Scott Treloar on fraud and value transfer through deception in crypto land

The crypto winter has turned into a crypto ice age. Is it the end? How is it all impacting the hedge fund industry? “I don’t see a great future for cryptocurrencies,” says Noviscient’s Scott Treloar as he shares his thoughts on the FTX collapse and where things are at.

Why do you think that many major financial firms got caught in the FTX collapse? That some inexperienced retail investors have fallen for the smooth sales talk is one thing, but supposedly experienced and risk-aware fund managers and institutional investors should know better, right?

It is interesting that some of the world’s most sophisticated investment firms put their investors’ capital into what turns out to be a very bad investment. How did this happen? Firstly FOMO. This was a hot market in a rapidly developing sector based on technology that seemed promising at the time. Sam Bankman-Fried was very high profile. In this situation, the fear of missing out drove the investment decision. It feels very much like Madoff where investors relied on the social proof of the prominence of the founder rather than an understanding of the business. The second reason was poor due diligence. Given the number of red flags that quickly appeared since the collapse of FTX, proper due diligence was clearly lacking. Alternatively, it was undertaken but more as a pro-forma effort because the decision to invest had already been made.

Do major VCs and financial institutions have a moral duty here? Those big-name early backers of FTX and other troubled firms seemingly led others to get involved. Do they have any kind of responsibility here?

With respect to investing in FTX, I think the big financial investors just got it wrong. They did a bad job and are suffering the consequences. Smaller firms that followed the big firms are also suffering and will need to think about their business models of relying on lead investors. Nevertheless, there are some morally dubious VC practices going on in crypto. For example, VCs will invest in a new crypto firm. As part of the investment, they get issued a lot of tokens at near-zero cost. Their involvement helps pump up the price of the tokens, which they then rapidly flip to retail investors before moving on to the next investment. Retail investors are then subject to the ineluctable decline in token value. This is classic value transfer through deception and not a good look.

Do you think that FTX started out as a fraud or was it a naïve operation that got out of hand and evolved into a fraud?

I don’t think FTX started as a fraud. Sam Bankman-Fried left an HFT firm, Jane Street, to create the Alameda Research hedge fund. They initially made good profits from the large inefficiencies in the crypto markets. But then competitors entered the market and started to make life difficult for Alameda. A quick pivot saw them launch FTX as a crypto market-maker, leveraging Alameda liquidity. Unfortunately, governance and operational control were suboptimal. There was a lack of external directors, operating and reporting infrastructure was missing, and Alameda and FTX had a secret relationship. FTX wouldn’t automatically close out Alameda positions no matter how bad it got. So as Alameda continued to lose money from trading, FTX kept moving funding across to it – which problematically seems to have included FTX customer funds. In summary, it was a lack of competence leading to a slippery slope that likely ended up in fraud.

Will we now see improvements in firms actually doing real due diligence, not least operational due diligence? Or will people forget and get back to old bad habits in a year’s time?

This was a shock for sophisticated investors and they will likely implement better practices into their standard operating procedures. That said, in finance, it is always about how well the incentives align the interests of the agents – investment professionals – with the principals – real money owners. For example, does the investment firm have too much capital and is under pressure to invest it? Do the agents have any skin in the game? Do the time horizons of bonuses match the investments? There is more that can be done to build a real structural alignment of interests. Jack Bogle did it at Vanguard. But the vision and intent of the people with the power to put this in place is rarely there.

Will the crypto-only hedge fund segment that has appeared in recent years survive this crypto ice age?

I don’t see a great future for cryptocurrencies. With institutional investors taking a giant step backwards and retail investors having largely lost money, there is no new money coming into the system. Which is appropriate because cryptocurrencies are empty vessels. As such, crypto-only hedge funds will also fade away.

What do you think will be the impact on those traditional hedge funds that have successfully traded some crypto and other digital assets as part of bigger macro or multi-strategy portfolios? Will they continue to trade the crypto markets long or short? No doubt, as long as there are “crypto believers” and “evangelists”, smart traders can take the other side of those bets and make money in the short term.

I guess there will continue to be some residual wealth transfer from retail traders to sophisticated hedge funds, at least for a while. However, with the unsavoury practices and general decline in cryptocurrencies, real money investors will increasingly eschew funds with any element of crypto trading. It won’t be worth the return or the fiduciary or reputational risk.

What about regulations? Are regulators waking up now and will we see any changes?

It is a difficult situation for regulators who want to encourage financial innovation while protecting retail investors and avoiding systematic risks. They should be looking to protect their citizens more as crypto has been a massive transfer of wealth from the uninformed hopefuls to institutions and whales.

Singapore seems to have changed their mind and moved from somewhat welcoming to crypto players to a more restricted stance, whereas Hong Kong seems to be moving back to becoming more welcoming of crypto firms again. In your opinion, is Singapore moving in the right direction and Hong Kong in the wrong one? Will we see more toing and froing as these financial centres fight to attract new business?

I think Singapore has broadly got it right by stopping crypto trading while remaining open to the possibility that something valuable may come out of blockchain – although I have my doubts.

The crypto/blockchain preaching about decentralisation and trustless solutions looked suspicious to many of us from the beginning. With the mirrors now taken down from the walls and the smoke cleared out of the room, will any kind of blockchain technology somehow evolve and be useful or is it all over now? So far, we have seen very little successful use of the technology.

The crypto movement had great timing in that it caught the zeitgeist of libertarianism and distrust of authority. An extraordinary amount of capital and talent was pushed into crypto. And while nothing good seems to have come out of all the money and effort, proponents continue to say, ‘it is still early.’ Well, it is hard to argue with that, so let’s go back to first principles. Crypto is all founded on the idea of the blockchain – the combination of cryptography and distributed ledgers. Both underlying technologies are quite old and putting them together creates a slow and clunky database that doesn’t seem to do anything that existing technologies can’t do better, faster, or cheaper.

Will the related Web3 nonsense now also face reality and either lie down and die like the shit sandwich it is or evolve to actually offer something tangible and useful?

Web3 is largely marketing hype driven by the crypto VCs that need to attract more retail money into crypto to keep the game going. To summarise my overall view, crypto has been gaslighting the world. It was entertaining, but now it is time to move on from crypto and onto activities that actually create value for the world.