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CFTC roundtable on non-intermediation focuses on FCM benefits and default waterfalls

Wide-ranging discussion touches on customer protection, product suitability, self-certification, margin and liquidation issues

26 May 2022

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The US Commodity Futures Trading Commission hosted a wide-ranging and at times contentious discussion on issues related to intermediation in derivatives trading and clearing on 25 May. The roundtable event was more than six hours long, and included representatives from CFTC-registered derivatives clearing organizations (DCOs) and futures commission merchants (FCMs) as well as trading firms, asset managers, agricultural industry representatives, academics, public interest groups, and others.

Though the event was ostensibly about non-intermediation broadly, a great deal of discussion centered around the specifics of a recent request by FTX US Derivatives to amend its order of registration as a DCO to expand its existing non-intermediated model to permit the trading and clearing of margined products. That request would open the door for FTX to offer futures on cryptocurrencies, and possibly other asset classes, through a direct clearing model in which customers bypass FCMs and become direct members of the FTX clearinghouse. As a result, FTX founder and CEO Sam Bankman-Fried, who participated in person in the roundtable, spent a significant amount of time responding to both general concerns as well as specific questions about the FTX proposal.

Generally, the vast majority of panelists expressed clear support for innovation and competition, but also raised concerns about potential risks that might arise from a disintermediated model for derivatives trading and clearing. The panelists also warned, among other things, about the potential risks of the "auto liquidation" feature that FTX has proposed, which would automatically close out customer positions if they have not posted enough collateral to cover a loss in value. Other areas of discussion included contract settlement, backup liquidity providers and the self-certification process.

Key topics of discussion are as follows:

Intentionally strict regulation for FCMs and their risk-managing benefits

Mariam Rafi, global head of clearing and FX prime brokerage at Citi, spoke at the roundtable on behalf of FIA and its members. She noted that FCMs offer key benefits including customer protection, bankruptcy controls and disclosures to serve clients as well as the entire financial system.

"Our primary interest is in customer protection, and the stability and soundness of markets," Rafi said. "We act as an additional check. We are looking at our customers' creditworthiness and we stand behind their commitments. None of that exists at the same level in this model."

Allison Lurton, FIA's chief legal officer and general counsel, also noted that rules governing FCMs are different than those for exchanges and clearinghouses and sometimes purposefully duplicative of those imposed on other entities. Additionally, exchanges and clearinghouses are governed by core principles but, by contrast, Congress and the CFTC intentionally applied very prescriptive rules to FCMs because of the important roles they play for customer protection and asset protection.

"We would hope that certain regulations are revisited for their purposes, so we can figure out if a non-intermediated entity should be bound solely by core principles or if additional rules are needed," Lurton said. Chris Edmonds, chief development officer at Intercontinental Exchange, agreed that regulation should be principles based, and called for it to be applied consistently. "To the extent we apply it to non-intermediated models it should be the same, with things like extreme but plausible tests for collateralizing the system," he said.

A number of participants also mentioned that FCMs also contribute capital to default funds to provide a layer of protection beyond what customers post for margin.

Auto-liquidation and potential disruption

One of the potential features of a non-intermediated model like the one proposed by FTX is that it allows for auto liquidation of positions on a 24/7 basis. Gerald Corcoran, CEO of independent FCM R.J. O'Brien, noted that auto liquidation can be "a weapon of mass destruction" by triggering a "cycle of flash crashes" if the algorithms behind that process are not finely tuned to consider market conditions and the customers' circumstances.

Rob Creamer, president and CEO of Geneva Trading, a principal trading firm, echoed concerns that a lack of intermediation could create disruptions caused by automatic and cascading liquidations in a time of stress.

"I appreciate the simplicity of this model, but I'm trying to reconcile how these things fit together," Creamer said. "If there is a flash event, could that make my company insolvent?"

The importance of margin

Alicia Crighton, managing director at Goldman Sachs and a board member of FIA, noted a non-intermediated model "ups the stakes dramatically from a margin perspective," Crighton said. The CFTC previously has approved exchanges that have no intermediaries, but their contracts are 100% collateralized.

"If you think about the resilience of the system, (FCMs) are the first line of defense and the last line of defense," Crighton said. "Taking those layers away is interesting but very much changes the dynamic from a regulatory perspective."

Hilary Allen, a professor at the American University Washington College of Law, also noted that "margin eliminates the need for other types of loss absorption" when it is well tailored. However, she noted that "while I see the rhetorical appeal of the (non-intermediated) model, it does not work when you cannot figure out what the actual risk is."

There were a few comments about the importance of the concept of "defaulter pays," where the party bringing risk into the system is paying and held accountable for that risk. However, there were specific concerns raised about the nature of certain assets like cryptocurrencies and whether there is enough history to properly account for tail risk or extreme but plausible occurrences.

Self-certification

Several participants questioned whether a non-intermediated model should have the same power to self-certify new contracts and rule changes as conventional exchanges and clearinghouses.

Alicia Crighton of Goldman Sachs warned that self-certification may not always provide the proper safeguards to consider the full risk profile of a new product, its suitability for exchange listing and central clearing, and the risk brought into the system for other market participants to now "backstop" against.

"We have to do a better job, I think, of considering the implications in the self-certification model, and I don't think we have enough protection in that regard," Crighton said.

Scope of Products

One rare point of agreement among members of the roundtable was that certain derivatives would not be appropriate for auto liquidation on a 24/7 basis. Sam Bankman-Fried of FTX admitted that futures based on physically-delivered agricultural commodities such as wheat may not be appropriate for this approach to risk reduction, and that he envisions only "digitally settled" contracts as best suited for this structure.

"There doesn't currently exist an easy way to post (physical commodities) as collateral for a futures position for a hedge on a marketplace," Bankman-Fried said. Separately, he also acknowledged that a non-intermediated model may not be easily applicable to less liquid assets.

Ag industry representatives were particularly vocal on this point. Nelson Neale, president of CHS Hedging, the futures brokerage arm of one of the largest farmer cooperatives in the US, strongly opposed the idea of extending this model into the agricultural futures markets. This model would not work for market participants that use futures to hedge their risks in the underlying commodity, he explained, and he added that auto liquidation could jeopardize loans secured with hedge positions.

Back-up liquidity providers

Several questions and comments focused on the role of back-up liquidity providers. In the FTX proposal, these firms would act as the "buyers of last resort" after a default occurs.

Neil Constable, head of quantitative research and investments at FMA, the parent of Fidelity Investments, noted that "with FCMs out of the loop, a lot of the risk absorption capacity will fall back on backup liquidity providers."

Sam Bankman-Fried noted that algorithms that auto liquidate can also auto allocate defaulted positions to market participants who opt in to such a model, and fielded several questions around the specifics of pricing and process when such an event occurs.

A noteworthy CFTC event

While not a formal rulemaking, the roundtable was the first public CFTC event featuring four new commissioners – Kristin Johnson, Christy Goldsmith Romero, Summer Mersinger and Caroline Pham -- since they were unanimously confirmed by the US Senate at the end of March and subsequently sworn into office.

The commissioners along with Chairman Rostin Behnam gave very brief opening and closing statements, but left the discussion to the roughly two dozen participants who attended. Robert Steigerwald, a senior policy advisor at the Federal Reserve Bank of Chicago, moderated the discussion.

The roundtable was also the first in-person event for the agency at its Washington, DC, headquarters in more than two years thanks to the easing of pandemic-related public health restrictions.

View an archived video of the event and view an agenda on CFTC.gov.

Review the full list of attendees who participated in the roundtable, and their alternates.

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