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The Secret Software Change Behind FTX's Use of Client Money

FTX's chief engineer secretly tweaked the code to exempt Alameda Research, allowing Bankman-Fried to misappropriate funds without anyone's knowledge. When caught, FTX declared bankruptcy and Bankman-Fried was charged with fraud. This serves as a reminder that deceptive practices won't be tolerated.

In the middle of 2020, FTX's chief engineer Nishad Singh 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-Fried, from a feature on the trading platform that would have automatically sold off Alameda's assets if it was losing too much-borrowed money.

In a note explaining the change, Singh emphasized that FTX should never sell off Alameda's positions. “Be extra careful not to liquidate,” he wrote in the comment in the platform's code, which Reuters has since reviewed.

This exemption allowed Alameda to keep borrowing funds from FTX irrespective of the value of the collateral securing those loans. As a result of this tweak in the code, the U.S. Securities and Exchange Commission (SEC) charged Bankman-Fried with fraud on Tuesday. According to the SEC, this software change meant that Alameda had a “virtually unlimited line of credit.” Furthermore, the billions of dollars that FTX secretly lent to Alameda over the next two years did not come from its own reserves but rather were other FTX customers' deposits.

As the regulator called FTX "a house of cards," details emerged about Bankman-Fried's use of customer funds without their knowledge and permission. Documents seen by Reuters, along with three people familiar with the crypto exchange, revealed how Bankman-Fried tapped into customer funds and spent billions more than FTX was making.

Police in the Bahamas, where FTX was based, arrested Bankman-Fried on Monday evening after users rushed to withdraw deposits and investors refused to provide more financing. FTX declared bankruptcy on Nov. 11, and Bankman-Fried resigned as chief executive.

Bankman-Fried apologized to customers and claimed he personally did not think he had any criminal liability.

The auto-liquidation exemption found in FTX's code had enabled Alameda to continually increase its line of credit until it became essentially limitless, per the SEC complaint. This was one of two ways that Bankman-Fried diverted customer funds to his hedge fund. The other was a mechanism whereby FTX customers deposited over $8 billion in traditional currency into bank accounts secretly controlled by Alameda, which hid its liability and received deposits without investor knowledge.

Bankman-Fried had proudly pitched FTX as a platform that was safe, tested and conservative when it came to consumer protection. In congressional testimony on May 12, he asserted that the software's auto-liquidation features would protect everyone involved. However, he failed to mention the code warping his company was engaging in to the benefit of his hedge fund.

Bankman-Fried had directed his subordinates to update the software in mid-2020 to enable Alameda to maintain a negative balance on its account, per the SEC complaint. This would allow Alameda to keep borrowing more FTX funds without the need to provide more collateral.

In software tweaks made in August 2020, Alameda was designated as the “Primary Market Maker” or “PMM,” per a review of FTX's codebase. To explain this change, Singh inserted a comment into the code: “Alameda would be liquidating, prevented.” He also gave a warning “not to liquidate the PMM."

Only a few people were aware of this exemption: Singh, Bankman-Fried, and a few other top FTX and Alameda executives. Additionally, a digital dashboard used by FTX staff to track customer assets and liabilities was programmed so it would not take into account that Alameda had withdrawn the client funds per two people and a screenshot of the portal.

In May 2022, Bankman-Fried's house of cards "began to crumble," according to the SEC complaint. When the value of crypto tokens plummeted, Alameda's lenders demanded repayment. Since the hedge fund didn't have the funds on hand to make those payments, Bankman-Fried directed Alameda to tap its line of credit with FTX for billions of dollars in financing, the complaint noted.

When FTX customers rushed to withdraw their own funds in November due to media reports about the company's financial health, many discovered that their deposits were gone. FTX had been unable to meet these requests, leading to its downfall and Bankman-Fried's downfall.

It is clear that Bankman-Fried had taken advantage of the unsuspecting customers on FTX, diverting billions of dollars away from them and using them to make undisclosed investments in venture capital, luxury real estate, and political donations - all without anyone's knowledge. This misappropriation of funds has led to harsh criticism and condemnation from authorities, as well as customers and investors whose money was stolen.

The fall of FTX is certainly a cautionary tale for those who would engage in similar behavior. It serves as a reminder to all that deceptive and dishonest practices like those employed by Bankman-Fried will soon be discovered, and the consequences can be severe. Unscrupulous behavior of this nature can never be tolerated, and it is essential that those responsible be held accountable for their actions.