We are often told that if we do not learn from our history we are doomed to repeat. If this is truly the case then apparently humans are screwed, as over 300 years of lessons have failed to teach us anything in the realm of financial fraud. The last few weeks have been a whirlwind of revelations and disappointment that crypto company FTX had managed to run for nearly 3 years apparently defrauding its investors.

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The company, run by acclaimed hotshot CEO Sam Bankman-Fried has been revealed to have been little more than a Ponzi scheme, with their very own CEO providing a better explanation of the likely criminal activity undertaken than anything we could write ourselves. Almost giving us a welcome break from writing.

person in black long sleeve shirt using macbook pro — Con, what con?

“You start with a company that builds a box and in practice this box, they probably dress it up to look like a life-changing, you know, world-altering protocol that's gonna replace all the big banks in 38 days or whatever…”

“And now all of a sudden everyone's like, wow, people just decide to put $200 million in the box. This is a pretty cool box, right? Like this is a valuable box as demonstrated by all the money that people have apparently decided should be in the box…”

“And so then, you know, [box] token price goes way up. And now it's [$330 million] market cap token because, you know, the bullishness of people's usage of the box. And now all of a sudden of course, the smart money's like, oh, wow, this thing's now yielding like 60% a year in [box] tokens. Of course I'll take my 60% yield, right? So they go and pour another $300 million in the box and you get a psych and then it goes to infinity. And then everyone makes money.”

The Ponzi scheme that young Mr. Bankman-Fried described blew up on November 7th, just as he was confidently tweeting “Assets are fine”. The cost to customers ranks in the billions of dollars with a b, and we will probably not get to the bottom of the amount lost by FTX for numerous years and countless court cases.

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2 months ago · 4 likes · 2 comments · LettsGroup

Nevertheless, though surely there weren’t lessons for regulators and intelligent investors to have learned from, to ensure that Ponzi style schemes such as FTX couldn’t be allowed to rise to the level of prominence that costs the customer billions, and threatens to tank an entire new industry. And obviously no similar example of a massive Ponzi scheme being unveiled right at the head of a major global downturn exists?

In the autumn of 2008 the financial world was in crisis. The global recession had reached a fever pitch and one of the world’s largest investment banks, Lehman Brothers, had just collapsed. Concerned about their investments, despite their apparently frequent returns, investors in the ever-profitable Bernard L. Madoff Investment Securities LLC began to call back their money to the sum total of around 7 billion dollars.

This decision prompted the soon-to-be disgraced Madoff to admit (post revelations of his fraud, unlike Bankman-Fried) that the entire investment arm of his major Wall Street firm had been a Ponzi scheme, and that investors had been having their investments stolen, and profits had simply come out of new investments being paid back out.

The scandal rocked the already careening Wall Street markets, and investors eventually sued for losses of as much as $65 billion. However, regulators and financial experts insisted they would learn from these mistakes and such major frauds and illegal activity would never be allowed to happen again. The major Dodd Frank financial legislation involved language to strengthen regulators teeth in cases like this, and most importantly Bernie Madoff was punished significantly, eventually condemned to 150 years in prison, serving notice to anyone inclined to commit huge financial fraud that society would serve a heavy penalty. Madoff died in prison on 14 April, 2021.

However, surely there hadn’t been any previous example of fraud that regulators and experts might have learned from to prevent a major destructive and expansive Ponzi scheme like this?

In the summer of 2001, as investment markets were still reeling from the major effects of the bursting of the dot com bubble, an SEC investigation was finishing up into some fishy going-on’s at a private investment club led by a scientologist known as Reed Slatkin. A founder of one of the world’s largest contributors to the platform the dot com bubble could grow on, EarthLink, Mr. Slatkin had been running a scheme for over 15 years, where he would take the money given to him by his good friends on Wall Street and in Hollywood, and invest it to get everyone a bit more dough. Because apparently they needed it. Presumably to invest in more dodgy .com’s.

Turns out though that Slatkin had not wanted the work and risk of properly investing his friend’s cash, and so simply paid back his friends with the money he could get from his other friends wanting in on this investment scheme. What began as a fun bit of financial speculation amongst friends would become a 15 year fraud that cost investors a total of nearly $600 million. The SEC somehow allowed Slatkin to carry on this scheme for over a decade and a half, and as it was revealed Slatkin’s only saving grace (per regulators who hadn’t acted) was that he had largely just screwed over the ever-unpopular Hollywood liberal elite. (Just a bit of fun between friends - including the poor guy who made the movie ‘boiler room’!!).

Financial experts and regulators would learn from this fraud, and ensure that checks and balances were put in place to prevent something like this ever happening again, for his part Slatkin was given a 105 year prison sentence, to punish him and ensure no one else would attempt such a crime again.

But surely there was no lesson these regulators or experts could have taken from a previous significant financial crime before to ensure a Ponzi scheme could grow to this scale and destructive capability?

In 1920 a young Italian con artist and swindler had spent the last 17 years of his life adjusting to life in America, so that he would be able to learn the language financial experts spoke (it certainly wasn’t English), and find a way to convince them to let him handle their major investments and earn them big cash.

He eventually learnt the tricks, and discovered that you could only get these new “Wall Street” people to part with their cash if you promised them big returns. And so Charles Ponzi was able to convince these folks to part with some of their cash for his big investment ideas. The only problem was that Mr. Ponzi did not actually have any investment ideas, rather, he simply intended to hold onto the money, convince some more investors of the idea’s success, and then use that investment to pay back his first investors.

His scheme proved a great success, and soon he was handling as much as $250,000 in investments every day. However, one fateful day in July of 1920, the Boston Post published an article that began to question where exactly Ponzi was finding the value he was claiming from his unique investment strategy. His response to this would prove his downfall. Eager to show his legitimacy he invited investigations from the municipal, state and federal agencies, as well as insisting he would not take on any new investment, simply maintain himself with the investors he had developed to this point.

Unfortunately for Ponzi though, his investors were similarly shaken by this revelation, and in the following days showed up practically all at once to demand he pay back what they had given him. As he consistently failed to pay back the sums that he owed, investigations sped up, and eventually the Bank Commissioner of Massachusetts insisted that the Hanover Trust Bank stop honouring his cheques. The jig had proven up for Ponzi, and he was found guilty in both a state and federal trial, landing him with a total of 14 years of prison time. A veritable snip compared to Madoff.

Overall Ponzi’s scheme had defrauded investors of around $20 million, today worth nearly $300 million, made all the more impressive by the just 8 months in which he had looted that amount, and the much weaker levels of communication and ease of transaction possible in those periods. Proving, yet again, how much people like to make a fast buck!

Nevertheless this was the 1920’s, and surely financial experts and regulators had no sort of lesson from history they could draw on to show the risk of allowing a rogue party to collect fake investments and use new investments to pay back old investors?

In 1713 the young British South Sea Company was given a royal monopoly of the trade of African slaves to the South Sea and South American colonies. This monopoly was considered a potential major boon, especially as people increasingly saw the returns being raked in by the Royal African Company, who had received a similar monopoly in 1672, just in the African Horn, gaining the right to transport 5,000 slaves a year and generating profits in the tens of thousands of pounds.

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People quickly flocked to invest in the unique opportunity of a monopoly company that had been also set up as a joint stock company, meaning it would be possible to publicly invest in the companies stock, gaining you the chance to make a part of its profits. Quickly the interest in the company sky-rocketed, and share prices peaked at £1,000 a pop in 1720.

The problem was that the monopoly of trade in the South Seas and South Americas proved rather fruitless once the company leaders realised in 1717 that not only did Britain not have any established colonies in those territories, but adding insult to injury, Spain would not countenance purchasing slaves from their ships.

Rather than admitting defeat and divesting from their hotshot company, the founders made certain things up. Artificially inflating the returns of their first voyage back from the South Seas by adding new investors funds, the company only built on their hype. To protect themselves from scrutiny and ensure the public’s sole admiration for the project, they bribed multiple MP’s and members of the Royal Cabinet, so effectively that in 1718 the King himself became governor of the South Sea company!! Sound like the PPE fiasco to you?

All these ill-gotten gains only proved to make the company more attractive. Investors continued streaming in until 1720, when suddenly, as the stock price peaked at £1,050, the public realised that this couldn’t go much higher, and began to question where the profits from their investments were coming from. As more and more sold their shares the bubble collapsed, eventually hitting just £120 per share, below where they had entered the stock market before gaining the monopoly in 1711.

Even Isaac Newton lost money. Newton allegedly said that he could “calculate the motions of the heavenly bodies, but not the madness of people.”

A Parliamentary inquiry was put in place, and the crown itself swore that it would severely punish any wrongdoers, particularly those who had taken bribes and contributed to the corruption involved with creating this rampant speculation. Parliament also passed legislation preventing future joint stock companies from being able to acquire a royal charter and monopoly.

The South Sea Bubble had collapsed as the public realised they had just been investing into a box, a box that had done nothing but get several £1,000’s invested in it. But it had been invested in, and so, people wanted to keep investing in this box that other people clearly valued at a higher market cap. Gee, I wonder where I have heard that before.

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From South Sea to FTX: Modern Economic Fraud…