FTX and Agricultural Products
FTX and Agricultural Products
On May 12, 2022 the House Committee on Agriculture held a hearing entitled “Changing Market Roles: The FTX Proposal and Trends in New Clearinghouse Models.” During that hearing the committee explored the implications of real-time risk management and different market structures facilitated by new technologies.
Similarly, the U.S. Commodity Futures Trading Commission (CFTC) hosted a staff roundtable on May 25, 2022, to discuss issues related to intermediation in derivatives markets overseen by the agency. This discussion also was inspired by FTX’s application to amend its clearinghouse license before the CFTC.
During both of these public meetings, a considerable amount of discussion covered the potential impact of the FTX risk model on the agriculture community, and particularly on the ability of agricultural producers and merchants to hedge their various risks through derivatives markets. Members of the Committee on Agriculture and ag representatives at the CFTC roundtable sought to understand FTX’s plans for agricultural products, as well as the effect on the agricultural community of listing and clearing digital-assets products with the FTX risk model.
There seem to be two issues of concern in particular. First, if FTX were to list an agricultural product, such as a corn future, how would the FTX risk model – and in particular the automated de-risking feature – apply to producers trading a corn future for hedging purposes? More precisely, since farmers are commercially reliant on hedging positions remaining in place to manage price risk, would the de-risking feature inappropriately present the possibility of that position being automatically reduced or sold off in the event of a significant market move, leaving them exposed to price risk?
Second, even if FTX did not list agricultural products on our platform, would investors onboarded to FTX and trading our products nevertheless expose the rest of the derivatives markets to unnecessary risks?
Background on Agricultural Products
Derivatives have been long lauded as an effective risk-management tool for commodity producers, including those from the agricultural sector. FTX strongly believes in ensuring that all U.S. commodity producers have adequate access to robust markets for these tools. Toward that end, U.S. derivatives exchanges list an array of agricultural products for risk managers and investors, including derivatives products referencing grains, oilseeds, livestock, dairy, fertilizer, lumber, and “soft” commodities such as canola, cocoa, coffee, frozen orange juice, cotton, and sugar.1 While some of these available products are financially settled, the vast majority of the total number of contracts available to trade are physically settled contracts.2
While there are a number of derivatives contracts for farmers to choose from, the reality is that not many farmers in fact use futures contracts for risk management. According to the U.S. Department of Agriculture (USDA), only a small percentage of U.S. agricultural producers use futures or options as risk management tools (less than 10 percent), and for those that do, derivatives on corn and soybean are the most commonly used.3 Farmers in the U.S. tend to rely more on other risk-management tools such as marketing contracts and crop insurance. Similarly, the share of revenues from agricultural products that the most popular venues for these products generate is also relatively small (also less than 10 percent of revenues).4
Additionally, and not surprisingly provided the foregoing facts, the trading volumes in agricultural products are relatively small compared to volumes for other derivatives. According to the Futures Industry Association, trading in futures and options on agricultural commodities amounted to around 3 percent of overall trading volumes globally for the months January through April of this year.5 Moreover, the trend is that trading in agricultural futures and options is declining when comparing 2021 to 2022, which is an interesting fact in light of the disruptions to the world’s food supplies caused by the Russian invasion of Ukraine earlier this year, which would seem to increase demand for risk-management tools for agriculture (perhaps the trend will reverse as the conflict continues).
There are a few takeaways from these facts that provide useful context for the discussion of how the FTX risk model might impact the agricultural community. The first is that even if FTX were to decide to list agricultural products, the interest in those products would be presumably rather limited given the relatively low overall demand for and usage of agricultural derivatives. The second is that presumably low demand for a relatively small proportion of the derivatives products calls into question any potentially disruptive impact of such listings on the overall agricultural sector, as some have wondered or feared. The third is that given the types of ag-commodity contracts available today, the agricultural market appears to prefer and demand mostly physically settled derivatives products, which are not contemplated by the FTX risk model under review by the CFTC.
Finally, farmers who use derivatives listed on traditional exchanges to manage risk face the same challenges that observers have raised with the FTX model: market moves can lead to under-collateralization of positions. In those instances on traditional exchanges, a farmer is faced with the challenge of finding liquidity to meet a margin call, or otherwise having their position closed. In fact, the USDA highlighted the stresses that margin calls can create on agricultural producers.6
With this background in mind, we explain how the concerns about the impact on the agricultural sector from FTX’s application before the CFTC are unwarranted.
FTX Has No Plans for Ag Products
First, FTX has no plans to list agricultural derivatives on its U.S. platform if the CFTC approves our margin application. The commercial opportunity presented by this product set is unknown at this time and in any case is presumably rather limited given the facts explained above. Additionally, FTX has not not developed expertise in agricultural products and consequently faces challenges in developing the best products to meet the demand that might exist. If members of the agricultural community approached FTX about developing such products, we of course would be happy to engage, but that has not happened to date. At this time, FTX does not plan to list these products, and we would plan to re-engage with the CFTC and industry should that ever change.
FTX Could Not List Agricultural Products Without Additional CFTC Staff Review and Approval
Second, even if FTX were to try and list agricultural products after its margin application were approved by the CFTC, the CFTC’s regulations require that the agency staff review the applicability and appropriateness of the risk-management system to qualitatively new or different products. As described above, today the market appears to demand mostly physically settled agricultural derivatives, and settlement of these products requires the ability to deliver the actual commodity. For instance, a physically settled corn future requires that at the time of expiry, the clearinghouse can facilitate the delivery of physical corn to the counterparty with the long position in corn.
This is not a type of contract that the FTX risk system under CFTC review contemplates. Instead, the FTX risk model under review was designed to clear digitally settled derivatives on digital underlyings. It is also important to note here that facilitating physical settlement requires the ability to store the physical commodity – again, FTX today is not positioned to provide this.
FTX would need to develop a risk-management model to support physically settled agricultural products, and have that model reviewed by the CFTC staff, before listing such products. More precisely, the CFTC’s rules require that a risk model “identifies and documents the range of risks to which the derivatives clearing organization is exposed [and] addresses the monitoring and management of the entirety of those risks.”7 Those risks include ones stemming from storage and facilitation of delivery of physical commodities.
The agency’s rules also require that initial-margin requirements be developed for each product, and other risk-control mechanisms be in place for those products, both of which are tailored given the fact that each asset class has different risk characteristics.8 Self-certifying a qualitatively different product for a listing such as a physically settled corn future would involve a CFTC staff review of these considerations, notwithstanding any CFTC order generally approving a DCO for licensure. Additionally, FTX would need to develop additional DCO rules for CFTC staff review regarding the process of delivering the referenced physical commodity.
A risk model designed to manage digital assets theoretically could be appropriate and applied to financially settled agricultural products, but the model would be subject to the CFTC staff review described above all the same.
Automated De-Risking under the FTX Model Is Rare
Third, even if FTX were approved to list and clear agricultural products using a similar risk-management system to the one under review, it is not at all clear that applying real-time risk management that included automated de-risking would imperil a farmer’s ability to manage price risk. The main reason for this is that the CFTC’s rules and the agency’s contingent review of the FTX risk model would ensure that initial margin for agricultural products is calculated appropriately. If calculated appropriately, the initial margin collected by FTX under an approved risk system would ensure that the resources pre-funded to the FTX clearinghouse are adequate to address even extreme but plausible price moves.9 Such margin collection would mean that the instance of partially auto-de-risking a position in an agricultural product would be extraordinarily rare – indeed, that has been the FTX experience with clearing digital-asset products.10
The reader also is reminded here that, for now, physical agricultural commodity markets typically do not trade 24 hours per day (although one could imagine a world with 24-hour agricultural markets in the future), and therefore a derivatives market for these assets would not necessarily be appropriate in any case, thus further mitigating concerns about a hedge “disappearing during the night” under the FTX model, while a farm producer is sleeping.
The FTX Risk Model Contains Contagion Risk
Fourth, approving the FTX model for non-agricultural products also would not otherwise pose contagion or other risks to the agricultural sector as some have suggested. FTX has explained before how its risk-management system – which assesses risk real time, relies on pre-funded collateral, and dispenses with margin calls that present credit risk – contains features that substantially limit risks from reverberating from the FTX platform into other traded markets more broadly, including agricultural markets. FTX continues to address these considerations with the CFTC in the context of its DCO application, and has posted multiple blogs on this topic as well. The FTX model allows the platform to have full transparency into customer accounts and the ability to manage risks posed to the platform from those accounts at all times. FTX strongly believes that this type of model is much more effective than more traditional models in containing risks to the FTX platform.
FTX understands that the questions about the impact of its risk-management on the agricultural community are sincere, but for the reasons above believes they are not warranted.
1 See https://www.cmegroup.com/markets/agriculture.html#products and https://www.theice.com/products/Futures-Options/Agriculture.
2 See e.g. the CBOT Australian Wheat FOB (Platts) futures (https://www.cmegroup.com/trading/agricultural/grain-and-oilseed/australian-wheat.html) and the CME’s fertilizer contracts (https://www.cmegroup.com/trading/agricultural/fertilizer.html). CME also operates spot cash markets for whey, cheese, butter and milk (https://www.cmegroup.com/trading/agricultural/spot-call-data.html).
4 See e.g. http://investor.cmegroup.com/node/50141/html#i3590c1fbb27c4fa782729b5275eab6af_16.
7 17 CFR § 39.13(b).
8 17 CFR § 39.13(g) and (h).
9 17 CFR § 39.13(g)(2)(iii).
11 See id. and https://www.ftxpolicy.com/posts/risk-management.