Sam Bankman-Fried’s Alameda silently used FTX client funds without raising alarm bells, sources say

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The quantitative trading firm that Sam Bankman-Fried founded was able to silently use client funds from its FTX exchange in a way that escaped the radar of investors, employees and auditors in the process, according to a source.

The way they did this was to use billions of FTX users without their knowledge, the source says.

Alameda Research, the fund started by Bankman-Fried, has borrowed billions of client funds from its founder’s exchange, FTX, according to a source familiar with the company’s operations, who asked not to be named because the details were confidential.

The cryptocurrency exchange drastically underestimated the amount FTX had to keep on hand if anyone wanted to cash out, according to the source. Trading platforms are required by their regulators to hold enough money to match what clients deposit. They need the same pillow, if not more, in case a user borrows money to make an exchange. According to the source, FTX didn’t have enough on hand.

Its largest client, according to a source, was the Alameda hedge fund. The fund was partially able to hedge this asset because the assets it was trading never touched its balance sheet. Instead of holding money, it borrowed billions from FTX users, then traded it, the source said.

None of this has been disclosed to customers, as far as CNBC is aware. In general, it is illegal under US securities law to mix client funds with counterparties and exchange them without explicit consent. It also violates the FTX terms of service. Sam Bankman-Fried declined to comment on the allegations of misappropriation of client funds, but said his recent filing for bankruptcy was the result of problems with a leveraged trading position.

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“A margin position has been hugely successful,” Bankman-Fried told CNBC.

In carrying out some of these leveraged trades, the quant fund used a cryptocurrency created by the exchange called FTT as collateral. In a loan agreement, the collateral is typically the borrower’s commitment to guarantee repayment. Often they are dollars or something else of value, such as real estate. In this case, a source claimed that Alameda was borrowing from FTX and was using the exchange’s in-house cryptocurrency, the FTT token, to back those loans. The price of the FTT token plummeted by 75% in one day, making the collateral insufficient to cover the trade.

Last week, FTX collapsed from a bankrupt, $ 32 billion cryptocurrency powerhouse. The blurry lines between FTX and Alameda Research have resulted in a massive liquidity crisis for both companies. Bankman-Fried stepped down as CEO of FTX and said Alameda Research is shutting down. The company has since said it is removing trading and withdrawals and moving digital assets offline after a suspected $ 477 million hack.

When asked about the blurry lines between its companies in August, Bankman-Fried denied any conflicts of interest and said FTX was a “neutral piece of market infrastructure.”

“I’ve worked a lot over the past few years to try and eliminate conflicts of interest there,” 30-year-old Bankman-Fried told CNBC in an interview. “I no longer manage Alameda. I don’t work for this, nobody at FTX does. We have separate staff, we don’t want to have preferential treatment. We want the best we can, treat everyone fairly.”

Trading on margin

Part of the problem, according to the same source, was FTX’s complicated network of leverage and margin trading. Its “spot margin” trading feature allows users to borrow from other clients on the platform. For example, if a customer deposited a bitcoin, they could lend it to another user and make money on it.

But every time an asset was borrowed, FTX subtracted the borrowed assets from what it needed to keep in its wallets to match customer deposits, a source says. In a typical situation, an exchange’s wallets must match what customers deposit. But due to this practice, the assets were not guaranteed one-to-one and the company was underestimating the amount it owed to customers.

Trading company Alameda was also able to take advantage of this spot margin feature. A source says Alameda was able to borrow client funds, essentially for free.

The source explained that Alameda could publish the FTT tokens it held as collateral and borrow client funds. Even if FTX created more FTT tokens, it would not reduce the value of the coin because these coins never made it to the open market. As a result, these tokens have maintained their market value, allowing Alameda to borrow against them, essentially receiving free money to trade with.

FTX has been able to sustain this model as long as it has maintained the price of FTT and there hasn’t been a wave of customer withdrawals on the exchange. In the week leading up to filing for bankruptcy, FTX did not have sufficient resources to match customer withdrawals, the source said.

External auditors are likely to have missed this discrepancy because client assets are an off-balance sheet item and, therefore, would not be reported in FTX’s financial statements, the source said.

Everything collapsed last week.

CoinDesk reported that the majority of Alameda’s balance sheet consisted of FTT tokens, shaking consumer and investor confidence. Changpeng Zhao (CZ), the CEO of one of its biggest rivals, Binance, has publicly threatened to sell its FTT tokens on the open market, causing the price of FTT to plummet.

This chain of events sparked a rush to the exchange, with customers withdrawing around $ 5 billion before FTX paused withdrawals. When customers went to collect their money, FTX didn’t have the funds, the sources say.

‘Nobody saw it coming’

Former employees also told CNBC that the financial information they had access to about the company was inaccurate due to these accounting methods. CNBC looked at a screenshot of FTX’s financial data that a source claimed was taken last week. Although the company was insolvent at the time, a former employee says the data incorrectly suggested that even if all customers withdrew their funds, FTX would still have more than $ 1 billion left over.

Three sources familiar with the company he told CNBC that he was caught off guard by the company’s stock and that, as far as he knew, only a small cohort knew customer deposits were being misused. Employees said that in some cases their life savings are tied to FTX.

“We are just shocked and devastated,” said a current FTX employee. “I feel like I’m in a movie that takes place in real time. Nobody imagined it.”

As a result of the public backlash that FTX has faced for these missing funds, employees who claim to be devastated as much as customers are now facing financial hardship, harassment related to their involvement with the company, and clouded future job prospects.

“We couldn’t believe how we were betrayed,” said one former employee.

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