Crypto Derivatives: Part 2

Ali: Markets conversation is a new ION podcast where we discuss topics of importance to capital markets participants with product owners, subject matter experts and industry leaders.

Advert: This episode is brought to you by ION. At ION our cleared derivatives solutions automate your complete trade life cycle and deliver actionable insights whenever and wherever you need them. To learn more, visit us at iongroup.com/markets or email us, [email protected].

Ali: Hi everyone, and welcome to markets conversation. I’m Ali Curi. In this episode, we’re following up on the CFTC round table that focused on the proposal by cryptocurrency exchange platform, FTX, to bypass FCMs with a direct clearing model.

It was a lively discussion with a cross section of industries, firms, and agencies represented, and a chance to learn more about the implications of FTX’s proposal. To help us sort all this out and look at the pros and cons of this new proposed arrangement, we are once again joined by Russell Levens, head of client engagement for derivatives at ION, and John Needham, product manager for ION Markets.

Gentlemen, welcome back to the podcast, John Needham, Russell Levens. Good to see you again.

John Needham: Thanks for having me.

Russ Levens: Thank you. Great to be here.

Ali: Last time we spoke, we talked about the emergence of cryptocurrencies as an asset class and the exchange platform, FTX, which, as you know, trades cryptocurrency derivatives. And we also discussed FTX’s proposal to expand their model, to clear margin products and to offer non- intermediated trading.

We’re gonna go over some of the things that were discussed at the, on the CFTC round table that was hosted on May 25th and some of the, uh, panelists had some, things to talk about there, the implications of this proposal. And also the founder and the CEO of FTX, Sam Bankman-Fried, was present to answer any questions.

It’s been in the news a lot, the FTX proposal. John, can you expand a little bit more about the proposal itself? So, you know, what is it? Who’s affected and why is it poised to become such a game changer?

John Needham: Yeah. Yeah. This is a good question. Let’s uh, take a minute to just set the stage right? Today, if somebody wants to trade futures or derivatives contracts or derivatives products, the model that exists today is that they will open account with a broker.

A broker is a future commission merchant, or FCM, but the broker will provide services, both to the customer, to the end customer and to the industry and to the industry at large. So brokers are members of exchanges, which means that they will verify, vet, and credit establish the credit worthiness of a customer, and then will grant that customer access to the market so the, so the customer can trade commodities. This is true whether the, the customer is, a speculator in the futures industry or futures markets, or is a, commercial end user, a hedger or a, you know, a producer, a producer of product or producer of, you know, grains or farmers of grains or cattle, ranchers, and feed lot operators and things like that.

So the broker provides access to the market so that these traders, these market participants can, can trade, futures and one of the services that the broker provides a number of services. Obviously they provide, you know, verify the credit worthiness. They sometimes provide funding and credit, they will provide website access to the markets, but they also provide to the, to the exchange, they will provide a guarantee that the customer will settle the trades that, that they execute. The FTX proposal that is currently before the regulators kind of takes out that broker level intermediation and the, so the trading community will simply log on to the FTX website or log on to an app on your iPhone or your Android, and you’ll open up an account and you’ll post collateral to the exchange. The exchange will then give you an opportunity to trade cryptocurrencies or other listed derivatives products on their, on their market, and they will, margin those products and they will serve many of the functions of the broker, but what they won’t do is extend credit. When a position moves against a customer instead of extending credit and guaranteeing the trade, they will simply start to liquidate the positions and that’s one of the big, uh, big differences between the intermediated model that exists today and the FTX proposal that exists in the future.

And Russ, would you, I mean, agree that I think I’ve kind of put, you know, set that table for people or am I missing anything?

Russ Levens: Yeah, that’s correct. Probably just to say on the, yeah. That item where positions are closed out, that it’s done on an automated basis. So it’s, you know, fully via technology. There’s no human intervention, um, which can be a good thing or a bad thing. I mean, it’s kindly how you approach it.

Ali: Russ, that’s a good point. Uh, the, the human aspect of it, right? Because there’s gonna be pros and cons to, anytime you take out the, the human aspect, like a self-driving car, is it good? Is it bad? Depends who you’re asking. Now, many round table participants in the discussion were in favor of innovation and how it could benefit the industry, but like everything that were concerns, particularly around customer protections, which is a big concern.

Uh, one topic was auto liquidation feature, which would automatically close out customer positions if they have not posted enough collateral to cover their loss. One of the panelists even said that this could be a weapon of mass destruction. So John and Russ, can you break down this feature and, and share with the audience why, why would this panelist be so concerned? John let’s start with you.

John Needham: Well, I think that calling it a, um, and he, he used the term, uh, a mass destruction event and I tend to think that’s a little hyperbolic and, and probably overstated, but the concern, I think, grows from this fact that there’s a possibility, some me some measurable amount of likelihood that a large position that falls into an under margin condition. And this algorithm starts auto liquidating the position at 10% at a time could potentially move the market further in the, against the under margined account. And that also could bring in other accounts to under margin conditions simply because of the movement of the market.

That is a result of the algorithmic kicking in and starting to liquidate positions. That was a, that was an expressed concern from a number of, of people on the, uh, on the CFTC’s round table. I think calling it a mass destruction event is probably overstating it, but I think that is, it is a, it’s a legitimate concern. Is a legitimate concern.

Russ Levens: Yeah, absolutely it is because this automated thing could just trigger a, you know, a spiral basically downloading the market or opposingly, you know, upwards as well. I mean, just similar to how perhaps was a violent with nickel prices, you know, not that long ago, uh, that wasn’t on an automated basis, but it’s still the same thing that this could trigger a market event, which in turn has, you know, wide impact on yeah, on users, and, and losses. So yeah, that’s something that needs to be considered and, and appropriately controlled.

Ali: Which is the whole reason, right? For keeping the FCMs in play, right? The, the CFTC had rules and guidelines that are applied to F to, uh, FCMs intentionally. They’re they’re strict because of the important role that they play in, in customer analysis protection.

And I know we talked about it a little bit last time, but you know, let’s go over, some of the, some of the arguments really for keeping the intermediary, the FCM in the process, unlike what FTX proposes, John, let’s start with you.

John Needham: Well, the, the, one of the things that came up in a whole section of that CFTC, the regulator’s, uh, round table event was, and it’s a simple statement of fact that, that brokers, like we’re talking about the FCM community. They are among the most highly regulated, uh, financial services entities that exist in the United States. They’re regulated every bit as stringently and as, uh, enthusiastically by the regulators, as our broker dealers in the stock market, you know, F D F D I C insured banks, they are highly regulated entities and the, uh, the regulations that exist and Russ, you know, as much about this as I do, or as anybody does, but the, the regulations that exist for an FCM for a broker are, uh, designed specifically to protect the customer assets and to protect the market, the integrity of the markets and those rules that exist for a broker do not apply to a designated contract market, like an FTX, an exchange or clearinghouse or CCP like FTX is. And Russ I’d think I’d be interested in hearing if you agree that the regulations are much more, uh, emphatic for the FCMs than they are on, on, on an exchange or a, or a clearing house.

Russ Levens: Yeah, that’s correct. Ultimately, uh, the FCMs in this, in the traditional model are ultimately the guardians or the custodian of customer client assets. The regulators, you know, number one objective is to protect the customers as far as possible, uh, and to ensure that their assets are safe and secure and that the brokers are held to high standards so that they don’t basically put customers risk at risk, um, and that they adopt and follow a very strong stringent set of regulations. Um, yeah, this is where things will change a little bit just with the FTX model. Again, being direct, there will no question be high standards applied, um, by, you know, the commission will demand that of, of FTX. So, so that doesn’t particularly change that item. It’s more just the fact that there is, you know, one less party in the chain and the biggest discussion that really is around ultimately the risk back backstop and what happens in the event of a default. What would happen if FTX were to go bankrupt and ultimately who would step in, you know, to basically take over, you know, the assets take over the client positions and you know, who would bear those losses again, under the, you know, the conventional model that exist today, the clearinghouse, you know, has clearing members who guarantee the trades.

If those clearing members themselves fail the, the clearing, the clearing members, ultimately, you know, are subject to a, a guarantee fund and that covers the, the losses of the defaulter, so that this is where this comes in. Whereas under this new model, the only party that is backstopping this financially is FDX themselves, um, which is different.

Whereas the traditional model there is, you know, the, the CCP and all the clearing members and, you know, many of the crew members are very large, very well, capitalized banks. Um, so this is, you know, sort of where the change is.

Ali: Which brings us to another interesting function that was brought up was backup liquidity providers, and that is a concept that FTX proposes. So basically in the, in the event of a default, the firms, the backup liquidity providers, they would act as buyers of last resort. We should unpack this a little bit, because exactly what is the situation in which, uh, an FCM would mitigate the customer risk?

Russ Levens: The FTX proposal on this, on this was, was put out there with this back backstop, liquidity providers. These are gonna be the parties that ultimately was slip into the market to take on, you know, the inventory that is liquidated. The concept sounds great. The, the concern, you know, of the industry on this was, was that the backstop liquidity providers are not identified, nobody at this point knows who they are.

They’re undisclosed to date. Uh, they would probably be disclosed later and these parties could be of different financial credit standings. So I’m sure there would be of good credit standing, but nobody knows for sure. And these parties themselves are not necessarily, um, you know, regulatory approved, you know, parties.

Um, they may not have to be regulatory approved in their current status. Um, but nobody knows who they are. So in the, again, in the, in the model, as it stands right now, the, the participants in the, in the defaults are regulated entities and their capital is, you know, why is, is reported every month and is known, so solely as a result, they sort of, their credit status is known too, but under the BLP model, again, that that’s not at this point in time transparent.

So, it could come later, but let’s see.

John Needham: That that’s an excellent point that Russ just made. The current broker model that exists today, all of the entities that would be responsible for helping to us, uh, clearinghouse cover a massive default or loss are themselves fellow regulated entities and the, the, the backstop liquidity provider program at FTX is, is populated by entities that we don’t know who they are or whether or not they’re regulated like the FCM community is that would step in to a, to help cover a default. That’s an important vitally important part. Now FTX did try to defend that program a little bit in two ways, one, by saying in a general sense, the BLP program, the back stock liquidity providers are not necessarily fundamental to their auto liquidation, algorithmic and risk management programs that they are there to serve as literally a backstop. But that generally speaking in a liquid market with good volume and open interest, liquidating a portfolio in the open market is, a perfectly viable option. Now, the, a, the others were making the argument that that could move the market.

That could lead to other accounts, being pushed into auto liquidation scenarios. The other big thing about it that, that, that FTX was talking about it is that he agrees that he has, he didn’t name that none of the BLP participants were named and he wouldn’t name them. And he said he wouldn’t name them at that time.

And if, you know, if it comes to pass, we may have that discussion in the future, but he did think it was a good idea for them to be able to provide, for FTX to be able to provide the amount of collateral that is available in the BLP program. And then that was something that I think introduces a little bit, not enough, but a little bit of transparency to the market participants and to the regulators.

So that was one of the options that’s out there. It was an interesting proposal. I thought, Russ, I don’t know if you picked up on that. It was just, but the, the them being not regulated entities is an important, important point that, that removes one level of, uh, of market protection for both the customer assets and for the market integrity.

Russ Levens: That’s correct. And I think what was also not talked about was what if one of the BLPs was a party that ultimately needed to be liquidated themselves? I mean, they caused the market event through something that they did. Um, I didn’t see much discussion on that. I’m sure perhaps there was, and it didn’t hit the yeah the tape that I saw, but, um, yeah, that’s an item for consideration as well. You know, who are these people? You know, and to what extent would they, they disclose their financial resources? Um, again, I’m sure many of them absolutely would be willing to do that. Uh, but again, it’s just an open question at this point.

Ali: It was a good start for the, uh, CFTC to host this round table. As discussed before they weren’t drafting just, uh, any policies just yet, but just generally how it stands right now, what are your thoughts? Is it too early to tell, is it something that could really, you know, with some accommodations really be able, to move the needle or, are traditional models here for a while, or maybe just becomes a hybrid?

What are, what are your, what are your thoughts overall. John, let’s start with you.

John Needham: There was a lot of, uh, interesting thought. I was very enthusiastic about this program when I first heard about it. Having watched this day long session at the, that the regulators hosted, um, I came away from it thinking, yeah, there are, there are some definite challenges here.

Most of the people on the panel, including some of the FCM representatives and CCP representatives, the clearing houses that were on the panel and the other brokers that would potentially be disintermediated in a model like this said, you know, coming out of this session, that they had an open mind about the proposal.

They have an open mind. And I think that’s where the regulators are. I think that’s where the industry is. There are challenges. There are definite benefits to the current model. There are challenges to the current model too. By virtue of the fact that you can, by as evidenced by the fact that there are, you know, 25 years ago, there was 140 brokers who were clearing customer businesses.

Now there’s less than 50. So the challenges that face the, the broker community should not be discounted either. We may wind up at some point in the future going to a disintermediated model because there’s so few brokers left, who knows, but this is a good model for two, for everyone to keep an open mind about.

And to continue to look at, I think it’s a, it’s a good thing for the industry to be having these discussions. And that was the general consensus of the panelists on the, on the regulators’ panel.

Russ Levens: Yeah. But if the number of participants basically reduces, you know, all, you know, parties, ultimately that hold the client accounts, you know, reduces, then you just get bigger concentration risks.

So, you know, again, 50 FC FCMS as it stands right now under this standing model with the FTX proposal, it goes from 50 parties to one. So again, there’s, you know, again, that element of concentration and that’s clearly a concern for everybody, you know, something that people need to be, get comfortable with.

Ali: So Russ given, uh, a lot of the things that we’ve heard, you know, some excitement, uh, there was some detractors, but in your opinion, what comes next? What, what do you think is the next steps here?

Russ Levens: From here the commission will, you know, has gathered their, you know, gathered the information that they heard and they, they heard all the arguments at the round table.

They’ll take those away. They’ll have the commission will have, you know, closed door sessions internally and, you know, come up with yeah. The next approach, which will I expect lead to, you know, more questions that they’ll ask of FTX to clarify areas of the model and those items that were raised as concerns, you know, by the participants on the round table.

So, there will not be a, I don’t expect, there’ll be a quick conclusion on this. I think there’ll be further questions and yeah, my, my thought is that perhaps the commission will form form an approval of some kind, but maybe a limited one with conditions, um, you know, conditions over, you know, the size of the transactions, perhaps conditions over the, over the products that are traded, you know, specifically though that is already part of a, uh, you, a condition that you know is on exchanges.

Um, but I think, you know, they will demand, you know, certain requirements of FTX, um, you know, in order you know, to grant them a license to do this. So I think, yeah, they will, you know, a approach it on a, you know, gently, gently basis.

John Needham: I think Russ hit it right on hit the nail right on the head. Uh, the next steps will be from the commission.

Um, I do expect that they will Have some kind of a approval of a pilot program or certain, certain specific products that are eligible, but you know, that remain to be seen. They may come back with more questions. There are, there are rules and regulations, as we talked about earlier, that apply to FCMs that are not in existence for a, uh, for a, a, an exchange or a clearing house.

And this commission might have to pass, do rule making, to make those apply for the customer protections and things like that, know your customers and make sure that nobody’s laundering money through the exchange and things like that. All the stuff that the FCMs that brokers do today, uh, those kind of rules might need to be addressed at a market that is going direct to customer and, and has direct clearing models.

So there may be rule making involved. I think if there is, and it’s gonna be a longer timeframe than what we’re looking at today.

Ali: Very well. So, uh, we will stay tuned to hopefully revisit and break it down some more as things develop.

John Needham, Russell Levens, Thank you once again for visiting us on the podcast and we shall do it again soon.

Advert: This episode is brought to you by ION. At ION, our cleared derivatives solutions automate your complete trade life cycle and deliver actionable insights whenever and wherever you need them. We offer execution and order management, post trade processing, and a complete front to back business solution. To learn more, visit us at iongroup.com/markets or email us, [email protected].

Ali: And that’s our episode for today, you can follow ION Markets on Twitter and LinkedIn. Thank you for joining us. Until next time.