Yo, Pit Crazies,

The sad crypto selloff playing out thanks to the FTX crash reminds me of the things I saw during my years as a floor trader in the pit.

I’m sorry for the folks who lost money, of course.

And, over the past decade, a key part of my approach to options education is helping students – folks just like you – understand the leverage of risk. 

It appears that FTX chief Sam Blankman-Fried did not.

But it’s not the first time this tale of woe has played out.

The first blowout I experienced firsthand was Drexel Burnham Lambert.

Just the year before its demise, DBL was the most profitable and storied investment bank on Wall Street.

Then the junk bond crash hit in 1989 and DBL had problems.

The trading firm I worked for had problems, too.

You see, Drexel was our backer.

Uh-oh! Read on to find out what happened.

I Woke Up One Morning and Our Backer Was Bankrupt

I was still a young fella, a few months away from getting a seat to trade, and was running floor ops.

DBL had been buying more customer bonds in deals and was getting over leveraged.

Sound familiar?

When the junk bond market crashed, DBL was out of collateral

Thankfully, funds at the trading firm I worked for, Group One, were in a different third-party clearing corporation.

The problem was our backer needed its cash back and we had to scramble and find a new backer and clearing arrangement.

We found Merrill Lynch. Crisis averted.

Of course, 19 years later Merrill Lynch would succumb in the 2008 financial crisis. The issue?  Owning too many mortgage-backed securities that got marked to $0. 

Thankfully, Group One funds were segregated in a separate clearing function elsewhere. What that means is Merrill Lynch capital accounts did not have access to G1 fund accounts. Because of that, G1 was able to post a record year trading options.

Group One had another scare in 1998 during the Russian bond default, but survived by having sufficient capital. (But it was close!)

G1 is now a top-5 option trading firm in the USA. FTX is toast.

The moral is to make sure funds are segregated, via a third-party, in an insured account.

The Option Clearing Corporation (OCC) is the 3rd party that has been efficiently regulating option trading for 40+ years, and it has strict regulations around capital requirements in OCC-registered broker-dealers.

FTX had no such third-party supervision. I’m a big believer in third-party … and the FTX debacle is just the latest example of why.

To Your Trading Success,

AG

PS – Pro Tip: Read When Genius Failed.