How FTX’s Sister Firm Brought the Crypto Exchange Down

In late 2017, Sam Bankman-Fried, then 25 years old, co-founded Alameda Research, a small trading firm that marked the beginning of his cryptocurrency empire.

Now the relationship between Alameda and his cryptocurrency exchange, FTX — and how the two propped each other up — is coming under scrutiny as prosecutors and regulators investigate the collapse of one of the best-known trading platforms in the crypto universe.

Alameda’s need for funds to run its trading business was a big reason Mr. Bankman-Fried created FTX in 2019. But the way the two entities were set up meant that trouble in one unit shook up the other as crypto prices began to drop in the spring. In the end, it brought down both Alameda and FTX, leading to billions of dollars in losses for customers and traders.

And although the collapse echoed past calamities on Wall Street, the lack of regulatory oversight — coupled with an ambitious start-up founder flush with venture capital money and few internal controls — meant that there were few parallels.

John Jay Ray, III, a prominent restructuring lawyer handling the cleanup of FTX, called the situation “unprecedented” in a U.S. Bankruptcy Court filing on Thursday. He blasted the company for the “concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals.”

Mr. Bankman-Fried co-founded Alameda in Berkeley, Calif. His scrappy team of traders in their 20s worked around the clock, showering in the locker room of the gym of the four-story building where Alameda had its headquarters. He soon moved the firm to Hong Kong, which had been wooing crypto traders and imposed little oversight on the nascent industry.

The main way that Alameda made money was straightforward: It bought Bitcoin and other cryptocurrencies in one part of the world and sold them in another, pocketing the difference.

Alameda’s methods borrowed many aspects from traditional high finance. It was a quantitative trading firm, similar to Wall Street hedge funds that use mathematical models and data to inform decisions. It used “leverage” — or borrowed money — to fuel its trades and make bigger returns. And its Bitcoin trade was a so-called arbitrage trade, also popular on Wall Street.

But while Wall Street firms operate within guardrails that limit risk-taking and require regular financial disclosures, Alameda had no regulatory oversight.

The firm initially managed around $55 million — a pittance in the financial world. Its capital came from a mix of the group’s own funds and high-interest cryptocurrency loans from wealthy investors, according to a 2018 firm presentation viewed by The New York Times and people briefed on the firm’s operations. In recent years, Alameda struck bigger financing agreements with other crypto trading firms, the people said.

In a video posted on YouTube three years ago, Mr. Bankman-Fried discussed the hectic nature of Alameda’s trading. Seated in front of trading screens, he talked about often having to make split-second decisions on trades.

Eventually, as more sophisticated investors like hedge funds piled into the crypto arbitrage trade, it became much less lucrative for Alameda.Still, with the price of Bitcoin and other cryptocurrencies soaring — and expected to keep going up — Alameda had no trouble paying back its loans in either dollars or crypto.

That’s why, in the presentation to investors, Alameda was able to say it could offer lenders “high returns with no risk” and “no downside.” However, finding a ready supply of dependable lenders was time-consuming for Alameda, especially since banks and traditional Wall Street firms largely shunned crypto because of the lack of regulation and oversight.

In 2019, Mr. Bankman-Fried hit upon an idea: Why not build a cryptocurrency exchange that could bring in revenue to help fund Alameda’s activities?

FTX was born. It moved from Hong Kong to the Bahamas, where Mr. Bankman-Fried built his base of operations, and the exchange took off. In financial presentations to investors, the company claimed in 2021 that it was raking in $1 billion in annual revenue by charging fees to customers who wanted to trade cryptocurrencies on its platform. It marketed itself aggressively to ordinary investors eager to trade the hot new thing.

With crypto exchanges proliferating, their owners, including Mr. Bankman-Fried, sought more ways to make profit. One way was for an exchange to invent a token for use on its platform. Customers can trade cryptocurrencies directly or by using these tokens; if they use the tokens, typically the exchange offers a trading discount.

As long as customers used them to trade cryptocurrencies, the tokens could be quite valuable.

FTX called its token FTT and sought “seed” money from investors to get trading going. To maintain the value of FTT and keep its price stable, Alameda, still based in Hong Kong, served as the token’s main market maker. That meant it bought and sold the majority of FTT on the exchange and, as a major trader, had the ability to set prices for the token.

As investors, enticed by the trading discounts, embraced FTT to trade on FTX, the newly minted token became one of the biggest sources of trading revenue for the exchange.

Both FTX and Alameda benefited from the token’s rising value. The exchange began using FTT to make dozens of investments worth billions of dollars in other crypto companies. A 2019 investor presentation for the new exchange said, “FTT will be the backbone of the growing FTX ecosystem,” and promised investors and customers “guaranteed liquidity,” or the ability to always get back their money.

In the presentation, a cartoon avatar of mop-topped Mr. Bankman-Fried gave a thumbs up and simply said: “So easy!”

At the same time, Alameda, which held a large stake in the token, began using its FTT holdings as collateral for more loans to facilitate its trading activities. As of Sept. 30, Alameda had roughly $13 billion in assets, according to Thursday’s bankruptcy filings, although Mr. Ray, the restructuring lawyer and newly appointed chief executive, said he had no confidence in the numbers.

The intertwined business model, with FTT propping up the two entities, turned Mr. Bankman-Fried into a crypto hero. Even if many backers and supporters of the exchange didn’t quite understand how it all worked, they were taken in by his compelling pitch. He styled himself as an idiosyncratic genius willing to engage with regulators and call out the scams plaguing the crypto industry. He also expressed a commitment to give away much of his wealth to charity.

In 2021 and early this year, FTX raised nearly $2 billion in equity from more than two dozen high-profile investors, including Sequoia Capital, SoftBank, Tiger Global and BlackRock. Some of those investors have since said they were blindsided by FTX’s implosion, partly because they didn’t fully appreciate the symbiotic relationship between FTX and Alameda, or the potential conflicts of interest that it could pose.

For instance, one of the co-chief executives of Alameda, Caroline Ellison, was at times in a romantic relationship with Mr. Bankman-Fried. The two met while working at Jane Street Capital, a New York trading firm, before Alameda opened for business.

Critics pointed to other potential conflicts. Alameda traded heavily on FTX and sometimes profited when other customers lost money. Mr. Bankman-Fried had a hand in Alameda’s big trading decisions as well as its venture investments, two people familiar with the companies said.

In the bankruptcy filing on Thursday, Mr. Ray said there had been an “absence of independent governance.” He also said he was not aware that any of Alameda’s financial statements had been audited.

The lack of transparency and regulation of Mr. Bankman-Fried’s businesses should have been a bright red flag early on, said Tyler Gellasch, president of the Healthy Markets Association, an advocate for greater transparency in financial markets.

“This catastrophe with FTX was enabled by two things: It was crypto, and it wasn’t public in any fashion,” Mr. Gellasch said. “It wasn’t a public company, so there were no robust disclosures. They were able to raise billions without public disclosure and without serious accountability.”

With the influx of investor money, Mr. Bankman-Fried started a giant publicity campaign for FTX, signing branding deals with sports leagues, advertising on television and hiring celebrities to endorse its platform and woo retail investors. At the same time, Alameda and FTX stepped up their ambitions, providing billions in early-stage funding to 246 crypto companies, according to PitchBook, a data company.

It’s hard to pinpoint the exact moment when Mr. Bankman-Fried’s empire began to spiral out of control, or whether a particular event precipitated it. Early this year, some lenders to Alameda wanted their funds back because they were concerned about the more than $2 billion that Alameda had invested in crypto start-ups.

Blockchain.com, a leading seller of Bitcoin and other cryptocurrencies, closed out a loan it had made to Alameda, concerned about “too many illiquid-related assets” on its balance sheet, a person with knowledge of the matter said.

But the problems cascaded this spring when the crypto market began to teeter, with a number of high-profile failures of companies that FTX had close ties to.

With crypto prices falling, more lenders wanted their money back. The falling prices also reduced the value of FTT, which Alameda had used as collateral for some loans. As the firm struggled to pay lenders back, FTX resorted to using funds that customers had deposited with the exchange for ease of trading to pay Alameda’s lenders back.

In an interview with The Times early this week, Mr. Bankman-Fried dodged questions about customer funds. But the amount of customer dollars lent to Alameda could exceed $10 billion.