CME Group and ICE both opposed the proposal from FTX US to offer central clearing of margin products directly to retail customers, which was defended by the crypto venue and the FIA, the derivatives trade body, in a Congressional hearing.
The US House of Representatives Committee on Agriculture held a hearing, Changing Market Roles: The FTX Proposal and Trends in New Clearinghouse Models, on 12 May. FTX’s proposal would replace the traditional distributed risk clearing model involving futures commission merchants with an automated and centralized process that does not use intermediation.
Terrence Duffy, chairman and chief executive of CME Group, said in his testimony that if the Commodity Futures Trading Commission approved the proposal it would represent a dramatic change to the market structure of the derivatives industry, and set a precedent with wide ranging negative implications for the safety and soundness of US financial markets. Duffy said: “FTX US’s proposal is glaringly deficient and poses significant risk to market stability and market participants.”
He continued that the proposed clearing model is rife with risk management deficiencies, market integrity issues, cross border implications and customer protection issues. Duffy described FTX ‘s proposal “as risk management light” because the crypto exchange will not impose any capital requirements on its participants and does not intend to maintain mutualism, i.e. loss sharing among non-defaulting participants to address participant defaults.
“More broadly, this proposal is insufficient as its direct model eliminates potentially billions of dollars of loss absorbing resources that are currently a feature of the derivatives market,” Duffy added. “Additionally by proposing to self fund its guarantee fund FTX eliminates a core incentive for participants to effectively manage their risks.”
He also opposed FTX’s proposed use of an auto liquidation algorithm across its customer base which he claimed would have knock-on effects on the real economy, including exacerbation of price increases already being observed due to inflationary pressures.
“FTX propagates a model where participants can be liquidated without notice in the middle of the night and on weekends and holidays during illiquid market conditions and at discounted prices,” he added. “Auto liquidation would inject uncertainty in the application of hedge accounting programmes.”
Duffy concluded that the CFTC should either reject the FTX proposal, or start a formal rulemaking to allow a broader public discussion of appropriate risk management standards.
FTX US Derivatives
Sam Bankman-Fried, chief executive and founder of FTX US Derivatives, defended the crypto firm’s proposal in his testimony and highlighted that the derivatives business is regulated by the CFTC. In October 2021 FTX, a US-regulated crypto exchange completed its purchase of LedgerX, which has been rebranded FTX US Derivatives. Through the deal FTX US gained a CFTC-regulated designated contract market, swap execution facility and derivatives clearing organization.
He said: “The FTX risk management system is tested, safer and more conservative than what is normally seen in US derivatives markets for a number of reasons.
First, he argued that the system assesses risk on a nearly real-time basis, assessing customers trading positions and account balances every few seconds to determine whether they have adequate resources or collateral in their account. In contrast, most traditional markets monitor risk on a less frequent basis.
Second, the system also requires customers to transfer the required collateral before they can begin trading to cover at least 99% of the one day portfolio returns using appropriate weightings for base value at risk and stress VaR. In contracts, on traditional derivatives exchanges,collateral is generally based on credit, exposing all market participants if that credit decision turns out to be unwarranted.
Third, the risk system has a real time liquidation feature to prevent a buildup of risk so customers are incentivized to proactively add collateral or reduce risk positions prior to partial auto liquidations.
“Users of the platform receive ample and repeated notice that a liquidation of a position could ensue,” he added. “Notably, unlike traditional platforms, the FTX risk system does not extend calls for additional margin or extend credit to the customer hoping that such a call can be met.”
The FTX system is based on presumption that the exchange will not have recourse against any customer for credit losses. In contrast traditional exchanges can take days to begin attempting to liquidate a large position by which time it can be substantially more underwater than it was initially.
“This also means FTX’s risk system is non-recourse and so customers cannot lose more than they proactively deposited to the clearinghouse prior to trading,” he said. “Unlike traditional platforms that may attempt to seize a customer’s other assets, auto liquidations are not expected to be the norm or common as some have or as common as some have feared, particularly because of the conservative initial margin methodology methodology.”
Bankman-Fried highlighted that on FTX’s international platform the notional value of liquidated positions is less than 1% of all historic notional activity.
He continued that without auto-liquidation there would be a call for additional collateral from a customer whose position suffered enough losses to require it and that during a period of market stress, market participants would be under pressure to find liquid resources to make a large margin call at a time when liquidity becomes more scarce.
“There are trade-offs to any risk management system and in times of market stress procyclicality will always be a risk to address and manage ,” he added. “FTX believes its risk system does so most effectively and appropriately.
The FTX risk management system also relies on backstop liquidity providers to take on the portfolio of a participant in default. They are automatically passed liquidating positions in real time and are unable to reject it legally.
He also argued it was incorrect to assume that if the FTX US Derivatives risk model relies only on its own capital that the guaranty fund must be too small to sufficiently absorb losses.
“Instead FTX has gone above and beyond the regulatory requirements and well above what has been necessary or required based on our experience over the past years of operation internationally,” he said. “All other things remaining equal, this type of system is a more conservative approach to managing risk.”
Bankman-Fried continued that FTX provides all the applicable suitability controls and know your customer processes that are often done by intermediaries ensuring that the standard safeguards are in place for users with direct access to clearing.
“While this market structure is not unusual among global derivatives exchanges, it is not the common market structure for the US derivatives market,” he added. “Nonetheless, the FTX US Derivatives market structure is familiar to the CFTC and permitted under the CFTC regulations.”
The CFTC originally approved FTX US Derivatives to clear fully collateralized derivatives in December 2022. The firm then submitted an application to amend its licence to clear margin futures contracts after many months of informal discussions with the regulator’s staff.
On March 10 2022 the CFTC released a 30-day request for comment on the FTX application, which was then extended for another 30 days to May 11 2022. The CFTC has also scheduled a roundtable to discuss the proposal on May 25.
“To be sure the CFTC has responded to and addressed the FTX application in a very deliberate and transparent manner allowing considerable opportunity to comment on this narrow licensing matter,” Bankman-Fried said. “Under the CFTC regulations the process for applying for a DCO licence is not required to be the subject of public comment and normally is not subjected to the same level of public scrutiny.”
Futures Industry Association
Walt Lukken, president and chief executive of the FIA, said in his testimony the the derivatives indicatory has reached an inflection point that requires careful consideration of the benefits of an alternative clearing structure while ensuring it does not compromise the battle-tested protections and checks of the existing structure afforded to customers and markets. For the first time clearing could combine margined futures with near real-time margining, 24/7 auto liquidation of defaulting customers, and a self-funded CCP default fund without the benefit of FCM’s risk management processes beyond retail cryptocurrencies.
“It is important to point out that FTX’s proposal would permit futures trading in any underlying asset class transacted by any type of customer, including commercial hedgers,” he added. “We must also consider the core users of our markets, including farmers, refiners, pension funds, and other main street businesses that use futures to hedge price risk in the real economy.”
He highlighted that U.S. registered FCMs hold about $175bn in regulatory capital that backstops their guarantee of customer trades and serves as a first line of defense against a more serious contagion event that could spread to a CCP and beyond and contribute another $15 billion to clearinghouse default funds.
However, the FIA supported the efforts of FTX to advance real-time risk management in clearing and bring greater competition. Lukken added: “We believe that further analysis and information are needed on the FTX proposal, and we look forward to the deliberative process of the CFTC that will help bring additional clarity and information to this unique clearing model.”
ICE
Christopher Edmonds, chief development officer at ICE said in his testimony that the FTX model raises significant questions around risk management, financial resources investor protections.
Edmonds said: “FTX’s proposal eliminates sound risk management practices and many customer protections for retail participants, which are key features of the centrally cleared derivatives market. The proposed structure creates risk-taking incentives that may serve to increase, rather than reduce, risk to market participants and the global financial system.
In addition, while FTX’s current business focuses on digital assets., the proposed framework is not limited to digital assets and could be applied to traditional agricultural or energy commodities.
“The CFTC must consider the implications of the proposed model as a policy matter for all products and markets,” he said. “Innovation cannot supersede the primary functions of futures markets for price discovery and hedging.”
In addition, he believed the proposal does not fully satisfy the Principles for financial market infrastructures, the international standards for financial market infrastructures.
“It is critical that any action by the CFTC not jeopardise the existing foreign equivalence determinations applicable to US clearing houses,” he added.
Edmonds argued there are fundamental differences in the treatment of losses. Currently clearing houses operate a ‘pay as you go’ model, meaning losses are settled at least once a day.
“Conversely, the FTX model is a ‘go as you pay’ model in which when a participant’s collateral is eroded below a prescribed threshold FTX liquidates a position,” he said. “ICE notes the risks when a clearinghouse is forced to automatically liquidate and the potential for a cascading downward spiral, especially in relatively illiquid markets.”
He also objected to FTX’s proposal to allow itself to use customer funds for FTX operations and replace the funds at some point in the future while traditional clearinghouses cannot use the margin of a non-defaulting member in the default by another member.
“The FTX proposal raises significant policy issues as well as questions about compliance with the PFM eyes and commission regulations that warrant further analysis,” said Edmonds.”The approval of the FTX proposal could undermine the internationally agreed to framework and commission regulations intended to achieve the goal of a robust and resilient clearing process.
CCP12
The Global Association of Central Counterparties said in its comment letter that FTX’s proposal represents a radical change in the clearing landscape, which would have far-reaching consequences.
“The FTX proposal does not seem to meet the risk management standards to which CCPs globally adhere, including the PFMIs,” said the letter. “Simply put, FTX’s proposal appears to eliminate sound risk management practices and many customer protections for retail participants, which are key features of centrally cleared derivatives markets across the globe..”
CCP12 argued that in particular, retail participants would no longer be guaranteed the customer protections, including those at the level of the CCP, that they have traditionally been afforded when accessing centrally cleared derivatives markets through a CFTC-registered FCM.
The letter claimed that FTX’s proposal inaccurately claims to provide improvements on traditional risk management practices provided by CCPs today.
“In reality, some of the supposed improvements cited (e.g., real-time risk monitoring and the collection of liquidity and concentration margin) are practices employed by CCPs today,” said the letter. “FTX’s proposal points to its autoliquidation mechanism as an improvement on traditional risk management, when in fact this approach has been considered in the past and dismissed, at least at the market infrastructure level, as detrimental to retail participants.”
CCP12 said clearing members play an important role in the traditional CCP model through an additional layer of informed risk monitoring and risk absorption.
“If the CFTC permits the FTX proposal to move forward as currently constructed, it would give credence to a model that fails to meet PFMIs and general risk management best practices, and could be a catalyst for other jurisdictions to adopt such models,” added the letter.
