For weeks, the news headlines have been screaming about FTX, the failed cryptocurrency exchange that recently entered bankruptcy. Part of the problem with FTX was the significant loss in value for FTT, which was the cryptocurrency token issued by FTX, along with a number of other cryptocurrency tokens heavily owned by FTX and its related companies.

To learn more about good versus bad cryptocurrency investments, we interviewed Eugene Plotkin, a former Goldman Sachs investment banker and current CEO of TechWallet. Plotkin is an expert on financial markets and has a deep understanding of the cryptocurrency space.

For the uninitiated, can you briefly explain what cryptocurrencies are and how they work?

Eugene Plotkin: Cryptocurrencies are a digital currency. Unlike traditional currencies that are issued by governments and exist in both digital and paper formats, cryptocurrencies are issued by private entities and exist only in a digital format. The specific technology used for cryptocurrencies is called blockchain and it provides a level of protection against digital counterfeiting. Cryptocurrency exchanges offer services to convert traditional currencies, such as dollars or euros, to specific cryptocurrencies, as well as services to convert select cryptocurrencies back to traditional currencies.

What gives cryptocurrencies their value?

Eugene Plotkin: That is a key question. Any currency is only valuable insofar as others are willing to accept that currency in exchange for goods, services, or another currency that can be used to purchase goods and services. In order for a cryptocurrency to be valuable, it must be stable and widely accepted. It must also have the backing of either a major set of financial entities or a large community that will ensure liquidity for that cryptocurrency.

Can you explain liquidity and why this is so important?

Eugene Plotkin: When we talk about liquidity, we mean how easy it is to buy and sell something. For example, Apple stock is very liquid. Tens of millions of Apple shares trade every day, so it is incredibly easy to buy and sell Apple shares. The same applies to highly developed cryptocurrencies such as bitcoin. However, less mature cryptocurrencies are not very liquid. Once the initial interest in that cryptocurrency wanes, there may be few or even no buyers left. As a result, such cryptocurrencies can lose their value very quickly.

What makes cryptocurrencies gain or lose value?

Eugene Plotkin: When we talk about investments, value is an important concept. When you buy stock in a company, you are acquiring a small share of an actual business. As long as that business continues to operate and capture revenue, that stock will have intrinsic value because it represents partial ownership of what we call a “productive asset.” On the other hand, cryptocurrencies that don’t provide ownership in a productive asset have no intrinsic value. They are only worth as much as someone is willing to pay for them. That makes crypto investments inherently dangerous. 

Would you consider crypto to be a speculative investment?

Eugene Plotkin: Yes, speculative is the right word for it. We have observed that many cryptocurrencies have followed a similar pattern. There is a flurry of buying in the beginning by speculators whose intent is not to hold the cryptocurrency as a store of wealth but to sell quickly as soon as it has increased in value. As a result, after the initial buying there is a rapid sell-off that can crash a new cryptocurrency to zero or near zero. If you are one of the majority of investors who did not cash out in time, you are left holding the proverbial bag. We have observed tremendous wealth transfers over the past couple of years from less sophisticated investors to professional crypto speculators.

Is this what happened with FTX?

Eugene Plotkin: In a way, yes. FTX was a cryptocurrency exchange that was built by individuals with significant experience in the crypto markets. Unfortunately, it does not appear that protecting less sophisticated investors was a priority for these individuals. According to various sources, FTX did not practice the necessary care in segregating and shepherding investor funds with which it was entrusted on the one hand, and took on tremendous financial leverage on the other. In other words, it took out significant loans that were collateralized by its own cryptocurrency tokens along with other cryptocurrency tokens. When these tokens lost value, those loans went deeply underwater and the exchange could no longer remain solvent.

Can what happened to FTX happen to any cryptocurrency exchange?

Eugene Plotkin: A financial exchange is a type of business, and any business is capable of being mismanaged. In addition, cryptocurrency exchanges are not subject to the same regulations as stock or bond exchanges. With that said, I believe that there are significant differences among cryptocurrency exchanges. Before investing in an exchange or trusting an exchange to hold cryptocurrency, an investor should take the time to read the exchange’s operating rules and financial statements. In particular, it is important to find out how much capital the exchange holds and in what form to ensure that it can always repay all of its obligations.

How can an investor tell a good cryptocurrency investment from a bad cryptocurrency investment?

Eugene Plotkin: Any cryptocurrency investment carries material risk. Because cryptocurrencies are not as widely accepted as traditional currencies, they fluctuate significantly relative to traditional currencies. Even bitcoin, arguably the most stable of the cryptocurrencies, went as high as $65,000 in 2021 and as low as $15,000 in 2022. That is a massive swing in the span of just months. If an investor is comfortable with the volatility of cryptocurrencies and believes that they are likely to become increasingly accepted in the future, I would still advise that they limit their investments to the most established, liquid, and stable cryptocurrencies. Bitcoin and ethereum are the two that best check those boxes.

Does that mean that any cryptocurrency outside of those main ones is a bad investment?

Eugene Plotkin: Whether something is a good or bad investment is only known in retrospect. However, the historical pattern has shown that many new crypto offerings have struggled after the initial speculative euphoria stage. For this reason, unestablished cryptocurrencies tend to be a poor choice for long-term, risk-conscious investors that are interested in capital preservation and accumulation.