FTX Tapped Into Customer Accounts to Fund Risky Bets, Setting Up Its Downfall

Crypto exchange FTX lent billions of dollars worth of customer assets to fund risky bets by its affiliated trading firm, Alameda Research, setting the stage for the exchange’s implosion, a person familiar with the matter said.

FTX Chief Executive Sam Bankman-Fried said in investor meetings this week that Alameda owes FTX about $10 billion, people familiar with the matter said. FTX extended loans to Alameda using money that customers had deposited on the exchange for trading purposes, a decision that Mr. Bankman-Fried described as a poor judgment call, one of the people said.

All in all, FTX had $16 billion in customer assets, the people said, so FTX lent more than half of its customer funds to its sister company Alameda.

Alameda took out additional loans from other financial firms, according to people familiar with the matter. As of Monday, Alameda owed $1.5 billion in loans to counterparties outside of FTX, the people said.

An FTX spokesman declined to comment.

FTX paused customer withdrawals earlier this week after it was hit with roughly $5 billion worth of withdrawal requests on Sunday, according to a Thursday morning tweet from Mr. Bankman-Fried. The crisis forced FTX to scramble for an emergency investment.

FTX struck a deal to sell itself to its giant rival Binance on Tuesday, but Binance walked away from the deal the next day, saying FTX’s problems were “beyond our control or ability to help.”

The failure of FTX to fill withdrawal requests shocked crypto investors and badly tarnished the reputation of Mr. Bankman-Fried, who had embraced regulation of digital currencies and branded himself as a crypto entrepreneur driven by ethics and philanthropy.

“An exchange really shouldn’t have problems getting its customers their deposits,” said Frances Coppola, a U.K.-based economist. “It shouldn’t be doing anything with those assets. They should literally be sitting there so people can use them.”

As questions were brewing about FTX’s health on Monday, Mr. Bankman-Fried tweeted: “FTX has enough to cover all client holdings. We don’t invest client assets (even in treasuries).” He later deleted the tweet.

On Thursday morning Mr. Bankman-Fried said in a tweet that Alameda Research was winding down trading.

In traditional markets, brokers must keep client funds segregated from other company assets and regulators can punish violations. In 2013, for instance, the Commodity Futures Trading Commission fined brokerage MF Global $100 million for misuse of customer funds during its messy collapse two years earlier—a downfall also driven by risky bets gone wrong.

But MF Global customers were ultimately made whole after a years long bankruptcy process. With FTX, operating in the Wild West of crypto, it is unclear whether customers will ever get their money back.

The revelation of the loans suggests that the root of FTX’s downfall lay in its relationship with Alameda, a firm known for aggressive trading strategies funded by borrowed money. Some crypto traders have voiced wariness of the affiliation, worrying that it posed a conflict of interest for an exchange to be attached to a trading business.

Mr. Bankman-Fried founded and is the majority owner of both firms. He was CEO of Alameda until last year, when he stepped back from the role to focus on FTX.

Alameda’s CEO is Caroline Ellison, a Stanford University graduate who like Mr. Bankman-Fried previously worked for quantitative trading firm Jane Street Capital. Alameda is based in Hong Kong, where FTX was headquartered before relocating to the Bahamas last year.

In theory, exchanges like FTX make money by allowing customers to trade cryptocurrencies and collecting fees for transactions. Alameda pursued a variety of trading strategies to make money from volatility, a riskier business model.

Among the strategies that Alameda engaged in after Mr. Bankman-Fried founded the firm in 2017 was arbitrage—buying a coin in one location and selling it elsewhere for more. One early winning trade involved buying bitcoin on U.S. exchanges and selling in Japan, where it commanded a premium over its U.S. price.

Another business at Alameda is market-making—offering to buy and sell assets on crypto exchanges throughout the day, and collecting a spread between the buying and selling price.

More recently Alameda has become one of the biggest players in “yield farming,” or investing in tokens that pay interest-rate-like rewards, according to analysts who used public blockchain data to track the firm’s activities. One crypto wallet controlled by Alameda has generated more than $550 million in trading profit since 2020, according to blockchain analytics firm Nansen.

Yield farming can be risky because the tokens often have an initial run-up in price as investors pile in, seeking the rewards, then a crash as they get out.

“It’s essentially like picking up pennies before a steamroller,” said independent blockchain analyst Andrew Van Aken. “You use dollars, or stablecoins, to get these very speculative coins.”

—Peter Rudegeair and Caitlin Ostroff contributed to this article.