This past Wednesday, the Commodity Futures Trade Commission (CFTC) held a gathering of senior figures from the financial industry to discuss ‘disintermediation’, a key topic contained in a license change proposal sent by crypto exchange FTX.US to the US futures regulator back in March.
Despite the banal-sounding term, the consequences of this meeting loom large. If approved, the proposal would let FTX.US – and firms with a similar Designated Clearing Organization (DCO) license – offer margin trading in crypto derivatives to retail customers without the required involvement of futures commodity merchants (FCMs) firms – ie disintermediation. The latter are the futures markets counterparts of broker dealers in the securities space, and they are the ones who would get ‘disintermediated’ or taken out of the middle.
FTX, which started in 2019 as a crypto exchange focused on derivatives, caters towards an active and professional trading audience that already trades futures on its Bahamas-based unit without middlemen. However, smaller US-based clients that must use FTX.US cannot utilize this service.
The event was chaired by CFTC Chair Rostin Behnam and assisted by a full 5-member commission, with Senior Policy Advisor Steigerwald acting as voice for the regulator.
The roster in attendance included FTX’s CEO Sam Bankman-Fried, Fidelity’s Neil Constable, Thomas Sexton of the National Futures Association (NFA), major advocacy groups including the Futures Industry Association, representatives of exchanges like Intercontinental Exchange (ICE)’s Chris Edmonds and CME Group’s Sean Downey, major trading firms like Citadel and DRW, asset manager BlackRock, large Chicago-based FCM RJ O’Brien, and banks with large futures businesses like JPMorgan, Goldman Sachs, and Citi.
The US has previously not prioritized having federal legislation to govern crypto trading, especially at the retail level. This oversight has led to turf wars between regulators. Crypto derivatives are an especially tricky issue because the SEC has claimed to any tokens that it deems to be securities, while the CFTC would oversee the derivatives contracts based on them. So far, bitcoin and ether are the only two assets deemed to be commodities, leaving a lot of room for debate and interpretation. For his part, CFTC Chair Rostin Behnam, expressed to Congress earlier in the year his desire to regulate both the crypto derivatives and spot markets if given the needed funds to do so. It may come down to Congress to make a decision.
On that point, the House of Representatives’ Agriculture Committee hosted its own review of the FTX.US proposal two weeks ago, where five CEOs interacted with the 25+ member Ag Committee in a lively debate with prominent exchanges between Bankman-Fried and the CME Group’s CEO Terry Duffy and where the Committee’s Chair David Scott (D-GA) telegraphed his views to CFTC Chair Benham ahead of last week’s meeting.
Key Points of Discussion
There were voices issuing caution and more time examining the proposal, but as the day progressed the nature of comments appeared more congenial with key aspects of the proposal in what could be seen as an auspicious sign when the matter comes up for a vote before CFTC commissioners before the summer is out.
Some of the matters discussed by industry experts included:
- Who Ends Up Holding The Bag? Both the rival clearing models have a ‘cascade’ of capital that kicks in during times of very severe market turbulence and limited liquidity. The makeup of these models varies dramatically, with the current system depending on mutualized losses and standby capital from some 61 firms called futures commodity merchants (FCMs). Mutualized loss is a concept that shares losses if an exchange needs capital because margin to support a trade becomes insufficient. Conversely, FCMs would be optional under the FTX.US model and institutional clearing members would not be forced to participate in a mutualized loss situation because trader positions would be marked to market every few seconds not once daily.
- Send Money Very Soon. Most traditional exchanges and FCMs in the room made a point of highlighting the difference in how the current model lets FCMs use their balance sheet to give customers credit and time to post more collateral in cases where they approach a margin call threshold. The FTX.US model is more automated, which means trades ‘auto-liquidate’ if there is insufficient margin. Here, traders are responsible to keep track of required margin, bearing in mind the need for collateral needs that could develop while the client is asleep or on weekends. Bankman-Fried and others acknowledged that while the new model was less convenient, it tackled risks faster and gave stability to the capital of all market participants. They noted that extending credit to participants short on margin – as FCMs currently do – could be more costly to all participants if prices start trending in a direction where losses keep on getting bigger. No one knows for sure if prices will revert to what they were before they dropped sharply. One such incident forced the London Metal Exchange to cancel trades under the traditional clearing model back in March, illustrating what could go wrong if losing positions are allowed to build.
- Market access. A number of firms expressed their openness to having access to diverse risk models so the current one, which is concentrated around one very large futures exchange and seven bank-owned FCMs, can see more meaningful competition. Neil Constable of Fidelity expressed that his employer is quite literally about the retail investor, and with that in mind, thinking about how to democratize create access to financial products for them, “this kind of proposal means that we want to be very engaged trying to get this into the hands of our clients,” along with the right amount of education, disclosures, and transparency.
- Who will police these exchanges? Thomas Sexton from the National Futures Association (NFA) stated the regulations don’t quite fit this model yet. He added: “We spent a lot of time talking about clearing, and our focus is retail consumer protection. It’s fundamental that we have in place protection for those participants, including: how sales solicitations start, how customer funds are protected, risk disclosures given, client and operational funds during a firm’s bankruptcy.” He concluded with a point yet unclear on the proposal of who will regulate compliance by these entities with expanded licenses: “Are we really going to let this entity govern and oversee its interfacing with participants who are retail customers?” and warned that if there is no independent self regulatory organization (SRO, like the NFA), it falls upon CFTC staff to do so.
The CME Group expressed earlier this month that it is not per se against a disintermediated model and joined Intercontinental Exchange (ICE) and Cboe suggesting that the CFTC should delay any approval so that FTX.US doesn’t have what they consider an unfair advantage that lets the firm have a start ahead of the competition. A delay, however, could unfairly hold up – possibly for months and even years – a well researched proposal built on moving parts for which there are precedents within the CFTC universe. A full commission vote on the measure is expected this summer.
Outlook and Implications
The fact that senior captains of industry showed up for this day-long event signals the momentous change that is likely to come because of it, and not just ushering crypto regulation and trading in the United States. The National Futures Association, the policing arm of the CFTC, will likely become the regulator of FTX.US and other crypto exchanges dealing directly with retail clients.
The behavior of FCMs, shifting their capital from one model to another, will prove critical to which clearing model prevails. Bankman-Fried made several not-subtle invitations to FCMs to come under his proposed model of him, thus creating a hybrid model that is more capital rich than that in his firm’s original application.
The ball is now on the CFTC’s court, and it now that it has heard industry and Congress, it can deliberate and make the needed changes. Should the CFTC approve the FTX.US proposal as we expect, retail investors have reason to be optimistic that the CFTC involvement in crypto markets is a strong plus long term. This seal of approval will give needed credibility and robustness to a scrappy, promising asset class that needs it. With more crypto trading being brought onshore, crypto projects will get more capital – retail and institutional – but these entrepreneurs will have to button up and do things they haven’t been strong in the past like crossing their t’s and dotting their eyes from a regulatory and governance perspective.