FTX is seeking to shake up the sprawling US derivatives market, marking the biggest intervention to date by a crypto group in to the heart of traditional finance.
The three-year-old exchange, founded by Sam Bankman-Fried, is seeking approval from the US Commodity Futures Trading Commission to offer customers bitcoin futures — contracts that allow users to bet on the price of the world’s most actively traded digital token.
The proposed process would strip out the brokers that for the past 40 years have acted as intermediaries between customers and the exchanges where deals are done. America accounts for a big slice of the global futures market where 29bn contracts were traded last year, meaning if FTX’s plans are approved, its effects could be wide-ranging.
Rather than brokers asking customers to stump up extra cash, known as margin, when trades go bad, the exchange would automatically monitor the market, 24-hour-a-day, seven-day-a-week, and debit client balances accordingly.
This rewrites the mechanics of futures trading and if it sticks, it could apply also to everyone who trades in futures markets, from farmers locking in prices for corn to hedge funds betting on oil prices.
Automatic liquidations vs margin calls
At the heart of both the existing system and FTX’s proposal is leverage. Futures traders typically only put down a small fraction of the overall value of their position, something that magnifies potential gains and losses. The chips that market participants place on the table are know as “margin”. Margin is critical in leveraged trading because it ensures that if a bet turns sour, the participant on the other side of the trade can be made whole.
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A key difference between the system that is in place now and the FTX proposal is the approach to margin. Under the current framework, when a bet falls too deeply underwater, a broker will ask a trader to stump up additional funds to back the trade, known as a “margin call”, by a certain deadline. If the trader meets the margin call, their trade remains opens, otherwise the broker will begin unwinding their positions and taking back the margin used to make the trade.
On crypto exchanges such as FTX and Binance — global platforms that are broadly unregulated — margin requirements on products like bitcoin futures are constantly updated. Traders deal directly with the exchange rather than through a broker.
Crypto platforms automatically begin unwinding positions if a user’s margin falls below a pre-determined level. Typically a user will receive an alert if their account is in danger — but given the volatility of digital assets, these kinds of forced liquidation events can leave traders wiped out extremely quickly.
Unlike crypto, which trades nonstop, most traditional futures such as those tracking commodities close at the weekend. However, since most trade effectively all the time during business days, some smaller market participants have said they worry about getting wiped out during off hours under the FTX proposal. A margin call, in contrast, provides some breathing room to meet funding requirements.
Case study: May 2021 crypto ‘flash crash’
Automatic liquidations are already in extensive use in the crypto industry, where $1.3tn worth of bitcoin futures trading took place last month alone. Traders can be wiped out extremely quickly during times of market tumult, with more leverage increasing the speed at which a user is forcibly liquidated.
The case study below is based on a “flash crash” about a year ago that wrongfooted many leveraged bitcoin traders. The trader in this illustration has taken out a 100-times leveraged position on Binance by putting down $2,500 on a trade notionally worth $250,000. When the market starts to tumble, they need to kick in more and more money to avoid being liquidated despite prices rapidly rebounding.
The brief tumble, which took place in May 2021, left many retail traders with steep losses. However, because of automatic liquidations, typically market participants can only lose as much as they bet on the trade as opposed to running up a debt.
The FTX plan has kicked off a fierce debate in the US since the CFTC opened a consultation in March.
Those in favour of the FTX proposal believe it is the next evolution of the market, as technology inevitably advances on markets like it has the rest of society. It fosters competition, democratises futures trading and just as importantly, protects smaller investors from racking up debts they cannot afford, which has sometimes led to tragic consequences, proponents say.
On the other side of the debate are those who say the traditional system provides a vital “breathing space” for important decisions to be taken and time to find extra cash. A farmer, for example, would not have to worry about sudden market moves liquidating positions he had opened to hedge against fluctuations in the prices of commodities. Customers would not have to put up more funds than are necessary, just to give them peace of mind. The intermediaries at the heart of the system, the exchanges and brokers, would be able to use human judgment to smooth out potential issues in volatile times.
The CFTC is examining every step of the chain to understand how it will work and the consequences, so it is taking its time. A decision may not come this year. It is possible it will permit both models. But as investors explore bitcoin futures, it may face more proposals.
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