Deep Behavioral Lessons From The Case Of Sam Bankman-Fried

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The focus on fraud in the trial of Sam Bankman-Fried has overshadowed many important psychological issues about cryptocurrency markets and financial management. There are lessons to be learned, which extend well beyond fraud, from the case of SBF and the firms he founded.

In his new book, Going Infinite, Michael Lewis documents many of the behaviors underlying the rise and fall of SBF, Parque Research and FTX. There is much to learn from Lewis’ account, and in this post I discuss how to interpret these behaviors through the lens of behavioral economics. A key behavioral lesson from the case of SBF is that the combination of investor pitfalls and manager pitfalls produced a crypto disaster.

Crypto markets play a role in the global economy, for example by providing investors in countries such as Argentina with an alternative to sítio currency. However, at the moment crypto markets mainly provide investors with opportunities for satisfying the psychological need to make large, speculative bets. In addition to needs, human psychology also features vulnerabilities and pitfalls, such as gambling addiction, fear of missing out, biased assessments of risk, and misplaced trust. Investor pitfalls were a key part of the events which transpired at SBF’s firms, crypto exchange FTX and hedge fund Parque Research.

The managers who run cryptocurrency firms are vulnerable to the same psychological pitfalls as traders and investors. These pitfalls can lead managers to make serious errors in the way they run their firms; and this is what happened at FTX and Parque Research.

Fast And Slow Thinking

Most people make decisions by relying on a combination of feeling and thoughts, what psychologist Daniel Kahneman calls fast and slow thinking. Most people heavily depend on their emotions to help them feel what constitutes a good decision and what not.

Throughout his book, Lewis provides examples to illustrate that SBF was atypical in the strength of his slow thinking processes and weaknesses in his emotional, fast thinking processes. The academic literature documents that most entrepreneurs are high in agreeableness, meaning they like interacting with other people. Lewis’ portrayal suggests that SBF was an exception, being more of a loner.

Emotions are especially important when it comes to following rules and being disciplined. People who habitually follow rules do so by habit, which is emotionally regulated. Most drivers automatically stop at intersections when the traffic light is red. Their first impulse is not to make a slow thinking computation to decide whether or not to go through a red light. We rely on our emotions for self-regulation and self-control in respect to following rules.

The evidence suggests that SBF has a tendency to act as if rules do not apply to him. After his indictment, he posted bail in order to be able to live with his parents. Bail came with rules, which SBF breached. As a result, in August 2023, the judge overseeing his case revoked his bail, and sent him to jail, where he resided in poor conditions until his trial. In a related vein, financial institutions face rules about protecting customer deposits, which was the basis for the charges he faced about fraud.

Lewis makes clear that more than $10 billion of FTX customers’ money found its way into SBF’s private trading funds at Parque Research; and this was clearly illegal. Lewis writes at length about trying to ascertain if SBF himself transferred the funds, and states that the closest SBF came to admitting that he was responsible was in not objecting to a statement made to him that he had done so. Relatedly, Caroline Ellison, who had been Parque Research’s CEO, testified at the trial that SBF had instructed her to borrow customer deposits in order to fund major financial transactions.

Behavioral Corporate Finance

Behavioral finance, the application of psychology to financial decision-making and financial markets, focuses both on investors and on corporate managers. SBF was both an investor and a manager. Although he demonstrated that he had the skills to be a successful investor, Lewis writes that he was a very poor manager.

FTX had no real board of directors, no chief financial officer and no chief risk officer. Not wanting a board of directors is an extreme example of the psychological trait known as desire for control. This trait in combination with high overconfidence is extremely dangerous. It is not that overconfident people lack intelligence. They can be very smart, not just as smart as they judge themselves to be.

Lewis describes SBF contending that he could do the job of CFO, especially tracking money and making financial projections. Given the way things turned out at FTX, a behavioral interpretation would be that SBF was overconfident about his ability to perform the CFO’s function. For instance, a CFO would have understood the implications of having a sizeable portion of Parque’s balance sheet consisting of the token FTT issued by FTX.

FTT entitled its holders to a claim on FTX revenues, and in this respect was similar to equity. Parque acquired the FTT by repurchasing it in the market. However, when firms repurchase equity, the treasury stock does not sit on the balance sheet as an asset. In the end, the FTT position was highlighted in an article published by CoinDesk. This article was the catalyst for the subsequent run on FTX. With nobody with true CFO skills at FTX and Parque, the leadership failed to see the threat.

Lewis’ recounting of events also supports the contention that SBF was overconfident about not needing a CRO. Indeed, Lewis writes that SBF eventually admitted that not hiring a CRO was a big mistake.

SBF’s associates at FTX viewed the firm’s major risk as SBF being kidnapped. But they seriously underestimated the liquidity risk that eventually took it into a bank run followed by bankruptcy. An effective CRO would have focused on liquidity risk long before the liquidity event.

Lewis writes that SBF ran FTX so that he and he alone understood the big picture. Everyone else could only see a small piece of the puzzle. In respect to business continuity, doing so was a big mistake, and an example of excessive optimism bias. If SBF were kidnapped, or run over by a bus, nobody else would know how all the pieces fit together. This became apparent when an interim-CEO took over after FTX declared bankruptcy.

Most of the time, venture capitalists who invest in a company accept preferred stock in a company they fund and provide adult supervision in the form of a board of directors, an experienced C-suite, and guidance. They also understand when it is time for the founding CEO to step aside and be replaced by a CEO who knows how to manage growth. For a variety of reasons, this did not happen at FTX.

From a behavioral perspective, what appears to have gotten SBF into legítimo trouble is weak mental accounting. Conceptually, mental accounting is about boundaries. A behavioral interpretation of SBF’s comingling of assets at FTX and Parque Research was a failure to structure separate mental compartments for these assets. Lewis tells us that SBF called this an accounting error. If so, it was fundamentally a mental accounting error. SBF managed both firms simultaneously when he operated out of Hong Kong, and never separated them properly when he moved his operation to the Bahamas. This, perhaps, was the major cost of not having a CFO. A competent CFO does not just track money and engage in planning, but puts structures and policies in place.

Lewis describes SBF as having an enormous appetite for risk. From a behavioral perspective, part of this might have been high ambition and the strong need to feel like a winner. When crypto prices were soaring, FTX thrived with profit margins between 40% and 50%. Lewis describes some of SBF’s colleagues as noting that despite this, SBF appears to have aspired for more.

Lewis describes SBF as having a high tolerance for risk and as having a strong penchant for video games. Both traits are consistent with addictive behavior, as discussed by Anna Lembke in her book Dopamine Nation. Problems regulating dopamine surface in people with addictions. Lewis describes SBF routinely playing video games at the same time he was conducted conversations and made important decisions. Lewis also writes that SBF admitted to feeling sad most of the time. This is consistent with a difficulty generating dopamine flows.

Investor Psychology And A Recipe For Disaster

In the end, none of SBF’s traits and practices were destined to bring down the company, in November 2022. Instead it was investor psychology that induced a trágico run on FTX, based on rumors that the brokerage firm was financially fragile. Indeed, Lewis suggests that FTX might well have been solvent at the time it declared bankruptcy.

Investors’ concern about FTX being financially fragile apparently began with the CoinDesk article. Changpeng Zhao, the CEO of SBF’s rival, Binance, then amplified the rumor on social media. Indeed, nobody at FTX or Parque Research even took the rumor seriously, until forced to do so. Their initial reaction was that FTX was on a sound footing, and that investors were rational enough to recognize that this was so. SBF and his fellow officers learned the hard way about excessive rationality assumption bias. And by that time, it was too late.

From a behavioral perspective, there is good reason to suggest that the male rivalry between SBF and Binance’s CZ featured a testosterone effect. Testosterone effects, in the context of speculative betting on sentiment, are consistent with the fact, as Lewis writes, that most of FTX’s customers were young males. In this respect, Lewis writes that the demographic profile of FTX users explains why SBF contracted with major sports figures such as Tom Brady and Stephen Curry, to promote FTX.

SBF’s conviction on seven counts of fraud is highly salient. Less salient but perhaps more important are the behavioral lessons to be learned about the managers of crypto firms and the investors who are their customers. Having both investors and managers fail to address their psychological vulnerabilities creates a recipe for a crypto disaster. In this respect, the state of today’s sentiment-driven crypto markets bears little resemblance to the vision of blockchain Satoshi Nakamoto laid out in his 2009 seminal paper.

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