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FTX: The Dominoes of Financial Fraud Have Yet to Fall Once assets are revealed as worth far less than claimed, insolvency is the inevitable result. What you will find is insight into the real innovation of FTX: FTX compressed the entire playbook and history of financial fraud into one brief cycle of the credulous bamboozled, Charles Ponzi bested and creative accounting being revealed for what it really is, fraud. All financial frauds share the same set of tools. The toolbox of financial fraud, whether it is traditional or crypto-based, contains variations of these basic mechanisms:
I have often recommended Herman Melville's novel The Confidence-Man for its masterful depiction of how The Confidence-Man persuades the skeptic that not only is The Confidence-Man trustworthy, but he is doing the mark a favor in taking his money. Note that there are quasi-legal versions of some of these tools. The full exposure to the risks inherent in extreme leverage and illiquidity can be cloaked, buried in off-balance sheet assets and liabilities, etc., while pages of mind-numbing disclosures were duly signed by blinded-by-greed marks. These quasi-legal versions are just as prone to unraveling and collapse as the blatantly fraudulent varieties. Properly disclosed leverage and illiquidity are just as prone to unraveling as undisclosed leverage and illiquidity. Mismatches of duration, liquidity and risk are just as toxic to full-disclosure firms as they are to fraudulent firms. This is why we can predict the dominoes of FTX's financial fraud have yet to fall. When there are mismatches in counterparty asset durations and liquidity, assets that theoretically cover loans that are called can't be sold or can only be sold at ruinous discounts. Leverage works both ways, and so the 100-to-1 leverage that's so glorious when the $1 yields $100 in gains also triggers the mass liquidation of illiquid assets when small losses unwind all that leverage. Everyone caught short by losses, redemptions and counterparty claims will be desperate to hide their exposure to insolvency. But humans are herd animals, and once the herd gets spooked, trust in assurances quickly plummets and all eyes are on counterparty risks and the actual market for lightly traded assets. Once assets are revealed as worth far less than claimed, insolvency is the inevitable result. How far will the lines of toppling dominoes extend? Quite possibly much farther than the credulous believe possible.
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