A trade group representing some of Wall Street’s biggest brokers has warned US regulators that a proposal by cryptocurrency exchange FTX to automate risk management in the leveraged futures market lacks sufficient detail to be approved in its current form and could prove disruptive.
The FTX plan has created a sensation in the financial world, raising the prospect that trading approaches being developed in the crypto markets will find wider uses in traditional finance if the Commodity Futures Trading Commission, a US derivatives regulator, gives its approval.
Wall Street’s response has been eagerly anticipated because FTX is seeking permission to use computers to perform functions in the futures markets now entrusted to brokers, called futures commission merchants, the largest of which are arms of JPMorgan Chase and Goldman Sachs.
The Futures Industry Association, which represents market participants including the FCMs, on Wednesday called on the CFTC to seek additional information before deciding on the FTX plan, describing it as “innovative” and possibly “transformative” but potentially risky.
“This model could exacerbate financial instability in a time of heightened market volatility,” the FIA said, adding that it was concerned the automated system could invite “market manipulation” by bad actors.
The CFTC set a May 11 deadline for comments on the FTX proposal, which has received a mixed reception. Terry Duffy, chief executive of futures exchange operator CME Group, called it a “glaringly deficient” idea that “poses significant risk to market stability and market participants”. Given the importance of the issues raised by FTX, other respondents suggested the CFTC would be better off writing new regulations.
In a sign of the debate to come, a House committee will hold a hearing on the plan on Thursday, with Duffy and FTX chief executive Sam Bankman-Fried among the scheduled witnesses.
Technically speaking, FTX is seeking CFTC approval for a small US futures exchange it bought last year to offer leveraged futures contracts, which enable investors to take large positions while putting up a fraction of the value of a trade, known as margin.
In today’s markets, FCMs collect margin and make sure customers have enough of it to support positions. If they do not, the brokers ask for more money, usually overnight. They also contribute to guarantee funds held at clearinghouses — the third parties standing between buyers and sellers of futures — to “mutualise” losses in a major default.
FTX would bypass the brokers, employing a system currently used in crypto. It would require customers to deposit collateral in FTX accounts and be responsible for having enough on hand to cover margin requirements, which would be calculated every 30 seconds every day of the year.
If the margin falls too low, an automated liquidation would begin, with FTX first selling off positions in 10 per cent increments. In worst-case scenarios, positions would be taken over by “backstop liquidity providers” who had agreed in advance to play such a role. FTX would also kick in $250mn to a guarantee fund.
Although the FTX exchange only deals in digital assets, approval of its proposal could clear the way for its approach to be used for other futures contracts.
The FIA argued that key details of the FTX plan remained unclear — ranging from the dependability of the algorithms it uses to calculate margin requirements to the requirements for “backstop liquidity providers”. It asked what would happen in the event of a “fat finger” mistake by a market participant or if FTX itself went bankrupt.
The trade association also made the case for the human intervention in the markets. FCMs not only deal with margin, it said, they also try to make sure clients have sufficient resources to trade and they look out for money laundering activity.
Automated liquidations could make a bad situation worse, FIA said. “During market turbulence, immediately liquidating a large participant during cascading markets can . . . add to market volatility and may cause further defaults,” it said, putting a premium on the “expert judgment” of financial services professionals to know when to act.
Requiring market participants to manage accounts on a 24/7 basis would be impractical outside the crypto realm, it said, putting undue burdens on investors using money deposited at banks.
“Meeting a margin call in fiat currency requires banks to be open, notwithstanding that the market is open 24/7,” the FIA said. “This is not the world we live in today.”
