May 23, 2022
In this episode, we dive into the rapidly evolving world of Crypto currency and its effect on the financial markets, specifically derivatives. We discuss how crypto could affect the derivatives market if the CFTC approves a proposal by crypto platform, FTX. This move could reduce the role of FCMs and seriously disrupt the trading status quo. Joining us in conversation are Russell Levens, Head of Client Engagement for Derivatives at ION, and John Needham, Product Manager for ION Markets.
Ali: Let’s discuss one of the emerging stars of the finance world. Probably know what it is, cryptocurrencies, but in particular, I want to dive a little deeper into crypto derivatives.
Russ, let’s start with you. Crypto has rapidly evolved as an asset class. What are some of the drivers that make crypto attractive to investors?
Russ: It’s exciting because it’s new. It’s exciting because it has a technology backbone. I mean, the cryptocurrencies, Bitcoin, obviously being the main one that people are aware of the digital currencies that ultimately allow the transfer of assets, away from one party to another away from banks and outside of banks and custodians.
If people have embraced the technology and the ability to trade these instruments. And they can’t look at it as a store of value and it kind of almost equivalent to sort of gold people who sort of said, okay, this is a currency that doesn’t have a government tied to it, so it can’t necessarily be influenced directly by those governments. And it was just to basically transfer assets from A to B as through this digital ledger technology. So it’s become exciting and it definitely has that tech buzz around it, and it has that element of non-governmental freedom to it. So it’s created quite a lot of excitement, a lot of buzz.
Ali: Yeah. Yeah. A lot of what I had initially heard was this kind of democratizing something that everybody could get into. But now it seems that the SEC is not taking kindly to this democratizing. Uh, it’s really beefing up its regulatory staff, et cetera. Have you heard anything around that? Is there anything around that you can share with us?
Russ: Sure. Yeah. I mean, regulators are there to protect the public and to ensure that investible assets where they put their money to work and where they invest trade and speculate that you know, that they’re protected by regulation and that there aren’t bad actors of it that ultimately are helping them picking their pockets.
Um, so it’s quite natural that as these trading venues emerge and ultimately, they become regulated and there’s this activity with Bitcoin, with CFTC and the SEC and their involvement with it is, you know, very similar playbook to how other, our other asset classes evolved. And the last one probably being the FX Market.
Um, so it’s yeah, so it’s quite natural where we’re going is that the technology and the innovation comes and the regulation follows with a desire to basically protect the investing public and protect people. That’s what it’s there for.
Ali: But not everybody has always been such a fan of crypto. John, were you a little skeptical initially?
John: I was skeptical at the beginning. The FIA formed a cryptocurrency working group that actually was part of the FIA markets and technology division at the time, formed a cryptocurrency study group or a working group in the summer and fall of 2017 before the CME and CBOE futures exchange were lists were intending, and had announced that they were going to list Bitcoin futures. And so we formed this group to basically see what the impact was going to be on our world, and me being the back office tech guy and the kind of the reg tech guy, I, my focus at the time was on the regulatory compliant, regulatory reporting and the compliance topics surrounding Bitcoin futures at the time.
But when we had these calls, I went in the very first call. I said, I’m a skeptic I’m skeptical of this asset class and I’m skeptical of the need for a derivatives market. Because to me at that time, it seemed like most of what you heard about in the crypto space and the Bitcoin space was criminal enterprises were using it extensively.
It was they were the largest users of Bitcoin, so I, in that sense, didn’t think it should have been included in the list of derivatives contracts eligible for trading. Terry Duffy had said at the time, he was the CEO of the CME at the time, he said, this is a volatile asset class and our traders want to trade it, so we’re going to list it. And I thought, that’s not the reason that a futures market should exist, because people want to trade it. But, you know, I think as over time, It has mainstreamed a little bit. There are car loans and home equity loans, and there are mortgages now that exist where the payments are done in cryptocurrency.
So it’s becoming more mainstream. I still think, you know, as recently as last year, there was hackers that were taking over pipelines and other businesses and were demanding payment in Bitcoin. So to, in a very real sense, It is still an asset class used extensively by the criminal enterprises in the world.
And you know, which that’s why I would welcome a world where these asset classes are better regulated than they are today.
Ali: Democratizing crypto is really exciting, but that means, for everyone means everyone. And now this firm, FTX, plans to offer crypto derivatives directly to its users. It could really disrupt the market. Tell us a little bit about what’s going on here. Let’s start with the basics. So can you share with our listeners some background on FTX and what its proposal means for the market?
John: FTX today is a cryptocurrency spot market trading platform. It is also a cryptocurrency derivatives trading platform. It’s one of many, there are a number of cryptocurrency derivatives trading platforms that exist today. FTX is one of them. FTX is also a designated contract market regulated by the CFTC, which means that they can list derivatives products on their, on their trading platform. And they are also a CFTC regulated DCO or Derivatives Clearing Organization, which means that they are eligible to clear the trades that execute on their trading platform in both in, in the derivatives, in the derivatives market. So they are a trading platform, a designated contract market and a derivatives clearing organization, all regulated by the CFTC.
Ali: So one would think this is great, right? It’s a one stop shop. Now it opens it up to a bigger audience and more players. So is there a downside?
John: Their proposal came to the CFTC to – today, you know, the trading community logs directly on opens up an account on the FTX platform, that isn’t the typically the case. It isn’t historically the case for a derivative contract. If you want to trade derivatives, if you want to trade futures contracts, you would open up an account at a broker, future commission merchant, or an FCM. Then you could post margin at the broker and execute trades on a designated contract market, and they would be cleared by the designated clearing organization.
So the broker was in between you, the customer and the clearinghouse or the CCP. FTX is proposing to turn that on its head and say, we’re going to have the customers open up accounts directly with us non-intermediated by brokers, and be able to trade derivative contracts. That’s what their proposal is.
That’s what their request is for the, to the CFTC. Now they already do that today for the spot market. So anybody can open up an account. I actually did. You open up an account at FTX, you can trade the derivatives spot market. You can trade Bitcoin, you can trade Ether, or Solana, or the FTX coin, but you cannot trade the derivatives in the U.S. Today. Outside of the U.S., customers can log in, open up an account and trade derivatives, but inside the U.S. That is not permitted.
Russ: Perhaps it’s worth saying here, for the benefit of the listeners is that a derivative contract by nature is a, is a leveraged instrument. Ultimately, what that means is that a party can get exposure to a particular product on leverage by putting down margin or a kind of a security deposit, they don’t have to, unlike the spot market or the cash market, don’t have to pay for the whole instrument. So in effect they can put down, let’s say 30 to 40% of the instrument of the contract value, and ultimately it gives them the ability to trade on margin and leverage. So that’s kind of the big driver here for the crypto exchanges is now they want to offer leverage products. How do they do that through futures? And to basically have that capability, they have to seek approval from the CFTC, the regulator, which is exactly as it as it should be. But the crypto guys, they’re driven to move into this, as a new territory for trading to expand their business opportunities.
Ali: Russ, but to John’s point, you know, it’s cutting out the middleman, right? The FCMs. Is that good? Is that bad? Upfront it sounds like this is a good opportunity. Everybody can get involved. We cut out the middleman. Are there some potential pitfalls in cutting out the FCMs?
Russ: Potentially. One thing is that people should recognize the FCMs, they bring two things to the marketplace in terms of derivatives. They bring distribution. They have a channel of clients themselves, and ultimately they plugged their clients into the exchanges through these distribution channels. That’s one item. So they in effect are the exchange members of exchanges, and they have that throughput, but traditionally as well, they also underwrite the risk in the marketplace and they disintermediate the risk as well.
The clearing members, the brokers have themselves got deposits with the clearing houses and in the event of a large catastrophic default, the brokers are subject to have exposure to that. And then by virtue of the fact that deposits that they have made and they are required to make.
Under the FTX model, this is where it differs. They don’t have the intermediate, these intermediaries, and as a result, they also don’t have intermediaries who stand basically behind the risk, the risk in the event of clearinghouse default. So in effect, with the FTX model, though it’s different, is it bad? No. Is it good? It’s interesting.
It’s just different in the way it operates and the, perhaps the concern could be, and I’m sure some of the exchanges probably also properly think this is that ultimately it is a one-stop shop with one party being on all sides of the transaction to include the, which we include the ending risk of the transaction.
And that’s substantially where it differs from the traditional models today.
Ali: John, anything to add to that?
John: Well, I think that’s a really good summary. I think Russ made some really good points there, describing the nature of the current market, but FTX’s proposal contained some specific changes to the market structure that look attractive, right?
This particular, in the case of me to a technologist, the risk management policies and practices that FTX is proposing, they might be attractive to a regulator. FTX is going to risk manage all their positions and calculate margins on all of the positions, all of the portfolios in each account, every 30 seconds, 24/7. And that’s more often than either the CCPs do today, and it’s more often than the carrying brokers or the FCMS do today. They’re going to be risk monitoring and risk managing those positions. If somebody goes into a underwater or under margined condition in an account, FTX is going to automatically start liquidating positions in that portfolio until such a time, as the account is no longer under margined. And they’re going to do that in real time.
Now they’re going to be doing that against their central limit order book, meaning they’re going to be doing it in the open market, which is normal, which is a good thing. That’s what an FCM would do if one of their customers defaulted, they’d start liquidating the positions in the open market, but the question then becomes, what happens in the case of a large position that moves the market against the general public, then you’ve got a different than you’ve got a different answer to that question. And the FTX proposal does have a group of traders or some number of traders or entities that will be that they refer to as a backstop that have promised the exchange that they will take on X number of defaulting positions in a particular time slice.
And they are also backing it with $250 million of their own money. Is that enough? I don’t have the answer to that. I think that the regulators are going to have to look closely at that figure, but FTX is proposing some radical changes to the way risk management does is done today in the derivatives market, the way FTX put it in their letter to the CFTC, which is public domain on the CFTC’s website is that their intention is to bring the futures market, the derivatives industry, into the 21st century.
You know, rather than waiting until the end of day to compute margins on a portfolio, even if you’re doing it in real time, there’s no capacity for an FCM today to start liquidating positions automatically like FTX is going to do. The challenge that they have there is that, is this proposal going to be enough? Is their risk management policies and practices going to be enough for the regulators to get behind it? I don’t know the answer to that, so we’ll have to wait and see how it all shakes out.
Russ: Yeah. What the CFTC’s done here, rightfully, and in accordance with their operating structure is they put out a public comment period, which they’ve extended.
It originally was 30 days. I think they pushed it out to 60 or 90 and they’re garnering commentary from participants far and wide as to what people’s concerns are with this change in model. The other item that John didn’t mention that that’s worth talking about, one other item the FTX is going to do differently is seeking to ultimately operate their market 24/7, which is different from the standard futures markets, which operate 23/5. So that’s different than the fact that know there’ll be active trading over the weekends. That’s no different from the cryptocurrency cash markets as it stands, so that’s not a game changer in the crypto world, but it is a change in the derivative world.
And that will be good for some but may pose challenges for others. So that’s a new item. I mean, there’s no doubt about it. That what FTX is doing and what the crypto world is doing to the capital markets is, yes, they are bringing into new innovative solutions and they are modernizing markets. There is no two ways about it. So it’s great to see that this is happening and the other markets, other products really will need to play catch up at some point. But there are some challenges around that too.
I guess we’ve got to think about things like rate in reality, banking is not 24/7, so this is currently a limitation. You might be able to trade round the clock, but you can’t necessarily move the collateral and the cash round the clock. This is a challenge.
The federal reserve payment window is open Monday to Friday, early in the morning, Eastern time through to let’s say, 5:00 PM Eastern I believe it is. Um, but outside of that, you can’t do a transaction. It backs up till the next day. The crypto markets are different. The ability to transact and settle and clear crypto and move crypto around is not incumbent or limited by that.
So this is where these differences are and this is all very positive, the momentum here, but people have just got to consider what risks this poses to the traditional model.
Ali: Well, I guess you’re going to learn a little bit more shortly, right? John? The CFTC is doing a public round table on the 25th.
John: Yeah. They’ve announced that. They’re going to have people from the traditional CCP market. They’re going to have obviously FTX represented. They’re going to have FCMs represented. They will probably have, finance professors and other intellectuals commenting and participating in their own table.
They will have the trading community represented. They will probably have other regulators like NFA represented. It’ll be very interesting. That day will be a very interesting day to see how this is going to shake out.
Ali: So the purpose of the round table is not really defined.
Is it really to just strip away and dissect the intricacies of the proposal?
John: They will not make him do any rulemaking at that meeting. No, that’s correct. They will simply use that as an information to help the five commissioners and their staff drive the decision-making process behind the FTX proposal, whether or not to approve it, whether to do it as a pilot program for specific cryptos.
Ali: Well, I think it’ll be exciting. I’d love for you both to come back to the podcast after that webinar from the CFTC and discuss some takeaways, I’m sure there’ll be a lot to dive into.
John: Yeah. If anybody wants to see that, it’s announced on the CFTC website, so you can look for their press release on that. It will be on May 25th. It’s a day-long session with an hour break for lunch. So I will definitely be listening and I’m pretty sure Russ will be too. It’s a topic of great interest to some of us in the finance world.
Russ: Sure it is. Let’s see how it pans out and let’s see where the commission ends up and how they format their view based on what they hear.
Again, they’re looking to seek to encourage innovation and change. But let’s see, how far are they willing to take it based on the feedback they get from, from the community. Time will tell.
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.