Risk Management, Process, and the Future – An Update
FTX US Derivatives (FUSD) has an application before the U.S. Commodity Futures Trading Commission (the “FTX Application”) that would amend its existing license to operate a clearing house, or “designated clearing organization” (DCO) in CFTC parlance. If approved, the FTX Application would allow FUSD to offer margined futures products referencing Bitcoin (BTC) and Ethereum (ETH). These futures products are available today on other CFTC-licensed venues.
The Resiliency of FTX System Under Duress
One of the key considerations for any license to operate a DCO is the adequacy, appropriateness and resilience of the risk-management system that the DCO intends to operate. FTX has written before about some of the key features of the risk management system that are part of the FTX Application materials and are modeled after the risk-management system operated on the international FTX.com platform.
Our April 2, 2022 article unpacks the methodology behind the sizing of the FTX guaranty fund (see https://www.ftxpolicy.com/posts/guaranty-fund), an important component of the overall system and especially so in the case of one that does not need to rely on clearing members (“futures commission merchants” or FCMs) to manage risk. On April 12, we further explained how features of the FUSD risk model might have prevented recent market failure which unfolded on a traditional exchange (see https://www.ftxpolicy.com/posts/risk-management).
In the meantime, the debate about the FTX Application has continued in policy making circles, including through the related CFTC request for information that ended on May 11, 2022 (see https://www.cftc.gov/PressRoom/PressReleases/8499-22), and a hearing before the House Committee on Agriculture on May 12, 2022 (https://agriculture.house.gov/calendar/eventsingle.aspx?EventID=2496). FTX is encouraged by the level of interest in the FTX Application and welcomes this debate.
From a policy and compliance perspective, the CFTC’s goal in reviewing the FTX Application (or any clearinghouse license application) is to ensure that a risk-management system deployed by a clearing house is as effective and resilient, and the agency approaches its review through the CFTC’s Part 39 regulations and ultimately determines whether any risk-management system complies with those requirements. These rules provide core principles that govern and inform the CFTC’s review, and they also allow discretion to the clearinghouse regarding the particulars of the design.
But the CFTC’s, clearinghouse’s, investors’, and the public’s goals are all aligned in this important respect: each wants the clearing house risk-management system to work, especially under unusual market circumstances. Indeed, the policy standard reflected in the CFTC’s regulations and a core principle of risk management generally is that a clearing house’s risk-management system should hold up under “extreme but plausible” circumstances.
The best test for any risk-management system is to see how it works in real-life circumstances, especially under such unusual or “extreme” market conditions. In our April 2 post, we explained how the FTX.com platform and its guaranty fund were minimally impacted by the extreme market moves of the most volatile trading days over the last two years.
We have witnessed again such circumstances in recent weeks, and in fact market volatility experienced most recently in both digital-asset as well as traditional equity markets was alluded to during the May 12 House Committee on Agriculture hearing.
The issue of whether a risk-management system is appropriate does not turn on whether there is market volatility, but of course how the system responds to that volatility. The FTX model once again performed exactly how it was supposed to during the recent weeks of market turbulence, with no operational disruptions and minimal impact on the guaranty fund.
To review, the FUSD risk-management system being considered by the CFTC presents the same model and system that operates on FTX.com, the international platform that has been operating for over three years. The FUSD risk model, however, is a more conservative model than the one deployed on FTX.com for two key reasons: first, the margin period of risk is 24 hours, consistent with CFTC regulations (even though the risk engine would assess risk every few seconds, leading to the over-collection of initial margin), and second, there are other additional, specific risk add-ons to the model required by CFTC rules. We should expect, therefore, that the FUSD system would perform as well or better on key metrics such as transactional activity from de-risking of positions by the risk system, or impacts to the guaranty fund.
On May 12, 2022, FTX.com saw the most significant market moves for Bitcoin (BTC) and Ethereum (ETH) since around this time last year. There were several days in recent weeks when trading volumes for BTC and ETH exceeded $10 billion in the aggregate on the platform. As was seen during a similar period last year, the trading day this year with the biggest market move for BTC (-11%) and ETH (-20%) experienced overall elevated trading volumes, but saw de-risking transactions performed by the risk engine that were still only a very small fraction of overall trading volumes for those assets (~o.6%). Draws on the guaranty fund were a small fraction of the guaranty-fund size – $250 million – in support of the FTX Application: ~0.16%.
Again, the FTX Application reflects an even more conservatively designed risk model than what is used on FTX.com, which means that transactional activity from de-risking as well as draws on the guaranty fund both would be lower using that model – higher initial-margin requirements would result in fewer de-risking transactions, as well as fewer draws on the guaranty fund.
The DCO Application Process
In the beginning of December 2021, FTX submitted the FTX Application to allow FUSD to clear margined futures contracts. The submission was made after many months of informal discussions with the CFTC staff, and after voluminous materials were created in support of the application and made part of the submission. Those discussions led to various adjustments and edits to the materials during the process.
As is the norm, FTX requested confidential treatment of key parts of the application. Because of this, there is substantially more material from the application that is not public, as is nearly always the case.
We are not aware of another instance where a DCO application was the subject of a public comment period, the focus of two congressional hearings, as well as a public, CFTC-staff roundtable discussion; and there is no recent history of DCO applications requiring rulemaking as some have mentioned.
FTX is delighted to engage in public discussions about the FTX Application in any venue. In every step of the process FTX has followed CFTC regulations.
CFTC regulations require that the agency review the FTX Application pursuant to the 180-day time frame and procedures specified in Section 6(a) of the Commodity Exchange Act and CFTC Regulation 39.3, and approve or deny the application. The agency, however, also can extend its review under the same regulation. The FTX Application was submitted nearly 180 days ago. We understand that while the rule-based timeline for review of the application is near at the time of this writing, the CFTC might need more time to complete its review, and FTX is happy to accommodate. In fact, this is often the case for DCO applications.
But the facts should make clear that the CFTC has followed an unprecedented public process in considering the FTX Application. FTX takes no issue with this approach – we are happy to be part of any procedure that better informs policy makers and other stakeholders, particularly when it could lead to the best outcome, and are encouraged that the CFTC has taken such a deep, thoughtful, rigorous approach. But the record should reflect that the existing process for reviewing FTX’s application has already been extraordinary – the public nature of which is what is unique here.
We remain committed to transparency, public engagement, and excited about the future of digital-asset markets and FTX’s role in them here in the U.S. The public and the markets have spoken through the comment period and have expressed overwhelmingly positive feedback in support of the FTX Application – more than 1400 comment letters were filed, with more than 98 percent urging approval. And we remain committed partners to the CFTC regardless of how the FTX Application is resolved.