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

The quant trading firm Sam Bankman-Fried founded was able to field client funds from the exchange FTX in a way that flew under the radar of investors, employees and auditors in the process, according to a source.

The way they did it was by using billions from FTX users without their knowledge, says the source.

Alameda Research, the fund started by Bankman-Fried, borrowed billions in client funds from the founder̵[ads1]7;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 crypto exchange drastically underestimated the amount FTX needed to have on hand if someone wanted to withdraw, 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 case a user borrows money to make a trade. According to the source, FTX did not have nearly enough on hand.

The biggest customer, according to a source, was the Alameda hedge fund. The fund was partially able to cover this activity because the assets it traded never touched its own balance sheet. Instead of keeping any money, it borrowed billions from FTX users and traded them, the source said.

None of this was disclosed to customers, as far as CNBC knows. Generally, it is illegal to commingle client funds with counterparties and trade them without express consent, under US securities law. It also violates FTX’s terms of use. Sam Bankman-Fried declined to comment on the allegations of misappropriation of client funds, but said the recent bankruptcy filing was the result of problems with a leveraged trading position.

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

In making some of these leveraged trades, the quant fund used an exchange-created cryptocurrency called FTT as collateral. In a loan agreement, security is typically the borrower’s pledge to ensure repayment. It’s often dollars, or something else of value – like real estate. In this case, a source said Alameda borrowed from FTX and used the exchange’s internal cryptocurrency, the FTT token, to back those loans. The price of the FTT token fell by 75% in one day, making the collateral insufficient to cover the trade.

In the past week, FTX has crashed from a $32 billion cryptocurrency powerhouse to bankruptcy. The blurred lines between FTX and Alameda Research resulted in a massive liquidity crisis for both companies. Bankman-Fried resigned as CEO of FTX and said Alameda Research is shutting down. The company has since said it is removing trading and withdrawals, moving digital assets offline after a suspected $477 million hack.

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

“I’ve put a lot of work over the last few years into 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 staffs — we don’t want to have preferential treatment. We want as best we can to treat everyone fairly.”

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

But every time an asset was borrowed, FTX subtracted the borrowed assets from what it needed to hold in its wallet to match customer deposits, a source said. In a typical situation, an exchange’s wallets must match what customers deposit. However, because of this practice, assets were not supported one-to-one and the company underestimated the amount owed to customers.

The trading firm Alameda was also able to take advantage of this spot margin feature. One source says Alameda was able to borrow customer funds, essentially for free.

The source explained that Alameda could post the FTT tokens it held as collateral and borrow customer funds. Even if FTX created more FTT tokens, it would not reduce the coin’s value because these coins never hit 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 held the price of FTT and there was not a flood of customer withdrawals on the exchange. In the week before the bankruptcy filing, FTX did not have enough assets to match customer withdrawals, the source said.

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

It all fell apart last week.

CoinDesk reported that the majority of Alameda’s balance consisted of FTT tokens, shaking the confidence of consumers and investors. Changpeng Zhao (CZ), the CEO of one of their biggest rivals, Binance, publicly threatened to sell their FTT tokens on the open market, crashing the price of FTT.

This chain of events triggered a run on the exchange, with customers withdrawing approximately $5 billion before FTX halted withdrawals. When the customers went to collect their money, FTX did not have the funds, sources say.

Former employees also told CNBC that the financial information they had access to about the company was inaccurate as a result of these accounting methods. CNBC reviewed a screenshot of FTX’s financial data that a source said was taken last week. Although the company was insolvent at the time, a former employee says the data falsely suggested that even if all customers cashed out, FTX would still have more than a billion dollars left over.

Three sources familiar with the company told CNBC that they were blindsided by the company’s actions, and that as far as they know, only a small group knew that customer deposits were being misused. Employees said in some cases their life savings are tied up in FTX.

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

As a result of the public backlash FTX has faced over these missing funds, employees who say they were just as devastated as their customers now face financial hardship, harassment over their involvement with the company and tarnished future employment prospects.

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