Will FTX-Like Unicorns Be the Next ‘Big Short’?

As his luck would have it, Michael Lewis has been trailing FTX founder Sam Bankman-Fried for the past few months. The author of The Big Short won’t be short of material, but one thing he probably won’t find is a big group of skeptics who successfully wagered on the demise of the $32 billion crypto exchange.

For one, credulous crypto traders aren’t natural fraud detectives: Even SBF rival Changpeng “CZ” Zhao, head of Binance Holdings Ltd., says he didn’t short FTX’s native token, FTT. He was instead left holding a big bag of near-worthless magic beans — along with hundreds of thousands of creditors.

Moreover, because Bahamas-based FTX is private, it wasn’t possible to short the company’s shares, which involves borrowing, selling and buying the stock back again, hopefully at a lower price.

But financial engineers are trying to solve that problem. Derivatives allowing institutions to bet against unlisted startups are beginning to gain traction, and that’s good news because short selling can help in holding unicorns to account.

With Theranos and now FTX, the herd-investing mentality and lack of gatekeepers and good governance in the startup world have become all too apparent.  

Due diligence seems to be an afterthought for some venture firms and late-stage investors, which is a problem when startups face the temptation of “faking it till they make it” and are staying private for longer. (One of FTX’s backers, Sequoia Capital, said it does extensive diligence on every investment and that it’s in the business of taking risk.) 

We shouldn’t count on VCs. Their desire not to miss out on the next big thing will tend to trump the fear of backing a dud. VCs only need a couple of spectacular wins to make decent returns; a startup blowing up is a cost of doing business.  

It’s harder (though not impossible) to imagine FTX-type shenanigans happening in the public markets without more people noticing. FTX exchange’s ties to Bankman-Fried’s Alameda Research hedge fund would certainly have drawn scrutiny from short-sellers.

Though short-sellers have gotten a bad rap recently, overall I think they provide a valuable service keeping markets honest and spotting abuses long before regulators do. Remember Enron and Wirecard?

Equities short seller Marc Cohodes concluded FTX was a bad actor months ago. He highlighted various red flags on social media but saw no way to profit from his informational advantage. “I did this one way for free…I didn’t stand to profit from exposing this guy,” he told the Hidden Forces podcast. “My friends saw me tweeting and talking about this thing and said: what are you doing…? It’s not a [publicly traded] stock, there’s no way to play it or make money.”

Admittedly some hedge funds and crypto investors had similar concerns about FTX and shorted the FTT token. But allowing crypto startups to issue their own make-believe money invites manipulation and regulators should crack down on it.  

Marketplaces for trading shares of private companies like Forge Global and Nasdaq Private Market don’t allow short-selling. It’s hard to persuade a startup founder to provide employees and VCs with liquidity prior to an initial public offering if the platform also facilitates bets that the company is overvalued. To short-sell you first need to borrow shares, and private companies prohibit stock lending.

Synthetic derivatives offer a potential workaround. Founded by two former Forge employees in 2021, Caplight Technologies lets professional investors make bullish or bearish bets on unlisted startups via call and put options. It recently received financial backing from Deutsche Boerse AG.

So far Caplight has mostly served investors looking to hedge their exposure to startups but it plans to allow investors to wager a company is overvalued without owning the underlying security (using other securities or cash as collateral).

“While we saw some (short) activity on FTX, I think it blindsided most people involved,” co-founder and Chief Executive Officer Javier Avalos told me. “Would there have been better price discovery if we had a more efficient market for institutions to short private companies? Absolutely. More transparency and better price discovery are essential for healthier private markets”. 

Short-sellers are just one aspect of the sunlight we need in private markets. I’m also in favor of large unicorns having to disclose financials.(1)

Expanding protections and incentives for whistleblowers at private startups is also worth exploring.

Yet the most effective way to keep startups in check is to give investors a financial incentive to uncover shoddy business practices and bad behavior. Private companies might then become the next Big Short.