The quant 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, according to a source. The way they did it was by using billions from FTX users without their knowledge, the source says. Alameda Research, the fund started by Bankman-Fried, borrowed billions in client funds from its founder’s stock exchange, FTX, according to a source familiar with the firm’s operations, who asked not to be identified because the details were confidential . The crypto exchange drastically underestimated the amount of FTX it 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 case a user borrows money to make a transaction. According to the source, FTX did not have enough on hand. Her biggest client, according to a source, was the Alameda hedge fund. The fund was able to partially cover this activity because the assets it traded never touched its own balance sheet. Instead of holding money, he was borrowing billions from FTX users and then trading them, the source said. None of this was disclosed to clients, as far as CNBC is aware. In general, commingling and trading client funds with counterparties without express consent is illegal under US securities laws. It also violates FTX’s terms of service. Sam Bankman-Fried declined to comment on allegations of misappropriation of client funds, but said the recent bankruptcy filing was the result of issues with leveraged trading positions. “A margin position took a huge hit,” Bankman-Fried told CNBC. When making some of these leveraged trades, the quant fund used an exchange-created cryptocurrency called FTT as collateral. In a loan agreement, collateral is usually the borrower’s commitment to ensure repayment. It’s often dollars or something else of value — like real estate. In that case, a source said Alameda was borrowing from FTX and using the exchange’s internal cryptocurrency, the FTT token, to back those loans. The price of the FTT token dropped by 75% in one day, making the collateral insufficient to cover the trade. Last week, FTX collapsed from a $32 billion cryptocurrency powerhouse into bankruptcy. The blurred lines between FTX and Alameda Research led to a huge liquidity crunch for both companies. Bankman-Fried stepped down as CEO of FTX and said Alameda Research was closing. The company has since said it is removing transactions and withdrawals and moving digital assets offline after a suspected $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’ve put a lot of work over the last few years into trying to eliminate conflicts of interest there,” Bankman-Fried, 30, said in an interview with CNBC. “I don’t run Alameda anymore. I don’t work for it, none of FTX. We have separate executives — we don’t want preferential treatment. We want to do the best we can, treat everybody fairly.”

Margin trading

Part of the issue, according to the same source, was FTX’s web of complex leverage and margin trading. The “spot margin” trading feature allows users to borrow from other customers on the platform. For example, if a customer deposited a bitcoin, they could lend it to another user and earn a return on it. But every time it borrowed an asset, FTX subtracted the borrowed assets from what it needed to hold in its wallets to match customer deposits, a source says. In a typical situation, an exchange’s wallets must match those deposited by customers. However, because of this practice, the assets were not supported one-to-one and the company underestimated the amount owed to customers. The Alameda trading company was also able to benefit from this spot margin feature. One source says Alameda was able to borrow client funds, essentially for free. The source explained that Alameda could post the FTT tokens it had 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 entered the open market. As a result, these tokens retained their market value, allowing Alameda to borrow against them – essentially getting free money to trade. FTX was able to maintain this pattern as long as the FTT price was maintained and there was no flood of customer withdrawals on the exchange. In the week before the bankruptcy filing, FTX did not have enough assets to cover customer withdrawals, the source said. The outside auditors likely missed that discrepancy because the customer assets are an off-balance sheet item and therefore would not be reported on FTX’s financial statements, the source said. That all came crashing down last week. CoinDesk reported that most of Alameda’s balance sheet consisted of FTT tokens, shaking consumer and investor confidence. Changpeng Zhao (CZ), the CEO of one of its biggest competitors, Binance, has publicly threatened to sell his FTT tokens on the open market, crashing the price of FTT. This chain of events sparked a rally in the stock market, with customers withdrawing about $5 billion before FTX halted withdrawals. When customers went to withdraw their money, FTX didn’t have the money, sources say.

“No one saw this coming”

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 incorrectly suggests that even if all customers withdrew their money, FTX would still have more than a billion dollars.
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. Workers said that in some cases, their life savings are tied to FTX. “We are 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 faced over these missing funds, employees who say they were just as devastated as customers now face financial hardship, harassment around their company membership and tarnished future employment prospects. “We couldn’t believe how they betrayed us,” said one former employee.