Sam Bankman-Fried’s Alameda quietly used FTX customer funds without raising alarm bells, sources said

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The quant trading firm Sam Bankman-Fried founded was able to quietly use customer funds from the exchange and 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 of FTX users without their knowledge, the source said.

Alameda Research, a fund started by Bankman-Fried, borrowed billions in customer 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 are confidential.

Crypto exchanges drastically underestimated the amount of FTX needed to keep on hand if someone wants to cash out, according to the source. Trading platforms are required by regulators to hold enough cash to match what customers deposit. They need the same cushion, if not more, if users borrow money to trade. According to the source, FTX does not have nearly enough.

Its biggest customer, according to sources, is an Alameda hedge fund. The fund can partially cover this activity because the assets it trades never touch its own balance sheet. Instead of holding the money, it borrowed billions from FTX users, then traded it, the source said.

None of this was disclosed to customers, to CNBC’s knowledge. In general, mixing customer and partner funds and trading them without explicit permission, according to US securities law, is illegal. It also violates FTX’s terms of service. Sam Bankman-Fried declined to comment on allegations of misappropriating customer funds, but said his latest bankruptcy filing was the result of problems with leveraged trading positions.

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

In making some of these leveraged trades, this quant fund uses a cryptocurrency created by an exchange called FTT as collateral. In the lending agreement, the guarantee is usually the promise of the borrower to secure repayment. This is often dollars, or something else of value – like real estate. In this case, a source said Alameda was borrowed from FTX, and used the exchange’s in-house cryptocurrency, FTT token, to support those loans. The FTT token price nosedived 75% in one day, making the collateral insufficient to cover trades.

In the past week, FTX has bump from a $32 billion cryptocurrency powerhouse, to bankruptcy. The blurred lines between FTX and Alameda Research led to a major liquidity crisis for both companies. Bankman-Fried resigned as CEO of FTX and said Alameda Research was closed. The company has said that it is removing trades and withdrawalsand transfer digital assets offline after a be presumed $477 million hack.

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

“I put in a lot of work over the last few years to try to eliminate the conflict of interest there,” Bankman-Fried, 30, told CNBC in an interview. “I don’t run Alameda anymore. I don’t work for it, no FTX does. We have a separate staff – we don’t want to get preferential treatment.”

Trading margin

Part of the problem, according to the same source, is FTX’s web of complicated leverage and margin trading. his”point margin“The trading feature lets users borrow from other customers on the platform. For example, if a customer saves a bitcoin they can lend it to other users and earn income on it.

But every time an asset is borrowed, FTX subtracts the borrowed asset from what it needs to keep in its wallet to match the customer’s deposit, sources said. Under normal circumstances, the exchange wallet should match what the customer deposited. But because of this practice, assets are not backed up one by one and the company considers the estimated amount owed to customers.

Alameda trading firms can also take advantage of this spot margin feature. One source said Alameda can borrow customer funds, essentially free of charge.

The source explained that Alameda could post FTT tokens held as collateral and borrow customer funds. Even if FTX creates more FTT tokens, it will not reduce the value of the coin because this coin never comes to the open market. As a result, these tokens held their market value, so Alameda borrowed against them – basically receiving free money for trading.

FTX has been able to sustain this pattern as long as it maintains the FTT price and there is no flood of customer withdrawals on the exchange. In the week leading up to the bankruptcy filing, FTX did not have enough assets to meet customer withdrawals, sources said.

The outside auditor likely missed this difference because the customer’s assets are balance sheet items, and therefore, would not be reported in FTX’s financial statements, the source said.

It all came crashing down last week.

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

This chain of events brought the exchange down, and customers withdrew roughly $5 billion before FTX paused the withdrawal. When customers withdraw their money, FTX has no funds, sources said.

‘No one saw this coming’

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