What lessons every investor should learn after the collapse of top crypto exchange FTX?
Many investors were blindsided after the FTX fiasco caused billions in funds to go missing
Dubai: While the recent collapse of prominent cryptocurrency exchange FTX has clearly shaken confidence among investors worldwide, with billions in hard earned money lost, there were many painful yet valuable lessons that could be learnt.
“The latest in a series of bankruptcies of multi-billion-dollar companies this year, the FTX fiasco raises questions around sound financial management and alerts how people’s investments can at times be gambled away for financial gains,” said Brian Deshell, a UAE-based cryptocurrency trader and analyst.
“Many investors were blindsided by the recent collapse of cryptocurrency exchange FTX, as customers wait for answers about an estimated $1 billion (Dh3.67 billion) to $2 billion (Dh7.35 billion) of missing funds. Investigations into the vanishing assets — are reportedly in limbo.”
While much remains unknown about the future of FTX, and the 130 affiliated entities that have already filed for bankruptcy protection across the world, there are a few things that investors should take away from all of this. Here are a three of those key lessons to be learnt or factored in going forward.
Lesson #1: Stop storing your cryptocurrency on exchanges – use cold wallets instead
While the FTX saga underscores the importance of choosing the right exchange from the get-go and highlights why you should spend some time on choosing the right one, given the current uncertainty surrounding exchanges, experts also suggest changing how you story cryptocurrencies.
The FTX collapse has renewed interest in cold storage, or taking digital currency offline, making it less susceptible to hacks
Most online exchanges access crypto through online wallets – also known as ‘hot’ wallets – which run on internet-connected devices like computers, phones, or tablets. This can create vulnerability because these wallets generate the private keys to your coins on these internet-connected devices.
The safest storage option are ‘cold’ wallets, and they’re not connected to the internet and therefore are at a far lesser risk of being compromised. These wallets store a user’s private key on a device not connected to the internet and the user can view their portfolio without putting the key at risk.
“The FTX collapse has renewed interest in cold storage, or taking digital currency offline, making it less susceptible to hacks,” added Deshell. “However, the move makes assets less liquid and harder to trade quickly.”
Lesson #2: Crypto will offer increased protection for investors in a post-FTX future
There’s been an ongoing debate about how cryptocurrency should be classified and regulated, and it has intensified amid the FTX fallout.
“The colossal-style collapse of FTX should result in greater regulatory scrutiny and therefore increased protection for investors,” said Brody Dunn, an investment manager at a UAE-based asset advisory firm. “The efforts by governments worldwide to increase transparency in the market has ramped up as well.”
“The collapse of FTX is likely to increase pressure on crypto entities to disclose more information about their balance sheets, to safeguard client assets, to limit asset concentration and will induce more diligent risk management including management of counterparty risk among market participants.”
The chance that one of the parties involved in a deal might not make good on its promises, causing the other party financial harm is something crypto investors need to understand. This is what is referred to as ‘counterparty risk’.
Unfortunately, as FTX's collapse has shown, this trust has cost many people their crypto wealth if the exchange misappropriates customer funds and cannot cover withdrawals. Another concern for customers of exchanges face is a security hack that exposes users' coins to theft.
Whatever the reasons may be, the common denominator is that users are at risk of losing their funds permanently. If this proves to be the case, the affected exchange or service provider has defaulted in its contractual obligation to process withdrawals when due.
Lesson #3: Don't invest more than you can afford to lose, don’t borrow to invest
The age-old adage is to not invest more than you can afford to lose. However, investing money you don't have, known as leveraging, can be a strategy in the right hands but it is risky. This is particularly so in the case of FTX, which created its own cryptocurrency, FTT, then used it as collateral to raise loans.
“Leveraging is more dangerous than ever as central bankers worldwide tighten monetary policies,” added Dunn. “Money has become more expensive and harder to come by and that makes things very tricky for those who need to borrow to stay solvent.”
“It is especially dangerous when your collateral is valueless. However, to guard yourself against such leverage-induced losses at an exchange, ensure that security, liquidity, fees, history, and user experience are essential checks you make.”
Additionally, whether you’re investing in stocks, cryptocurrency or other assets, experts say a large percentage of a single holding can be risky. “For individuals who had a very high allocation to cryptocurrencies, whether in FTX or not, the crypto price crashes this year were a painful lesson in the importance of diversifying one’s investment classes,” Deshell added.
“When weighing portfolio allocations, 5 per cent of a single asset starts to be material and 10 per cent is very concentrated. Of course, there may be risk-mitigating circumstances for some investors. Even if a financial asset is speculative in nature, it can still play a role in a well-diversified portfolio, albeit in small amounts.”