FTX: The Dominoes of Financial Fraud Have Yet to Fall
Authored by: Charles Hugh Smith

Once assets such as FTX are revealed as worth far less than claimed, insolvency is inevitable. If you haven't plowed through dozens of post-collapse commentaries on FTX, I'm saving you the trouble: here's a distillation of what matters going forward. If you're seeking a forensic accounting of FTX, others have done this work already. You won't find that here if you're seeking an ideological diatribe.

You will find insight into the real innovation of FTX: FTX compressed the entire playbook and history of financial fraud into one short cycle of the gullible, bamboozled, Charles Ponzi bested, and creative accounting being revealed for what it 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:

1. Using clients' capital (without full disclosure) to increase the private gain of the Owners of the Con (OOTC).

2. Using the clients' capital to arbitrage yields differentials in duration, risk, and other asymmetries to the benefit not of the clients but of the Owners of the Con (OOTC).

3. Overstate assets by listing illiquid, insider-controlled, non-marked-to-market assets at valuations wholly disconnected from reality, i.e., what they would fetch on the open market in size. Rely on assets issued by the firm or its subsidiaries for the bulk of its assets, i.e., its claim of solvency.

4. Attracting new capital investments and client funds with "too good to be true" (but borderline plausible, given the tremendous growth and track record of high returns) returns, goals, and promises to cover the typical churn of redemptions, so the fraud goes undetected. (Ponzi Scheme)

5. Play fast and loose with leverage, the full extent of which isn't disclosed to clients or regulators.

6. Issue securities (i.e., "money"--tokens, bonds, shares of stock, etc.) whose value is based on the firm's fraudulently listed assets and mouth-watering growth.

7. Persuade investors and clients that you're doing them a favor by letting them get a piece of the action. In other words, they exploit their near-infinite greed.

8. Present a facade of prudent, audited, transparent, regulated stability which cloaks the interlocking network of fraud, bogus accounting, illiquid assets, etc., and insider looting.

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 total exposure to the risks inherent in extreme leverage and illiquidity can be cloaked, buried in off-balance sheet assets and liabilities, etc. At the same time, 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 cracking as undisclosed leverage and illiquidity.

Mismatches of duration, liquidity, and risk are just as toxic to full-disclosure firms as 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, 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 belief possible.

This article was printed from TradingSig.com

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