Waves of retail investors saw Web3 and envisioned a utopian wild west where millionaires are created overnight… and capital management is needed.
Not fully taking the time to educate themselves or with a lack of understanding of risk tolerance can result in massive financial loss for various reasons. Even the brightest minds in any market can crumble.
For this reason, I recommend that any investor or individual passionate about financial markets read When Genius Failed by Roger Lowenstein. Lowenstein tells the story of the firm Long-Term Capital Management (LTCM), which is riddled with lessons for retail and institutional investors and organizations alike.
Here’s the story in short:
Short-Term Capital Management
In 1994, Nobel Prize-winning economists Myron Scholes and Robert Merton backed esteemed Salomon Brothers trader John Meriweather to form a hedge fund. Their strategy was to take trade of advantage of arbitrage opportunities using leverage to yield a greater return. The numbers rose quickly and did not fall; investors were quite happy with their returns.
The “catch 22” was investor funds ($10mm minimum investment) were locked for three years upon deposit, and investors were not to ask where funds were invested. Despite investors lacking clarity and insight into the fund’s investments, LTCM had no issue raising capital and delivering massive ROI in their initial years of operation.
In 1998, LTCM was at the top of the game—with >$120bb in AUM and >$1tt in exposure from leverage, LTCM was untouchable…or so they thought.
Let’s go back to 1993 for a second: When the Soviet Union collapsed, the Russian Government issued its first round of «Государственное Краткосрочное Обязательство» (ГКО) in the spring of ’93. A «ГКО»/”GKO” or “government short-term commitment” were zero-coupon (discount rate with no interest amount) bonds issued to help revitalize the new Russian economy. The bond issue, and other actions taken to privatize and redistribute previously state-owned assets and companies, were made to bootstrap the new Russian economy.
The firm had tremendous success trading the previous year during the Asian financial crisis, and Russia appeared to many as a ripe ground for investment. Seeing the potential in this investment, LTCM went in big.
A «ГКО»/”GKO” or “government short-term commitment” were zero-coupon (discount w/ no interest payment) bonds issued to help revitalize the new Russian economy. Flash forward to 1998: LTCM holds a significant position in GKOs and is still highly leveraged in these investments. In August of 1998, the Russian Govt defaulted on its debt. LTCM was hemorrhaging money, but their model suggested that LTCM hold their GKO position…so they did. A mixture of high leverage, a lack of disclosure, and bad luck in the markets crushed the firm of all firms.
Genius Failed and Lessons Learned
As bankruptcy loomed, financial authorities recognized that allowing LTCM to go bankrupt would crash markets around the world due to the scale of the firm and its holdings. In short, LCTM was deemed too big to fail, and the United States Federal Reserve helped structure a bail-out. Sound familiar? I can think of a few recent examples in the TradFi and DeFi ecosystems that come to mind: Three Arrows Capital, Celsius, Voyager, LUNA, and FTX.
While there are several notable differences between the cases of LCTM and FTX, the parallels between the collapses of LTCM and FTX are intriguing. Respected individuals considered among the brilliant minds in their fields of investing achieved massive success and appeared as behemoths incapable of failing.
Both firms traded using extreme leverage in their investments to get to the top, contributing to their downfall. Until June 2021, FTX offered their customers the opportunity to trade using 100x leverage before deeming the risks too severe and lowering the max leverage on a margin trade to 20x.
Following FTX’s collapse, SBF was arrested and charged by the US government, the most recent charge coming on February 23rd, bringing the total number of criminal charges faced by Sam Bankman-Fried to 12. Despite blocking FTX from entering the Canadian market in the months before FTX’s collapse, Canada passed new legislation to prevent leverage and margin-trading on cryptocurrencies, in addition to enacting regulation that prevents exchanges from combining user funds and cash needed for business operations.
Despite disaster after disaster, the system fails to correct itself until any problem reaches the worst possible levels where the retail consumer bears much of the brunt. Even then, it is often too late. Understanding the history of markets and the lessons learned in the past may not make us perfect investors.
Still, we can move forward with a better understanding of risk tolerance and why we, as investors, need to assess it to develop a more well-informed thesis of how and why we put money where we invest. Do your research and due diligence, and take no proclaimed word as an absolute; it might save you a few bucks on your investment journey.
