What Now, Crypto?

Catholic investors who seek to manage their assets through the lens of their faith know to exercise prudence and due diligence in decision-making and assessing risk, but the latest financial scandal involving the FTX crypto exchange raises questions about whether that is adequate.
 
Samuel Gregg, an affiliate scholar at the Acton Institute and a distinguished fellow in political economy at the American Institute for Economic Research, said that investing in cryptocurrency is like any other investment product.
 
“You need to look at the substance of what you’re investing in and to try and understand how it works,” Gregg said. “If you don’t understand it, then you probably shouldn’t be investing in it. If you have no conception of how a particular industry or a sector of the financial market functions, that’s probably a good reason not to invest in the first place.”
 
Michael Pakaluk, professor in the Busch School of Business at Catholic University of America, concurs. Especially when it comes to something as speculative as crypto, he remarked, prudent investors should not invest in anything they can’t afford to lose.

Forsaking due diligence?

Still, many investors who supposedly understood crypto and thought FTX was a strong name — and one of the most transparent crypto operations — were taken in and lost money when the $32 billion exchange collapsed and more than $1 billion in customer funds disappeared recently.
 
A high-level example of this was Sequoia Capital, which has apologized to its fund investors for losing $150 million on FTX. The company’s partners have said they believe they were misled by FTX and will enhance their due diligence in the future.

“If you’re in financial markets and you’re doing proper due diligence of any firm, you would look at things like governance structures and reports,” Gregg said. “I think we can say in retrospect that FTX’s governance structures were at a minimum unclear and that transparency was not the strong point of FTX.”
 
Jason Reed, assistant chair of the finance department at the University of Notre Dame, said he thinks even risk-averse investors would have been fooled by FTX founder and CEO Sam Bankman-Fried and the messages he was relaying to investors. “Without independent auditing of financial statements, Bankman-Fried and FTX could get away with the high level of fraud that they were committing.”

Underregulated industry

Pakaluk characterized cryptocurrency investing as “pretty much a Wild West. It’s not well regulated, and that is part of the ethic of crypto.”
 
People involved in crypto are concerned about what’s called “monopoly currency,” he added, and therefore prefer it remain unregulated.
 
Yet that, said Reed, is also one of the dangers.
 
“Because of the decentralized nature and lack of regulation in crypto, consumers looking to invest in crypto should be prepared to shoulder the immense risk that comes with that space,” he explained. “Right now, I don’t know if consumers can tell the difference. That’s a little scary.”
 
Even in such an environment, however, many investors considered their money safe in Bankman-Fried’s hands. Although Tesla CEO Elon Musk famously said he backed out of a partnership with the FTX founder because he “set off my B.S. detector,” other prominent, seemingly responsible investors were caught up in a kind of hysteria.
 
Gregg said that in financial markets there can be a tendency toward this sort of herd mentality. “But even so, it doesn’t excuse you from doing your due diligence as far as you can,” he pointed out.

Such frenzied following of the pack was common in the 1920s, Pakaluk said, and led to the Great Depression. That in turn spawned the Securities Act of 1933, which requires that before investing in any company offering shares for sale across state lines, investors be given a prospectus with audited financial statements along with a transparent explanation of what the business is and its risks.
 
Still, he continued, although people read those prospectuses for a time after they were mandated, few bother to look at them now. “People are buying stocks on smartphones because of hunches, tips, and momentum,” Pakaluk warned. “It’s a dangerous place for society to be at in general.”

A cryptic future

Gregg said he would like to think that financial advisers were looking beyond the smoke and mirrors of FTX when it was making enormous donations to political campaigns, securing a sponsorship agreement for the Miami Heat arena and doing Super Bowl advertisements. Rather than accepting the exchange’s prominence as a sign of financial health, he said, advisers might have investigated to make sure that appearances matched reality.

As for what effect FTX’s demise will have on crypto investing’s future, Reed said, “I think that the crypto markets will weather the storm but will lose some of the independence that makes it attractive.”
 
Pakaluk said after an initial rush and bubble and a lot of new entrants into the crypto space, a shakedown is now going on, and valuations will decrease with it.
 
“Basically, anybody would have made money on crypto four years ago, but now it’s a very difficult market and institutional investors are moving away from it,” he said. “Some used to say that some portion of your portfolio should be in crypto, but no one is saying that now.”

Nonetheless, he added, the market is doing its work and going through a self-correction.
 
Gregg agreed: “We should allow the market to test crypto’s effectiveness, and if it turns out it doesn’t live up to its promise, the market will tell us that.” For now, he continued, “Some see it as one possible option while others won’t touch it with a barge pole. I expect this will be the case for some time.”

Reed said he thinks that imposing stronger protections for consumers and investors will lower the associated riskiness with crypto. “We may end up seeing more crypto investing and adoption if regulators begin to lay down consumer-protection regulations,” he suggested.

If crypto is to be regulated, however, Pakaluk does not think the government should do it.
 
“FTX was good old-fashioned embezzlement, and I don’t think that in itself raises questions about the nature of crypto or cryptocurrency,” he said. “Just ordinary due diligence and prudence and good sense should be sufficient.”

Crypto-virtue signaling?

When it came to a virtuous image, FTX seemingly had it all – high ESG (Environmental, Social, and Governance) ratings and a CEO who donated to progressive causes and was interested in Effective Altruism (EA), which seeks to identify and solve the world’s most pressing problems.

Yet, that may have blinded some investors to the problems that led to FTX’s demise.
 
Samuel Gregg of the Acton Institute said FTX’s presentation of itself as guided by EA, along with its ESG ratings, was attractive to many.
 
But “the more you look at EA and ESG, you soon discover that it’s internally incoherent and methodologically deeply suspect,” Gregg explained. “Yet these things have acquired a type of virtue-signaling function so that people thought that by investing in these companies, they were not just making a good return, but they were also letting everyone know that they were being a good person as well.”