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On March he Commodity Futures Trading Commission (CFTC) has requested public comment on a proposal from FTX US to modify their Derivatives Clearing Organization (DCO) license. to offer margin trading to retail customers in what is considered a ‘non-intermediated’ model of crypto derivatives trading. For those who trade futures and options regularly, you are likely aware that margin trades are cleared using a Futures Commission Merchant (FCM) intermediary.
It is, of course, not a decision that the CFTC has seemed to enter into lightly nor one that Congress thinks should be considered quickly either, as derivatives are a sore subject regarding the causes of the Global Financial Crisis. As a former U.S. regulator, the lack of transparency in the derivatives market and concentrations of risk led this country to the brink of failure amongst the global financial markets, so it is understandable why there is so much ado about a brand new crypto exchange looking to change the way margin trading for derivatives are cleared at the retail level.
In this story, I review the timeline of events regarding this proposal first and then an interview with Brett Harrison, the President of FTX US who breaks down why this proposal is significant and his belief in how this type of margin clearing actually reduces the risks inherent in the current derivatives marketplace.
January 4, 2022 – Rostin Benham is sworn in as Chairman of the CFTC, after being nominated by President Biden. Benham spends what he describes as months working behind-the-scenes with FTX US on their novel proposal regarding the clearing of margin trades for crypto derivatives at the retail level.
March 10, 2022 – The CFTC formally announces that Derivative Clearing Organizations (DCOs) are seeking to offer clearing of margined products directly to participants without using a FCM intermediary. The CFTC also announces it is reviewing a formal request from FTX US Derivatives (FTX) to amend its registration to modify its existing non-intermediated model that currently clears futures and options contracts on a fully collateralized basis to clearing margin products for retail participants while continuing with a non-intermediated model. The CFTC requests public comment on FTX that is originally due in 30 days.
March 24, 2022 – The CFTC announces that it is extending the request for public comment on FTX to 60 days, moving the due date to May 11, which is two weeks away. Comments can be provided through this link and materials from FTX US can be reviewed here.
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March 31, 2022 – The House Agriculture Committee holds a hearing called ‘State of the CFTC’ where Chairman Rostin Benham of the CFTC is the sole witness. Chairman David Scott (D-GA) of the Committee starts the hearing with a moving statement about his ‘love and affection’ for the world’s greatest financial system, and his background at the Wharton School of Business, that those watching, “…understand the concern that I have with this cryptocurrency situation.”
“Now I understand there is a proposal pending at the CFTC by a cryptocurrency exchange that is seeking approval to operate a new and untested exchange … new and untested exchange that is seeking approval to operate in a new and untested system of clearing derivative trades and I’m very concerned about this … very much concerned about this proposal and the broad implications it poses,” stated Scott.
Scott announced that he is putting together a hearing in the House Agriculture Committee on Tuesday, May 17 based on his belief the FTX proposal needs more review and more oversight. The hearing would consider the way traditional clearinghouses such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) view the FTX US proposal and that he was inviting the CEOs of both CME and ICE to testify at this upcoming hearing.
May 11, 2022 – Deadline to respond to the FTX. According to the site where stakeholders can provide comments on the proposal, there are a whopping 768 responses already posted.
May 17, 2022 – The date that Scott has promised a hearing with the CEOs of the Commodity Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) to listen to the traditional clearinghouses provide their views on the non-intermediated model of cryptocurrency derivatives margin clearing by FTX US.
May 25, 2022 – Roundtable of CFTC staff will be held with DCOs, FCMs, FCM customers, end-users, academics, proprietary traders, public interest groups, and others to discuss in detail the impacts in general of non-intermediated models of margin clearing.
Interview with Brett Harrison, President of FTX US
Jason Brett: Can you tell us about the significance of the CFTC’s review of your application to amend your registration to allow for a new kind of clearing process for derivatives that are directly between FTX US and your customers?
Brett Harrison: The story and the significance hasn’t really been picked up, but I think it is definitely a topic…I think the significance really can’t be overstated. In crypto, 97% or more of that derivative volume happens offshore outside the United States. And that is because, in order for these crypto native companies to be able to offer derivatives in the U.S., they would have had to get appropriate CFTC licenses and then they will be able to offer those products, but those licenses can be difficult and long to obtain. FTX US obtained the licenses through the acquisition of Ledger X, but Ledger X’s license designation required full collateralization of products. So the point of this application is to amend the DCO designation to be able to remove fully collateralized from the requirements to allow people to take to post margin and to take leverage on positions. And by doing this, we’ll be able to really compete as a derivatives exchange in the U.S.
Brett: Why do you need to modify the license from the CFTC? How are cryptocurrency derivatives different?
Harrison: The way in which FTX conducts derivatives trading with customers is novel in three different dimensions. One is a ‘direct to retail’ or ‘direct to customer’ margin model. The way that every crypto exchange in the U.S. or globally works is that customers onboard with the exchange and they directly post collateral drafting with the exchange. When all the collateral is posted directly by the exchange, it also allows that crypto exchange to be able to fully measure the risk in the system. Today, it’s basically impossible to know the full risk that’s in the Commodities Mercantile Exchange (CME) clearinghouse because CME relies on the diligence that the Futures Commission Merchant (FCM) had done on behalf of their customers. For example, to know the creditworthiness of the customers to decide how much the FCM is likely to be able to receive from them in the case of a margin call. That’s not the case with us – all the collateral is posted directly from the customer to the DCO ahead of time.
Number two: CME, ICE, have basically a daily margining system where they compute the initial margin requirements for the next 24 hours, which is once per day on five days a week on normal trading hours. The FTX US derivatives margin model is proposing to compute that risk every 30 seconds, 24 hours a day, seven days a week. This is real-time risk calculation and margining. And the strong belief that we hold here is that this will result in a much safer system for financial markets because instead of worrying that if you are on a position on 3pm on a Friday, and some catastrophic global event happens on Saturday, you suddenly have to wait 24, 48, or 72 hours before margins are going to be reassessed, which ultimately results in large dislocations and people being liquidated. Instead, we can liquidate people, piece by piece in a continuous fashion. We can flush risk from the system, again in a continuous fashion. And this is ultimately a safer, more effective way to be able to manage risk. And this is empirically been proven by the fact that we’ve been able to operate this model with many billion dollars per day in the overseas derivatives market with FTX, where we’ve encountered large price movements with assets such as Bitcoin BTC and Ether ETH .
The third dimension is the margin model itself. A new market model has not been approved in a very long time. And in general, it takes a very long time for new margin models to be approved by regulators. So in having a new margin model approved for us through this exchange would be in itself, a significant event. Not to mention we would be the first crypto-native company to be able to offer margin products in the U.S. Right now, with the CME you are not able to post Bitcoin into the CME for collateral. You have to post cash and so there’s a capital efficiency problem there if you want to trade Bitcoin versus Bitcoin futures. Our aim is to be able to integrate the spot and the derivatives platform together under one roof.
Brett: Is it your opinion that your way is s a healthier way for financial markets in general to operate?
Harrison: The short answer it’s definitely a safer system. Actually, a bigger concern for people who keep waking up at 4am to find that 10% of their position got liquidated. It is a farmer who bought a corn future and all of a sudden because of three days worth of price movements, wakes up by Monday to find that the price of cows has suddenly moved 10% in a very discontinuous fashion. And their entire position gets liquidated at once. And they don’t even have enough time to post more collateral and have to basically re-enter the position, as opposed to being liquidated in small batches. In a real-time fashion, this gives people the opportunity to come back and post collateral. So we think that this is a healthier way of operating markets in general and I think, you know, not just crypto derivative markets. I think that the 24/7 nature of crypto markets, results in much less, you know, discontinuous type of events that you see under normal circumstances where large news can come out overnight for securities or derivatives in such a way that people can’t actually express their opinion and enable price discovery and either put on or take off risk in an efficient fashion.
Brett: Are you hopeful that the 97% of crypto derivatives trading that currently occurs offshore comes back to the U.S., as a benefit to our country?
Harrison: For the majority of the plurality of the volume trades in the U.S., think about equity index futures or bond futures. So much of that volume occurs in the U.S. and the strong belief behind this is the U.S. has some of the best regulated markets in the world. And investors have the confidence to be able to trade in large quantities at low latencies in a market where investors know that there’s proper regulation and oversight. So by and large, it is better and healthier for the global crypto markets and derivative markets in general for that volume to be trading in the U.S. under the oversight of the U.S. federal regulators. And right now because of ambiguity or because of difficulty obtaining certain licenses, or just historically in how U.S. regulators approach new products, much of that volume is happening offshore, and it would be better for the health of the entire ecosystem for a lot of that volume to move onshore into the U.S. market. It doesn’t make sense that only 2% to 3% of the total crypto futures volume is trading in the U.S. That’s what we want to change and so at FTX US we’ve been taking an approach by saying we want to be regulated, we want to walk into the front door of the regulatory system, and get licensed in the existing frameworks, and not wait for something new to happen in the future. We want to be licensed now with whatever current paths exists and be able to bring as much of that trading on U.S. shores as possible. And we’re not the only ones if you see recent trends.
Brett: Can you tell me a little bit about yourself for the readers to get to know you?
Harrison: Sure. So I joined FTX US in May of 2021 before we first engaged with Ledger X about considering acquiring them. My journey to FTX actually came through Sam Bankman-Fried. He and I worked together for four years at James Street when he was trader and I was an engineering manager there. I spent the better part of eight years of my career at Jane Street. My exposure to crypto started when I was exchange trading when they were forming their crypto arbitrage desk.
And so I went on my separate way for a while and Sam went off to start Alameda and later FTX. Knowing that there was such a large hole in the crypto market, which was the U.S. and being himself from the U.S., Sam really wanted to engage in the U.S. market and so started FTX US as a separate company to engage in the licensed and regulated path in the U.S. to be able to eventually offer services like futures and options to U.S. customers. And he wanted to bring someone in who could help lead those efforts and sort of pull together a proper business here and that’s where he first engaged with me and recruited me to come be the President of what is now FTX US.
Brett: Right, thank you so much for your time.