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Analysis

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May 24, 2022

FTX Application to CFTC for Direct Trading and Clearing

BACKGROUND

Leveraged Futures Trading, DCOs, and FCMs

Futures trading is conducted using leverage, i.e., traders do not put up 100% of the value of the contract when entering a trade, but instead put up only a fraction as “initial margin,” and, if the value of the contract moves against them, may be required to put up more money, known as “variation margin.” Using leverage increases risk, as traders may suffer losses many times their initial investment. CFTC-regulated derivatives clearing organizations (“DCOs”) help manage the counterparty credit risk by “clearing” contracts, i.e. standing as the counterparty to every contract.  Therefore, traders do not have to evaluate the credit risk of the counterparty to their trades.  The members of DCOs are CFTC-regulated intermediaries known as futures commission merchants (“FCMs”). FCMs accept futures trades on behalf of their customers, collect margin from them, and post that margin at a DCO. Thus, a DCO is directly exposed to the credit risk of its FCM members, and the FCMs are exposed to the credit risk of their customers.

FTX’s Application to Provide Retail Investors with Direct Access to Futures on a Margined Basis

FTX, which operates a CFTC-registered DCO, is requesting a change to its registration to allow it to offer direct access to clearing for margined Bitcoin futures contracts. If approved, it would mean traders would not need to go through an FCM to trade and clear a Bitcoin futures contract on FTX but could simply make the trade and clear it directly on FTX’s platform. FTX, as a DCO, would then be directly exposed to the credit risk of traders in Bitcoin futures. To manage this risk, FTX proposes a model where it automatically calculates each member’s margin requirements on a second-by-second, 24/7/365 basis, and auto-liquidates the portfolio of members with insufficient margin 10% at a time (initially on FTX’s order book) until the account complies with the maintenance margin requirements or the entire portfolio is liquidated. In theory, this real-time margining prevents investors from accruing greater and greater losses. To the extent FTX’s order book is not able to handle liquidations resulting from auto-liquidation margin requirements, FTX proposes to have backstop liquidity providers accept those orders. Finally, FTX proposes to establish a guaranty fund that will cover any losses not covered by members or backstop liquidity providers.

FTX’S APPLICATION RAISES SIGNIFICANT CONCERNS

As we explained in our comment letter, FTX’s application raises a number of concerns.  Many of these are related to the nature of Bitcoin and cryptocurrencies, which raise serious concerns about the further integration of such volatile, speculative assets into the financial system. It also would invite significantly greater retail participation in speculative futures trading, which would fundamentally transform the futures market.  That market has historically been a venue enabling commercial producers and purchasers to hedge price risk, and it has historically been populated by institutional players who have the sophistication and resources to protect themselves.  Transforming this market into a 24/7/365 non-intermediated market populated by retail participants trading on margin would almost certainly be to the detriment of retail traders if not the financial system and entire economy.

The Cryptocurrency Market Is Marked by Volatility and “Carnage” and Futures Trading Only Intensifies That Risk

One of the defining characteristics of the Bitcoin and cryptocurrency market has been its extraordinary volatility. Tragically for many investors, these markets are fundamentally nothing more than casinos. Prices often shoot up to unimaginable levels, capturing the attention and money of traders hoping to ride the wave “to the moon,” only to plummet rapidly.  This is illustrated by what has happened to cryptocurrency values recently. Over the last few weeks, the price of Bitcoin and other cryptocurrencies has plummeted, in what many observers have described as “carnage.” This cycle inflicts enormous harm on traders, many of whom are lured by dreams of quick riches but often find they have bought near the top of the market—a recent report found that 40% of Bitcoin investors are underwater. Margined futures on cryptocurrencies are triply risky, adding the heightened risks associated with futures contracts to the already risky and volatile underlying cryptocurrency assets and then adding leverage.

The FTX Model Raises Investor Protection Concerns

By removing FCMs as in effect the brokers or intermediaries in the Bitcoin futures markets, the FTX platform will remove an important layer of investor protection. FCMs are highly regulated and must segregate all customer margin funds, submit to audits relating to capital sufficiency, and make risk disclosures to customers. It is not clear whether and how well FTX will ensure that investors are fully informed of the risks associated with futures trading, especially on such a volatile underlying asset. And the same digital engagement practices or gamification features that have appeared on equity trading platforms (detailed here), which are used to manipulate investors into trading, may become a feature of the FTX platform.

Increased Retail Participation in Futures Trading Poses Risks to Investors

Cryptocurrency markets are also characterized by significant retail participation, driven in large part by high-profile marketing campaigns, including FTX’s Super Bowl ad featuring Seinfeld co-creator and Curb Your Enthusiasm star, Larry David. In turn, FTX’s proposed model makes it much easier for retail traders to trade futures contracts. Because FTX would make retail trading much easier in an asset class with a high degree of advertising-driven retail interest and participation, there is a likelihood of an influx of retail traders into the futures markets. This would almost certainly be to the detriment of those retail traders, who tend to perform poorly when engaging in speculative derivatives trading.

The FTX Platform Also May Increase Systemic Risk

The FTX platform may also be to the detriment of the broader financial system, if not the economy, particularly if FTX’s proposed model spreads to other DCOs and other asset classes because increased retail participation tends to increase volatility. It also will make the financial system riskier, because it will further integrate volatile, risky, and fraud- and manipulation-prone cryptocurrencies into the financial system, increasing the possibility that problems in the crypto market will spread through the financial system.

A DELIBERATIVE APPROACH

The CFTC has a statutory duty to promote responsible innovation. Thus, while FTX’s application raises a number of significant concerns and questions, most of which have not been addressed at this stage, Better Markets (which supports responsible innovation) is not calling on the CFTC to outright reject the application. Rather, we are calling on the CFTC to take a deliberative approach to FTX’s application. The CFTC has already begun that process, first by putting FTX’s request out for public comment and convening a roundtable discussion on May 25. As it works through the many issues raised by FTX’s application, it must continue to engage, in a transparent manner, with all stakeholders and the public. Ultimately, depending on the answers to those many questions, the CFTC would only be able to approve FTX’s application if it develops a framework (which must itself be put out for public comment) that will protect market participants, the financial system, and the public from undue risk as a result of adopting FTX’s proposed model.

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