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Sam Bankman-Fried, the founder and former CEO of cryptocurrency exchange FTX, is escorted out of the Magistrate Court building in Nassau, Bahamas, on Dec. 21.DANTE CARRER/Reuters

Cryptoexchange FTX invented a currency, repeatedly propped up its price through a sister company, then used the inflated value to orchestrate wide-scale fraud, according to the U.S. Securities and Exchange Commission.

In charges laid late Wednesday against Caroline Ellison and Gary Wang, two former top officials in the FTX ecosystem, the SEC painted the clearest picture yet of how exactly FTX co-founder Sam Bankman-Fried orchestrated what the regulator alleges was “a massive, years-long fraud.”

The scheme, according to the SEC, involved “diverting billions of dollars of the trading platform’s customer funds for [Mr. Bankman-Fried’s] own personal benefit and to help grow his crypto empire.”

The SEC’s charges were filed in parallel with federal criminal charges laid by the U.S. Attorney’s Office for the Southern District of New York. Ms. Ellison and Mr. Wang pleaded guilty to the federal charges and are co-operating with federal prosecutors.

Federal prosecutors, the SEC and the Commodity Futures Trading Commission (CFTC) have already charged Mr. Bankman-Fried. Their charges include allegations of wire fraud and securities fraud, among others.

FTT is a cryptocurrency FTX invented, and it was central to the alleged fraud, according to the SEC. In the crypto world, FTT is known as an exchange token, and most cryptoexchanges have one of their own, including Binance and Coinbase. These tokens are, in simple terms, currencies created out of thin air and they function similar to loyalty program points. By owning FTT, for instance, FTX users could get discounts on trading fees when using the trading platform.

Until very recently, exchange tokens were rarely scrutinized by regulators, lawmakers or crypto skeptics. This is partly because no one could decide how to define crypto assets – as a currency, a security or something else entirely – and that meant there was very little governance.

FTX may have used this vacuum of regulation to its advantage. The SEC alleges that FTX and its sister trading arm, Alameda, “manipulated” the market price of FTT “with the goal of supporting the price of the token.” Doing so was critical to the alleged fraud because Alameda used FTT as collateral to borrow billions of dollars from outside lenders.

In its charges, the SEC clearly laid out that it now views FTT as a security. “From the time of its offering, FTT was offered and sold as an investment contract and therefore a security,” the SEC wrote. It is now charging two top FTX-affiliated executives with fraud in the sale or offer of securities, and fraud in connection with the purchase or sale of securities.

FTT was created in May, 2019, when FTX minted 350 million tokens and kept half of them for itself. FTT was made available for public investment in July, 2019, and it was marketed as “the token powering the FTX ecosystem.” That same month, Alameda received “a substantial portion” of the tokens that FTX kept for itself. The SEC alleges that Alameda did not pay for them.

This gift proved to be a major culprit in FTX’s collapse, but it took years for the web of connections to come to light.

From 2019 to 2022 Alameda borrowed billions of dollars, and Alameda would often pledge its FTT holdings as collateral for these loans. Alameda was a crypto hedge fund privately owned and controlled by Mr. Bankman-Fried and Mr. Wang, who split ownership 90 per cent and 10 per cent, respectively. Ms. Ellison became co-CEO of Alameda in October, 2021.

According to the SEC, much of the borrowed money flowed to Mr. Bankman-Fried, and the regulator alleges that he used Alameda as “his personal piggy bank to buy luxury condominiums, support political campaigns and make private investments, among other uses.”

By using FTT to backstop loans, Alameda was vulnerable to any drop in FTT’s value. Alameda, therefore, had an incentive to inflate FTT’s price, and the SEC alleges that, in multiple instances, Alameda manipulated the token’s value to do just that.

The SEC alleges that Alameda CEO Caroline Ellison, “at Mr. Bankman-Fried’s direction, caused Alameda to manipulate the price of FTT by purchasing large quantities of FTT on the open market to prop up its price. This manipulative activity was in furtherance of [the alleged fraud] because it allowed Ms. Ellison and Alameda to engage in further borrowing, while concealing Alameda’s true risk exposure.”

But it all came crashing down in November, after an allegation that Alameda had a major exposure to FTT – something that was not publicly known. Shortly afterward, rival cryptoexchange Binance announced it was selling the roughly US$500-million worth of FTT it owned, and the price of FTT soon crashed by 80 per cent.

Ironically, Binance had not purchased FTT on the open market. Binance had previously owned a stake in FTX, and Mr. Bankman-Fried repurchased this stake by paying Binance in FTT.

From the outside, it wasn’t immediately clear how Alameda’s FTT holdings would impact FTX. But the SEC alleges that FTX had been directing client funds to Alameda for years, despite assuring FTX customers that their assets were secure. FTX’s terms of service explicitly stated: “Title to your digital assets shall at all times remain with you and shall not transfer to FTX,” and “none of the digital assets in your account are the property of, or shall or may be loaned to, FTX Trading.”

The alleged fraud started to unravel in the spring of 2022 when the prices of many crypto assets nosedived following the collapses of two notable cryptocurrencies, luna and terraUSD. Around this time, according to the SEC, Alameda’s lenders demanded repayments on billions of dollars’ worth of loans.

“Despite the fact that Alameda had, by this point, already taken billions of dollars of FTX customer assets, it was unable to satisfy its loan obligations,” the SEC alleged. To plug financial holes, Mr. Bankman-Fried “directed FTX to divert billions more in customer assets to Alameda to ensure that Alameda maintained its lending relationships, and that money could continue to flow in from lenders and other investors.”

In all, more than US$8-billion in FTX customer assets had been deposited into Alameda-controlled bank accounts.

This web of connections was exposed when the price of FTT plummeted in November. The collateral Alameda posted on its loans dried up in an instant, and there was no way to prop up FTT’s value any more. In turn, the more than US$8-billion that Alameda owed FTX’s clients became visible, and within days FTX filed for bankruptcy protection.

For the institutional investors and celebrities who backed FTX and Mr. Bankman-Fried, including Ontario Teachers’ Pension Plan, the exchange’s collapse has been an embarrassment. However, the SEC alleges that they were likely misled. While investors were provided with audited financial statements, the SEC alleged these documents did not mention the client money that Alameda borrowed from FTX, and they “were, at the very least, materially misleading.”

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