FTX irks exchanges by pushing for crypto derivatives

The cryptocurrency exchange FTX is seeking a green light from regulators to let individual investors use derivatives to place leveraged bets on bitcoin, a move opposed by rivals.

Traditional exchanges and financial-industry groups say FTX’s proposal might endanger market stability. Their concerns centre on a key element of the plan, under which investors could deal directly with FTX instead of going through a broker. This approach represents a change from the way derivatives markets have operated for decades.

“The FTX model would significantly increase market risk,” Terrence Duffy, chief executive of CME Group, said in a May hearing on Capitol Hill. The Chicago-based exchange company offers a competing bitcoin-derivatives product.

FTX, led by the 30-year-old billionaire Sam Bankman-Fried, says its proposal will bring 21st-century technology to US markets, adding that it has safeguards to limit risk.

Consumer advocates worry that FTX’s proposal will put volatile derivatives in the hands of unsophisticated investors as crypto suffers a severe downturn. FTX says it is committed to investor protection.

“We’re going to have a more complete set of customer protections, disclosures and suitability checks in place than currently exists in the futures industry,” Bankman-Fried said in an interview. “If anything, we’ll be going a little bit overboard on that.”

Following months of lobbying by both sides, the Commodity Futures Trading Commission is considering the proposal and could make a decision later this year.

Winning CFTC approval would help FTX fulfil its ambition of penetrating the US market. To date, the Bahamas-based firm’s core business has been its huge offshore crypto-derivatives market. That market is off-limits to Americans because of regulatory restrictions.

The effort to gain approval poses a test for Bankman-Fried, a relative newcomer to Washington lobbying. After his proposal drew opposition from established interests, the California native gave up his trademark FTX T-shirt and shorts for a suit and tie to defend the plan before lawmakers.

Derivatives are financial tools that let people attempt to make money based on price swings in various markets—in this case, crypto. Traders can use them either to hedge against losses or place speculative bets.

Last month Coinbase Global, based in San Francisco, launched bitcoin futures, a type of derivative, for individual investors. CME introduced bitcoin futures in 2017.

To trade bitcoin futures at Coinbase or CME, one must connect to a broker. The broker’s job is to collect the cash collateral that investors post to enter derivatives trades, called margin. If an investor’s bet goes wrong, the broker issues a margin call. The investor typically gets a day to deposit more cash.

Such brokers date to the origins of futures trading in 19th-century Chicago grain markets. Today their ranks include Wall Street banks as well as specialised firms such as Advantage Futures and R.J. O’Brien & Associates LLC. They are subject to various CFTC regulations, including minimum-capital requirements and obligations to warn customers about the risks of futures trading.

Under FTX’s plan, users could post margin directly to FTX, with no brokers involved. The exchange would monitor markets 24 hours a day, seven days a week, settling users’ profits and losses every 30 seconds. If a user fell short of the margin requirement because of a losing bet, FTX would begin to close out their trades. A sufficiently large market move could trigger a process called auto-liquidation, in which FTX takes away the user’s collateral. Potentially, that means an FTX customer could wake up in the morning and discover that the exchange had liquidated the account overnight.

Dennis Kelleher, head of the advocacy group Better Markets, said FTX’s plan is risky for investors, particularly its auto-liquidation feature. While investors can lose their money in existing futures markets, the current system gives them more time to meet margin calls, and brokers can loan customers money to tide them over a rough patch. In contrast, FTX would move at hyperspeed and robotically take investors’ money if a trade goes bad, Kelleher said.

“The automation is set at a hair trigger to liquidate retail investors’ accounts on a 24/7/365 basis, which is impossible for a retail investor to monitor,” he said.

FTX says it would send investors alerts as they approached a potential margin call and would then begin to close out their trades in phases, giving them time to react. FTX also says its US exchange wouldn’t be as quick to liquidate customers’ portfolios as many overseas crypto exchanges.

By not requiring brokers, FTX would gain more control over its customers’ experience, down to the interface of its website and app. Potentially, FTX might also be able to offer lower margin requirements than rival exchanges with bitcoin futures. Lower margin requirements would give users more leverage on their trades, amplifying their gains and losses — a key element of the appeal of crypto derivatives.

FTX argues that its approach is ultimately safer for markets, because it wouldn’t involve brokers extending credit to customers. That sometimes trips up markets: In March 2020, for instance, the Dutch bank ABN Amro reported a $200m loss after one big customer failed to meet a margin call during coronavirus-fueled volatility.

Still, incumbent exchanges such as CME and Atlanta-based Intercontinental Exchange say FTX’s plan would inject risk into the financial system. Cutting out brokers would erase a layer of protection that helps prevent defaults from rippling through markets, the exchange operators told the CFTC in comment letters criticising the proposal.

FTX counters that its plan has protections to contain systemic risk, including a $250m guaranty fund to cover losses in an extreme market event.

Write to Alexander Osipovich at [email protected]

This article was published by The Wall Street Journal, part of Dow Jones

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