In mid-2020, FTX’s chief engineer made a secret change to the cryptocurrency exchange’s software.
He tweaked the code to exempt Alameda Research, a hedge fund owned by FTX founder Sam Bankman Friedby a feature on the trading platform that would have automatically sold Alameda’s assets if she lost too much borrowed money.
Explaining the change, engineer Nishad Singh emphasized that FTX should never sell Alameda’s positions. “Be extra careful not to liquidate,” Singh wrote in the comment in the platform’s code, which showed he helped author it. Reuters reviewed the code base, which was previously unreported.
The exemption allowed Alameda to retain FTX debt regardless of the value of the collateral backing those loans. This change in code caught the attention of the US Securities and Exchange Commission which Bankman-Fried charged with fraud on Tuesday. The SEC said the optimization means Alameda has a “virtually unlimited line of credit.” Additionally, the billions of dollars that FTX secretly lent Alameda over the next two years were not from its own reserves but were deposits from other FTX clients, the SEC said.
The SEC and a spokesman for Bankman-Fried declined to comment on the story. Singh did not respond to multiple requests for comment.
The regulator, which described the exchange as “a house of cards,” claimed Bankman-Fried hid FTX diverting customer funds to Alameda for secret venture investments, luxury home purchases and political donations. US Attorneys and the Commodity Futures Trading Commission also filed separate criminal and civil complaints, respectively.
The complaints — along with previously unreported FTX documents viewed by Reuters and three people familiar with the crypto exchange — provide new insights into how Bankman-Fried dipped into client funds and spent billions more than FTX unaware by investors, its customers and has earned the most employees.
Police in the Bahamas, where FTX was based, arrested Bankman-Fried Monday night, capping a stunning fall from grace for the 30-year-old former billionaire. His company collapsed in November after users rushed to withdraw deposits and investors shunned his requests for more funding. FTX declared bankruptcy on November 11 and Bankman-Fried resigned as CEO.
Bankman-Fried has apologized to customers but said he personally doesn’t believe he is criminally responsible.
The automatic liquidation exemption written into the FTX code allowed Alameda to steadily increase its line of credit until it “swelled to tens of billions of dollars and became virtually limitless,” according to the SEC complaint. It was one of two ways Bankman-Fried diverted customer funds to Alameda.
The other was a mechanism whereby FTX clients deposited over US$8 billion (around Rs.64,940) in traditional currency into bank accounts secretly controlled by Alameda. Those deposits were reflected in an internal account at FTX that was not tied to Alameda, thereby obscuring its liability, the complaint said.
Safe, tested and conservative
As Bankman-Fried, FTX grew into one of the largest in the world crypto Exchanges, consumer protection was a key tenet of his pitch for crypto regulation in the United States. Bankman-Fried has emphasized this issue in countless statements to clients, investors, regulators and legislators. FTX’s auto-liquidation software would protect everyone, he explained.
In a May 12 congressional hearing, he called FTX’s software “safe, tested, and conservative.”
“By rapidly unwinding the riskiest and least collateralized positions, the risk engine prevents the build-up of credit risk that could otherwise cascade across the platform and lead to contagion,” Bankman-Fried said.
He didn’t tell lawmakers about the software change to exempt Alameda. In fact, he told investors that Alameda did not receive preferential treatment from FTX, the SEC complaint states.
Bankman-Fried instructed subordinates to update the software in mid-2020 so that Alameda could maintain a negative balance on its account, the SEC complaint said. No other customer account at Alameda is eligible, the complaint added. This would allow Alameda to continue to borrow more FTX funds without having to post more collateral.
For software adjustments made in August 2020, Alameda was referred to as a “Primary Market Maker” or “PMM,” according to a Reuters review of its codebase. Market makers are traders who facilitate trading in an asset by being willing to buy and sell it.
To explain the change, Singh, the chief engineer, added a comment to the code: “Alameda would liquidate, prevented.” He added a warning “not to liquidate the PMM.”
Only Singh, Bankman-Fried and some other top executives at FTX and Alameda knew about the exception in the code, according to three former executives briefed on the matter. A digital dashboard used by staff to track FTX client assets and liabilities was programmed not to account for Alameda withdrawing client funds, according to two of the people and a screenshot of the portal Reuters previously reported Has.
Bankman-Fried’s house of cards “began to crumble in May 2022,” according to the SEC complaint.
As crypto tokens plummeted in value this month, several lenders demanded Alameda be repaid. Because Alameda did not have the funds to fulfill those requests, Bankman-Fried instructed Alameda to tap into its “line of credit” with FTX to receive billions of dollars in funding, the complaint says.
When FTX clients wanted to withdraw their funds in November of this year, spooked by media reports about the company’s financial health, many eventually found their funds were gone.
© Thomson Reuters 2022
