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Sam Bankman-Fried’s Alameda Quietly Used FTX Client Funds Without Raising Alarm, Sources Say

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

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

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

The crypto exchange drastically underestimated the amount FTX needed to keep on hand if someone wanted to cash out, according to the source. Trading platforms are required by their regulators to hold enough money to match what customers deposit. They need the same cushion, if not more, in the event that a user borrows money to complete a transaction. According to the source, FTX didn’t have enough on hand.

Its biggest client, according to one source, was hedge fund Alameda. The fund was able to partially conceal this activity because the assets it traded never touched its own balance sheet. Instead of holding money, it borrowed billions from FTX users and then traded them, the source said.

None of this has been disclosed to customers, as far as CNBC is aware. In general, mixing client funds with counterparties and exchanging them without express consent under US securities law is illegal. This also violates FTX’s Terms of Service. Sam Bankman-Fried declined to comment on allegations of embezzlement from clients, but said his recent bankruptcy filing was the result of issues with a leveraged trading position.

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“A margin position took a huge hit,” Bankman-Fried told CNBC.

In making some of these leveraged trades, the quantitative fund used an exchange-created cryptocurrency called FTT as collateral. In a loan agreement, collateral is usually the borrower’s promise to guarantee repayment. It’s often dollars or something else of value, like real estate. In this case, a source said that Alameda borrowed from FTX and used the exchange’s internal cryptocurrency, the FTT token, to collateralize these loans. The price of the FTT token plunged 75% in one day, making collateral insufficient to cover the transaction.

Over the past week, FTX has gone from a $32 billion cryptocurrency powerhouse to bankruptcy. The blurred lines between FTX and Alameda Research resulted in a massive liquidity crunch for both companies. Bankman-Fried resigned as CEO of FTX and said Alameda Research was closing. The company has since said it is removing trades and withdrawals, and disconnecting digital assets after an alleged $477 million hack.

Asked about the blurred lines between his companies in August, Bankman-Fried denied any conflict of interest and said FTX was a “neutral part of the market infrastructure.”

“I’ve put a lot of effort over the last few years trying to eliminate conflicts of interest there,” Bankman-Fried, 30, told CNBC in an interview. “I don’t run Alameda anymore. I don’t work for it, none of FTX does. We have separate teams – we don’t want to get preferential treatment. We want the best we can, treat everyone fairly. “

Margin of negociation

Part of the problem, according to the same source, was FTX’s complex leverage and margin trading network. 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 earn a return.

But each time an asset was borrowed, FTX subtracted the borrowed assets from what it needed to hold in its portfolios to match customer deposits, a source said. In a typical situation, an exchange’s wallets should match what customers deposit. But because of this practice, the assets were not individually secured and the company underestimated the amount it owed its customers.

Trading company Alameda was also able to take advantage of this spot margin feature. A source claims that Alameda was able to borrow funds from customers, essentially for free.

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

FTX had been able to maintain this pattern as long as it maintained the price of FTT and there was not a flood of client withdrawals on the exchange. In the week leading up to the bankruptcy filing, FTX did not have enough assets to handle customer withdrawals, the source said.

The external auditors likely 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 fell apart last week.

CoinDesk reported that the majority of Alameda’s balance sheet consists 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, driving down the price of FTT.

This chain of events sparked a run on the exchange, with clients withdrawing around $5 billion before FTX suspended withdrawals. When the customers went to withdraw their money, FTX did not have the funds, sources said.

“No one saw this 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 has reviewed a screenshot of FTX financial data that a source said was taken last week. Although the company was insolvent at the time, a former employee said the data incorrectly suggested that even if all customers were to withdraw their funds, FTX would still have over $1 billion left over.

Three sources familiar with the company told CNBC they were blindsided by the company’s actions and that, to their knowledge, only a small cohort knew that customer deposits were being misused. Employees said that in some cases their savings were tied to FTX.

“We are just shocked and devastated,” a current FTX employee said. “I feel like I’m in a movie that plays out in real time. Nobody saw that coming.”

Due to the public backlash FTX has faced over these missing funds, employees who say they are just as devastated as customers are now facing financial hardship, harassment surrounding their involvement with the business and tarnished their future employment prospects.

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