A showdown worth of pay-per view television will be available this morning at 10am EST. But this will not be a UFC fight, instead it is a hearing to discuss the future of derivatives trading. Derivatives are financial contracts that let investors hold hedging or speculative positions at regulated U.S. exchanges overseen by the Commodity Futures Trading Commission (CFTC). In particular, the event will center on crypto derivatives, which let investors get exposure to digital assets such as bitcoin and ether.
The Key Players
Representative David Scott (D-GA), Chair of the U.S. House of Representatives’ Agriculture Committee will preside over the proceedings. Five speakers will discuss the merits of the disruptive March 2022 FTX.US proposal to change the way that derivatives contracts are cleared and settled.
A little history. Last year, FTX.US, the U.S. affiliate of Bahamas-based FTX, acquired LedgerX, a CFTC-regulated entity that can operate in the futures market in a similar capacity as much more established futures exchanges, such as Chicago-based CME Group and Atlanta-based Intercontinental Exchange.
The high-powered list of speakers for tomorrow’s debate includes the CME Group CEO Terrence Duffy, crypto billionaire and FTX CEO Sam Bankman-Fried, Futures Industry Association (FIA) CEO Walt Lukken, Atlanta-based Intercontinental Exchange (ICE) Chief Development Officer Christopher Edmonds, and Christopher Perkins, President of Coinfund Management.
Bankman-Fried will be the youngest (only 30 years old) and only multi-billionaire speaking. His exchange FTX made a name for itself by specializing in sophisticated crypto futures and derivatives contracts of cryptocurrencies. Despite the commercial success of FTX since 2019, there are powerful people who are not convinced the technology is up to the task of competing against the current way of doing things.
It does not help that the crypto industry is prone to seeing dramatic nine and 10-figure liquidations during times of market stress, exacerbating market runs. This week alone we have seen more than $1 billion in liquidations following the collapse of the dollar-based stablecoin TerraUSD and bitcoin falling below $30,000.
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The Futures’ Industry Likely Arguments
Thursday’s hearing will likely see the heads of the CME, ICE, and FIA praise the benefits of FCMs in the futures industry and explain that the clearing model works well in its current state. In other words, they are likely to oppose the innovation because it could disrupt exchanges, even if the proposal’s scope of the change refers to a trading product that for now will only compete with CME crypto futures.
Based on concerns expressed by Committee Chairman Scott, the tougher questions will probably go to Bankman-Fried. While hosting Rostin Behnam the new CFTC Chair giving a State of the CFTC briefing to his Committee in late March, Chair Scott expressed his alarm over “a proposal pending at the CFTC by a cryptocurrency exchange that is seeking approval to operate a new and untested exchange” and how he was “very concerned about this ...very much concerned about this proposal and the broad implications it poses.”
Scott’s reaction reflected the industry’s startled reaction to the FTX.US proposal. It is also worth noting that one of these major exchanges (ICE) is based in his home state. The proposal has caused fear in sectors that depend on the sleepy, collegial structure that has been in place for decades to trade futures using intermediary firms akin to broker dealers in the equities world and which are called futures commodity merchants (FCMs).
FTX’s Likely Arguments
FTX’s Bankman-Fried is sure to articulate that the exchange has held many meetings on the topic with CFTC Chair Rostin Behnam, who gave encouraging words short of an endorsement and suggested that the FTX.US proposal to directly settle margined crypto trades could be classified in the "responsible innovation" category.
In the FTX.US proposal, exchanges take on the task of onboarding retail clients, something that traditional futures exchanges do not offer. Meanwhile, the FTX CEO will make a case that the proposal aims to give traders choice, lower costs, and improve the risk models without per se requiring the rest of the futures industry to change.
Crypto exchanges claim to have systems that manage trading risk and collateral requirements from clients at an atomic, real-time level, 24/7/365. This means that the matching between buyer and seller happens much more quickly so they don’t sit on the exchange’s settlement systems. If a trade needs to be closed due to lack of funds, crypto exchanges could conceivably react faster than traditional finance because they are open all of the time.
The posture of the futures industry is that crypto exchanges have risk management methods that are amateurish and unproven by comparison. Crypto’s cascading liquidation throughout the years may lend some credence to these arguments. These more ‘mature’ futures market participants follow a risk management model that uses a mutualized loss approach following events when one or multiple major firms stopped honoring their commitments to the exchange. This means that everybody shares in the pain.
Futures exchanges today have fared well through recent financial crises, but even so the concentration of risk around very large FCMs could impact market stability if two or more of them were to go down after an unexpected global event. Prices can gap dramatically over one weekend and this kind of risk hits harder exchanges that don’t manage collateral requirements on a 24/7/365 basis.
The Bottom Line
Thursday’s hearing comes down to two points: Firstly, the futures industry is facing a new evolution milestone akin to when stocks and futures exchanges closed down their trading pits. These were a specialized group of professionals who discovered current price on securities by screaming, hand-gesturing while in uniforms shouting orders for a few hours a day. Second, Congressional leaders wish to have their voices be heard loudly and this meeting was scheduled before the May 25 CFTC public hearing on the topic, where it will evaluate the more than 500 public comments that came in through May 11.
