There are few big news events that don’t make front-page news... this is one of them. FTX has submitted a direct clearing model under the Commodity Exchange Act and CFTC regulations which if approved will forever change how financial products and derivatives are cleared.
Current DCO Clearing Models
Three types: Margined Products, Intermediated Clearing, and Mutualized Losses. The most common model in derivatives clearing is where clients are risk-managed by Futures Clearing Merchants (FCMs) or “Clearing Brokers”. These entities are members of a Derivative Clearing Organization (DCO) or “Clearing House”. These members guarantee a client’s obligations as well as contribute to the Default/Guarantee Fund of the DCO. For reference, the model used by CME requires that its member brokers kick money into a Guarantee Fund to cover defaults. So in summary, those companies use a model that relies on brokerage intermediaries to deal with margined-product trades. This involves collecting some money from clients ahead of time to cover possible losses if bets go sideways.
FTX has requested an amended order to permit it to clear non-intermediated, margined products. FTX intends to offer its products to retail participants, and its financial and operational requirements for participants only require that the participant be able to post the margin required for a given position.
FTX’s model does not contemplate receiving any funds from a participant not on deposit when the trade is executed. FTX has two margin requirements for its participants, the initial margin requirement and the maintenance margin requirement. The initial margin requirement is the amount of margin the participant must post to open a position. Maintenance margin is a set minimum percentage of the notional value of the portfolio that the margin on deposit must exceed. A participant’s margin level is recalculated every 30 seconds as positions are marked to market, and if the collateral on deposit falls below the maintenance margin level, FTX’s automated system will begin to liquidate the portfolio. The automated system will liquidate 10 percent of a portfolio at a time by placing offsetting orders on the central limit order book. Once the liquidation process results in collateral on deposit that exceeds the maintenance margin requirement, the liquidation will stop. Because the liquidation is done automatically and positions are marked to market every 30 seconds, these liquidations can occur at any time, on a “24-7” basis.
Below the maintenance margin threshold, FTX will also set a “full liquidation” threshold based on a set percentage of the notional value of the positions. If the margin on deposit falls below that threshold, FTX will liquidate the remainder of the portfolio. To fully liquidate a portfolio, FTX intends to enter into agreements with backstop liquidity providers who agree ahead of time to accept a set amount of positions if a portfolio needs to be completely liquidated, and who will receive the remaining margin for the position once the full liquidation threshold is hit. FTX will also fund a guaranty fund with $250 million of its own capital to cover any losses incurred on positions beyond those accepted by the backstop liquidity providers. FTX will also use its guaranty fund to reimburse the backstop liquidity providers when the participant’s margin does not cover the value of the portfolio acquired by the backstop liquidity providers. FTX does not propose to mutualize losses among its participants in its default waterfall.
FTX would still require an initial margin from users along with maintenance deposits. FTX would recalculate margin levels every 30 seconds, and if the deposited collateral falls below the maintenance level, the automated system could start to liquidate positions. FTX mentions there are agreements in place with third-party firms to backstop losses while also guaranteeing losses with $250 million of their own capital. This model is very similar to other legacy crypto exchanges like Bitmex which have their own “Guarantee Fund” with automatic liquidation engines based on margin requirements.
The current model is inefficient and not structured for time-sensitive positions and liquid derivatives. Including third parties in a system that relies on inefficiencies will only self-correct eventually. We are seeing that now with the removal of intermediaries and the creation of an all-in-one platform. This will reduce third-party risk and create more transparency for the provider and the user. Now, who does this threaten the most? Traditional finance. This model will be applied to other assets which directly threaten Wall Street’s infrastructure business. This also brings algorithms to the forefront by utilizing their efficiency to clear trades, rather than brokers.
You have two very large parties that are being targeted here, brokers and derivative intermediaries like ICE and CME. I would not expect this to be smooth and forthcoming. This will give FTX the ability to expand into vast markets for everything from oil to gold to currencies while maintaining dominance in the crypto derivatives market.
If passed, this could bring more crypto-related products to the mainstream with all the needed licensing to do so. Other platforms such as Coinbase, Kraken, and Gemini could follow which could see a major shift in user frequency from traditional financial platforms to newer financial platforms such as FTX. I’ll leave you with a question to mull over.
If FTX is given the green light, what is the need for an institution like the CME group? Redundancy always finds a way to self-capitulate.
Written by Theo White