practically a rounding error. Most of his investors even recovered sizeable portions of their original investment5.

Financial fraud and acts of terrorism get a lot of media attention, but actual instances of both are extremely rare. Using either as a reason never to fly again or sit in cash and lose to inflation can cause way more harm than good.

The attacks on 9/11 changed the world in many ways. Thousands died, and it took years to move on. But in the process, our country became safer and stronger. Name a single hijacking that lasted more than 90 seconds since then. I can’t. They don’t happen anymore in developed countries.

Sure, one could happen again, but the controls to prevent them appear to be working. The world learned a lot from 9/11, and airport security and anti-terrorism efforts have improved to where the warning signs that once went undetected are now apparent.

Madoff and FTX tricked a lot of very smart people, but the irony is that both made the investment industry safer. Investors conduct far more due diligence today than before, and standards of practice have been adopted across the industry, forcing elevated levels of transparency and risk controls.

But while we may not see another major hijacking anytime soon, expect more financial frauds. Also, accept the reality that most investors won’t see them coming. The lessons learned from FTX and Madoff have made investing less risky, but they haven’t made it bulletproof.

The bottom line is that the best way to protect against the next fraud is to remain diversified and never put too much into one investment. Sure, this may sound cliché, but only because it works.


 

Sources

1 https://www.somethinginteresting.news/p/the-fall-of-ftx-part-i

2 https://seekingalpha.com/article/111559-if-you-ever-see-a-chart-like-this-run-away-fast

3 https://www.npr.org/2009/02/04/100242196/madoff-whistle-blower-testifies-blasts-sec

4 https://www.cambridge.org/core/journals/judgment-and-decision-making/article/terrorism-dread-risk-and-bicycle-accidents/C92A446489D5A92BF07FF5265DA40313

5 “The Future of Wealth in The United States” – Deloitte Consulting, 2015

6 https://www.businessinsider.com/bernie-madoff-ponzi-scheme-363-billion-dollar-exodus-investment-funds-2017-7/

Disclosures

This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.