I had this post in my ‘queue’ for a while; I was hoping to ride a bit of the Netflix wave about the Madoff doc but I had other 3k things going, including surgery so…here we are, finally.
The initial flash of inspiration came when I watched this video from Giovanni, an Italian YouTuber that discuss personal finance topics since 2008. The video is about the whole FTX saga and how Giovanni got (unwillingly) involved in it via some investments in BlockFi. Unfortunately, he dedicates most of the time to describing who SBF is and what FTX did rather than his particular investment circumstances; I say unfortunately not out of pure curiosity (or schadenfreude) but because I think details would have encouraged a more informed conversation. I also wanted to use BlockFi to invest years ago and then for some reason I cannot recall (prob at the time it was open only to selected US investors) I did not: in a parallel universe, at least part of his story would be mine as well.
What we know: Giovanni bought EUR 2K worth of BTC and ETH that at the crypto top were worth EUR 30k.
What I suspect: he held his crypto on BlockFi to earn interest on his crypto holdings. In fact, BlockFi was lending crypto to hedge funds and leveraged investors and paid back some of the interests they were charging to lenders like Giovanni.
Counterparty Risk
I got intrigued by Giovanni’s story because I am dealing with a similar issue since I started investing in p2p lending in 2015. In order to profit from p2p high yields, you need to invest funds; in order to take advantage of compounding, you need to re-invest your gains and stay invested for a long time, the longer the better; but…the longer your stay invested, the higher the chance you would be exposed when a platform defaults.
Time in the market beats timing the market, someone smarter than me once said. But that’s not true if you are dealing with a meaningful default risk. P2p lending platforms, and crypto exchanges too, are, besides anything else, start-ups and start-ups tend to blow up frequently. Not much more complicated than that, long-time readers of the blog know how much I stressed this aspect in my posts about p2p.
I am walking on this tightrope, balancing between maximizing the investment opportunity and avoiding that all my capital will go puff one day.
The BlockFi case is great because it is the perfect example of how greed chases greed. Not your keys, not your coin, another smart dude blurted once. With crypto, investors can avoid counterparty risk if they go cold (as cold storage), a bit less so if they use their own wallet like MetaMask. But this requires additional work and also opens the door to other types of risks, like losing the cold storage device or your MM password/key/words/whatever is called I do not remember.
Crucially, you need to deposit your coin on BlockFi to earn interest. Now, it is smart to invest in an asset that you think can go up 10.000.000% and risk it to get an additional 5 %/year? Well, someone else could say that using BlockFi was extremely user-friendly (I guess, I did not use it), way easier than an exchange + MetaMask, AND it was paying interest: free money.
As usual, the correct approach depends on the risk you are facing. I bought my first £100 of ETH on Revolut, not because I knew it was a good platform (it is not) but because I already had it on my phone and I could do it with a few taps. When I decided that I wanted to have more exposure, I opened an account on Kraken…but only because I saw Corey doing perp-arbitrages there. I could have landed on Coinbase or FTX as easily. Point is, I am not a genius because I dodged all the crypto platforms that went upside down (for now) but for sure you won’t find me with all my eggs in one basket. However convenient that basket might be.
But let’s be clear: I do not know what I am doing. I never had the opportunity to really discuss with other investors their approach to this problem. That’s what prompted this post…not this:
I never had any real counterparty risk issues with my crypto holdings because their balance never reached a meaningful amount. That’s why I refer to my experience in p2p and there my strategy was built onto two pillars:
- diversify across platforms (and ideally across countries, borrowers, collateralized/uncollateralized loans, etc)
- periodically take out some of the profits. With no clever clue, I landed on a Solomonic 50/50: leave 50% of the profits to compound, take out the other 50%. In 2021, I started to take out 100% of the profits on the platforms where I had the bigger exposure.
For sure, this is not the optimal strategy to maximize returns. But so far it worked well in managing my risks. Here you can find the last post I wrote on my p2p investments: no additional platform defaulted since and the ones that didn’t are still paying interest.
I am not sure why but I have always been quite paranoid about counterparty risk. I have never had more than 30% of my net worth in a single institution and I am referring to names like Vanguard, Fidelity and Interactive Brokers, not Revolut or RobinHood. When I prepared the ‘Excel Treasure Map’ for my wife, just in case one day I get hit by a bus, she looked at me like:
It was not 100% by design, when I moved from Switzerland to the UK I did not even bother to exchange my driving license. But I still have a fair amount of Boomer blood in me that reminds me if I ever have a problem with IB, I will have to rely on a chatbot to solve it.
You should diversify your skepticism as well. Apply too little and risk losing everything every couple of years, apply too much and you would pass on too many opportunities. I listened to all the episodes the BlockFi guy was on Animal Spirit and he sounded like a reasonable guy. If anything, my conclusion is that Michael and Ben are a bit too loose in accepting (paying) guests on the show. I will always be in favor to explore and take risks.
The Importance of Rebalancing
At the end of the video, Giovanni lists some “lessons learned”, including the fact that he should have rebalanced his investments. Without knowing his Net Worth or targets and risk appetite, I can only make some assumptions. If he has a total NW of 1 million, at the peak his crypto holdings would have been 3% of that, not an unreasonable amount. Definitely not something that should prompt a rush to rebalance or diversify counterparty risk. Even if he set his target at 2%, he only lost an additional 1%…
Maybe his NW was lower but he wanted to ride the “crypto lottery ticket” (invest a small amount but hope that it grows into a sort of life-changing pot): in that case, he should have considered the counterparty risk but not rebalance.
You see, context matters 😉
Anyway, it is safe to assume that he had a target exposure that was lower than 30k and he did not act on it. He came to the right conclusion (not that he lost the money, that he realized he should have rebalanced) so all good, you should listen to him!! 😉
All of this preamble to say that rebalancing is the key trick to maximize your chances to exit a Ponzi as a winner…unless authorities claw back your gains. Just remember, this is not financial, and in regards to the last sentence, legal advice. More importantly, I am NOT suggesting you invest ON PURPOSE in Ponzi, just because now you have the possibility to gain out of it. Rebalancing will save your a$$, to various degrees depending on your timing, if you happen to find yourself in one.
How to NOT make money in a Ponzi
The classic characteristics of a Ponzi are (perceived) low risk and high returns. It is weird to say but…high returns are a key ingredient. DO NOT INVEST IN A PONZI! But if you do, at least choose one that promises you a great yield.
Who would invest in something shady that is also offering low returns?
Thank you for the question, my friend. I honestly do not know but let’s enter my favorite platform of the last 7 years: Bondora. I have written seven posts about Bondora in the past and the gift keeps on giving. As a very short recap, Bondora started as a classic p2p platform, offering high-yielding consumer loans that retail investors could fund. For some years, investors earned 15%+ returns because the loan default rate was low. Unfortunately, after the initial honeymoon period, defaults started to increase; to mask this, Bondora at first changed the way they were reporting data and then, marketing geniuses they are, they invented a new product: Bondora Go&Grow. G&G was marketed like a high yielding money market fund, a product offering a 6.75% return AND daily liquidity. In an environment where EUR rates were negative, you can understand the appeal of the investment, even if it came with the canonical asterisks: the yield and daily liquidity were not guaranteed. This way, investors could stop worrying about increasing defaults because the only thing they could see was the interest accruing on their accounts. This is already nonsensical by itself because how can you accrue yield on a daily basis if the return is guaranteed?
With yields going up and the ECB rate forecasted to reach 3.4% in July, Bondora just closed G&G to new investors (maybe also to old ones?) and introduced Go&Grow Unlimited: a new product that pays…8%? 10%? No, an “impressive” (verbatim from their website) 4%. To be fair, now they guarantee daily liquidity.
I do not think Marcus, the Goldman Sachs retail platform, is available in Europe but a 1 year French Government Bond pays 2.6%. Lyxor has a money market ETF, $CSH, that currently yields 1.83% and, if the rate forecasts are correct, will yield more than 3% in the fourth quarter of the year. Why would you risk putting your money in a start-up, backed by consumer loans when you can have almost the same yield at essentially no risk?
Why do I insist on the fact that Bondora is a Ponzi? These are data taken from their website:
Before you jump to the conclusion that starting in 2020 things seem to have improved, remember that it takes time to put a loan in arrears (the borrower has to be late in their payments by definition). I hope for them they got their s*&t together, but given the past I would bet the under on this.
Even when a loan pays 10%+ interest, it doesn’t take much to put the overall picture underwater:
Starting from 2014, the blue bars got really small and after 2016 they disappear completely. We are talking about a max 5-year loan, so all loans originated in 2015, 2016 and 2017 should have nice blue bars if they generated positive returns.
Here is the same reading but with a different point of view:
Again, these are unaudited data they put on their website. Bondora is on the clock because G&G investors are promised a 6.75% return they already see on their balances, ditto for the G&G Unlimited ones. Guess how Bondora paid the investors who cashed out so far?
How to Make Money in a Ponzi
The first rule of the Ponzi club is: Be early to invest.
The second rule of the Ponzi club is: take out your gains before the music stops.
Obviously, you cannot control either of the above, I hope you understand I am trying to rationalize something that should not. The Madoff scheme lasted 18 years but the average fraud endures around for 4, like the Terra/Luna stablecoin system that started in 2018 and collapsed in 2022. In short, the “life expectancy” of a scheme depends on the easiness to withdraw money and the ability of the promoter to find new investors. Madoff lasted so long partially because he was targeting endowments, charities and foundations, institutions that typically withdraw only 5% of their investments per year.
So let’s say our investor has a 50/50 portfolio:
- 50% invested in a 60/40 portfolio that returns 5%/year
- 50% invested in TheItalianLeatherSofa PonzY that pays 15%/year
Here you can see the total portfolio loss if the PonzY busted that particular year, assuming the investor does not rebalance their portfolio:
Here is the same with portfolio rebalancing:
Every time you dial down the PonzY yield, the loss in each year gets worse or, seeing it the other way around, you need the PonzY to last more to get a chance to exit with a profit. This is the reason why investing in something that offers a relatively low yield but promises to be ‘super safe’ is uber-stupid. If you want no risk, suck it up and accept no return; if you want a return, be prepared to bear a risk that is at least commensurate with it.
If it was not evident so far, I used Ponzi as a click-bait, to show you the power of rebalancing: it might save you even in the dumbest of situations, ie when you are involved in a fraud. If you know that something is a fraud, do not invest in it, FULL STOP. If you are interested in something that might be a fraud, be sure you are rewarded for the risk you are taking.
My favorite example revolves around this security:
SVXY is one of those infamous inverse volatility ETFs that, at least, managed to survive 2018 volmageddon. As you can see it went nowhere over 10 years but at the top it returned 744%. What happens if we pair it with a 60/40 portfolio?
We manage to add a 1%/year return…not bad for an asset that seemingly brought a ton of vol and no return [here I rebalance quarterly but you get similar results if you change the rebalance frequency or use rebalance bands; intuitively, if you add more stocks and reduce bonds, results get even better].
Some time ago I saw a tweet where someone was comparing the TQQQ (Nasdaq 3x levered) performance with the QQQ (Nasdaq) one like this:
Too bad I did not save it but his conclusion was the classic “ah ah you bought something levered and what you got was the unleveled performance”.
TQQQ offers an investor 3 times the performance of QQQ (minus fees) only the first day. Past that, without rebalancing, the leverage becomes ANYTHING but 3x because the ETF itself resets its own leverage. If the investor wants to maintain a 3x leverage compared to their initial investment amount, they have to sell a bit every time the ETF goes up and buy a bit when it goes down.
I can replicate QQQ performance with TQQQ if I pair it with cash:
I guess more interestingly, I can get an almost perfect QQQ levered twice just by flipping the weights of the second portfolio:
Yes, it works even if I start in 2017, mirroring the tweet example:
So, protect ya neck and do not forget to rebalance.
What I am reading now:
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