Understanding FTX’s Guaranty Fund Sizing
Many of the questions that FTX US Derivatives has received in connection with its proposal to offer leverage for U.S. crypto futures, and its $250 million guaranty fund (of unencumbered USD cash), relate to perceived uncertainty around how or whether the 24x7 risk model and the guaranty fund will work in times of stress and/or volatility. Fortunately, through FTX’s experience running the FTX.com trading platform over the last several years, we have objective and historical data based examples that show how well the FTX risk and clearing model works.
- In this post, we walk through the model and the real world experience showing that, even on days of 35% or higher movements in the price of bitcoin, FTX.com has never had to use more of its guaranty fund than FTX.com made in revenue for that day
- We then observe that while the FUSD risk model will follow the FTX.com model concept, there are at least two important enhancements that allow it to provide an even greater level of comfort and protection to market participants and regulators -
- First, the FUSD risk model assumes that it will take 24 hours to start to close out undercollateralized positions (versus the reality of the risk program running in real-time) - meaning that the initial margin requirements themselves are materially more conservative than they need to be.
- Second, FUSD has sized its guaranty fund at a level that is many multiples of the amount that even its conservative risk model projects as the required guaranty fund level (i.e., approximately 100 times the estimated highest daily draw on the default fund in extreme volatility scenarios).
- Finally, the FUSD initial margin model uses a sophisticated filtered historical simulation to capture market risk, concentration risk, and liquidity risk, incorporating anti-procyclicality controls such as stress VaR and volatility floors.
CFTC Comment Period (Open Until May 11, 2022)
As many are aware, FTX US Derivatives (“FUSD”) operates a futures exchange and derivatives clearinghouse in the U.S. via licenses issued by the U.S. Commodity Futures Trading Commission (“CFTC”). Currently, FUSD is only permitted to list and clear fully collateralized derivatives products; however, FUSD has requested that the CFTC amend FUSD’s derivatives clearing organization (“DCO”) registration to permit FUSD to list and clear leveraged / margined futures contracts. If approved, FUSD intends to list and clear leveraged/margined futures and options contracts on digital assets, including bitcoin and ether, among others.
- The CFTC has invited the public to comment on FUSD’s request, through May 11, 2022.
- The CFTC’s 6-page request for comment is a straightforward list of questions and may be viewed here: https://www.cftc.gov/media/7031/CommentFTXAmendedOrder/download.
- Any member of the public may submit a comment here, through May 11, 2022: https://comments.cftc.gov/PublicComments/CommentForm.aspx?id=7254.
Robustness of the FTX Clearing Model and Guaranty Fund
The FUSD clearing and risk model for leveraged futures products is patterned on the clearing and risk model that FTX has deployed and operated on its non-U.S. venue, FTX.com, for several years. FTX.com routinely handles the trading and clearing of $10 billion or more in transactions daily, measured on a notional basis (any interested observer can track daily notional volume and open interest levels for all of the major global crypto exchanges here: https://ftx.com/volume-monitor). Notably, the FTX.com risk model operates on a 24 hours a day, 7 days a week basis, and under this risk model positions that become undercollateralized are de-risked (or “liquidated”) on an orderly step basis (i.e., the overall position is reduced/closed out some percent at a time, subject to prevailing liquidity and market conditions) through a process that runs essentially in real time. This is in contrast to the traditional clearing and risk model deployed by most of the U.S. futures market today - where undercollateralized positions may generally be held open for a day or more (particularly if over a weekend), even if the underlying collateral has been completely exhausted, while the clearinghouse and typically its clearing members wait for the owner of the undercollateralized position to respond to a request (i,e., a margin call) to deliver collateral (or margin) in an amount sufficient to bring the position back above water. Liquidation or close out of the position is then generally initiated only when the owner of the position has failed to meet this margin call after some determined period of time - which could be on a 24 hour delayed basis or, depending on the market and timing, several days delayed basis. During that gap, the position can continue to deteriorate and the level of insufficiently collateralized risk accumulates without being backstopped (other than by the assets of other market participants and the clearinghouse).
Under FTX’s model, risk is not permitted to build, unchecked, on an under- or uncollateralized basis, full stop. Instead the FTX risk model, on a 24x7 basis, operates to de-risk (and liquidate) these positions in real time, down to levels where the collateral that is posted is sufficient to support the remaining position (if any). Where the posted collateral is insufficient to support any remaining position, the positions may be given over to backstop liquidity providers (each, a “BLP”, which generally are sophisticated trading firms with substantial balance sheets that have pledged, via contractual agreement and actually posted collateral, to take over liquidating positions programmatically and in real time; the BLPs collectively have billions of dollars of collateral sitting in FTX’s clearinghouse at all times). If the BLP program is insufficient to take over the position, FTX’s guaranty fund (which is funded fully by FTX in cash and has no assessment authority over any other trading participant, clearing member or otherwise) provides a backstop pool of capital to wind-up and close-out the position.
As noted above, many of the questions that FUSD has received in connection with its 24x7 risk model and its $250 million guaranty fund relate to perceived uncertainty about how it may work in times of stress and/or volatility. Fortunately, through FTX’s experience running the FTX.com trading platform over the last several years, we have objective and historical data based examples to demonstrate its performance.
Mapping the FTX.com Risk and Clearing Model Experience to the FUSD Proposal
The following core facts underscore our confidence in the implementation of the FTX.com risk and clearing model as it has been proposed by FUSD:
- While average daily volume ranges from $10 billion to $20 billion notional, per day, FTX.com has traded up to $50 billion / day of notional volume and has held up to $11 billion in notional open interest at one point in time.
- Over the last three years we have experienced single-day bitcoin price moves of up to 38%, and the insurance fund has paid out a net total of $9.5 million (across that entire time period).
- Generally, FTX.com operates on a 5% collateral threshold requirement.
- The single biggest daily drawdown from the FTX.com insurance fund was $4.7 million, on a week that the bitcoin price moved down 38% – notably, that drawdown was less than FTX.com’s revenue for that day.
- Had FTX.com set margin requirements as high as we plan to for our US platform, the insurance fund would not have had a drawdown at all and instead, over time, we would have actually added to the fund.
- Had FTX.com set margin requirements to the low end of the range we anticipate requiring in the US - say, 15% - the single biggest daily drawdown would have been $1.7 million.
FTX’s experience running the FTX risk and clearing model provides very strong support for concluding that “it works”, particularly as it is proposed to be implemented at FUSD. The FUSD default fund is super sized ($250 million versus a historical draw of less than 1% of that on FTX.com). In the US, the initial margin collateral requirements are meaningfully higher than the initial collateral thresholds used on FTX.com, meaning that we anticipate draws to be even smaller.
Nonetheless, we have already committed to growing the guaranty fund’s minimum size as activity on the platform grows: Instead of fixing the fund’s size to sustain the failure of the largest clearing FCMs (“Cover 1” or “Cover 2”), we have instead voluntarily committed to cover 10% of total outstanding initial margin, up to a “Cover 3” standard if required. This is substantially more conservative than is required by regulation.
Regarding the risk engine’s auto-derisking feature, two questions often come up: (1) does the risk engine promote pro-cyclicality in the market; (2) what implications does the risk engine’s behavior have for systemic risk and contagion; and (3) is there a way for an investor to opt out of the auto-derisking feature of the risk engine. First, FTX has built in risk-mitigating protections to address procyclicality, including price bands, position limits and concentration charges on platform users whose positions reach a certain threshold – all of these features together restrain the extent to which market prices will move in response to the risk engine liquidating a customer position.
The anti-procyclical nature of the FTX.com margin model has been proven over time: Orderly liquidation of undercollateralized positions has been refined and tested through multiple high volatility days and periods over recent years. The risk engine is also built to wind down positions in an orderly manner, limiting its activity to a small fraction of overall market volume so as to avoid undue temporary impact.
Second, by quickly unwinding the riskiest, most undercollateralized positions, the risk engine prevents build-up of credit risk that could otherwise cascade beyond the platform, resulting in contagion. Because the risk engine operates 24x7, moves in the underlying cash markets, which are also 24x7, do not result in excessive credit risk buildup in derivatives markets. This is especially true during overnight, weekend or holiday times, when traditional derivatives markets remain closed. Instead, the platform reduces systemic risk by closing down or otherwise re-collateralizing these positions in real-time (as described below).
Third, the FUSD platform offers multiple methods for connecting to the platform, including through an FCM – indeed, the FTX.com platform has brokers connected to the platform today. For users that connect through an FCM to FUSD, there are a variety of methods the FCM could deploy to “shield” an investor from auto-derisking of her position, including the fee-service of re-collateralizing to the investor’s account as necessary to prevent liquidation of the position.
No one is more interested in ensuring that the risk and clearing model holds up in even the most extreme of conditions than us, as we are backstopping it with the guaranty fund. FTX.com’s experiences have allowed the FUSD risk team to build a model that is time tested and exceptionally persistent (however measured, across any number of quantitative metrics). The chart below helps illustrate these points in a striking way: Based on historical data, the FUSD guaranty fund would have actually grown in size over time if the FTX margin model had been in operation over the past 3 years, under our anticipated minimum US initial margin requirements.
Above, a graph over the lifetime of FTX.com of the performance of its risk engine. The yellow line is a $250m initial guaranty fund size; the blue line is the empirical performance of the FTX.com insurance fund, and the orange line is the performance the insurance fund would have had if it had required 15% margin, which is on the lower end of FUSD’s anticipated range. The fluctuations are small under both the FTX.com and FUSD risk models, and under the FUSD model the guaranty fund actually grows over time. For reference, the gray line is FTX.com’s cumulative historical revenue. Net movements in the guaranty fund are less than 1% of the initial size and less than 1% of the revenue FTX.com collected over the period.
- FTX International trades up to $50b/day of volume and up to $11b open interest.
- Over 3 years with single-day market moves of up to 40%, the insurance fund has net paid out a total of $9.5mm.
- If we required 15% margin instead of 5% and limit to BTC/ETH -- which we anticipate our US application likely requiring -- the insurance fund would have net *gained* $51mm.
- The singles biggest drawdown was $4.7, in the middle of a week that markets were down 50%.
- If we required 15% margin and limit to BTC/ETH, the single biggest drawdown would have been $260k.
As shown above, given even the minimum anticipated margin levels we expect for US operations, our guaranty fund would have had a large (+$45MM) gain over time.
We are grateful for all of the questions, comments, and feedback we have received from the CFTC, FCMs, and futures and cryptocurrency communities about our proposal. It is absolutely essential for the safety of derivatives markets that there is a high degree of investigation, scrutiny, and oversight of any margin model, new or old, and we are grateful for the time (thousands of staff hours), thought, and energy that the CFTC has put into evaluating our application over the past year. Our goal is to increase choice and competitiveness in US futures markets: to give users multiple ways of accessing a platform; traders multiple sophisticated options for risk models; and the ecosystem multiple platforms to choose from: all subject, of course, to the careful oversight and evaluation of appropriate regulatory bodies, including the CFTC.