Introduction
On March 10, 2022, the Commodity Futures Trading Commission (CFTC) released a notice requesting public comment on a request by LedgerX, LLC d.b.a FTX US Derivatives (FTX US) for amendment to its registration as a derivative clearing organization (DCO). The amendments would permit clearing of margined products directly by participants on a non-intermediated basis, without use of a futures commission merchant (FCM) clearing member. The release also notes that similar questions have been received by the CFTC from current DCOs and potential DCO applicants.
Background on DCO Clearing Models
There are currently fifteen registered DCOs, with most operating under a model that includes three features: margined products, intermediated clearing, and mutualized loses.
Margined Products
DCOs that offer margined products collect a specified portion of the possible counterparty losses, and as such are at risk of having to cover the obligations to the member that holds the opposite position in the case of a counterparty default. To address this risk of potential loss, a DCO will employ a margin model that will determine an initial margin requirement and maintenance margin requirement that is intended to estimate potential future exposure to a specified confidence interval. In contrast to this model, there are four registered DCOs, including FTX US, that operate under a model that clears only fully collateralized trades. DCOs that offer this product hold 100% of the potential loss as collateral and do not separately collect initial margin.
Intermediated Clearing
Under an intermediated DCO model, most market participants (other than certain participants that choose to self-clear) are customers of an FCM intermediary. The FCM acts as the direct clearing member of the DCO and is responsible for all financial obligations to the DCO with respect to its customers’ transactions. By contrast, a non-intermediated model would have all market participants effectively acting as self-clearing members. Out of the fifteen registered DCOs, there are only four that do not employ an intermediated clearing model.
Mutualized Loses
Many DCOs can effectively mutualize losses through sharing the risk of counterparty default with all clearing members under the default waterfall. In its traditional form, the default waterfall will use contributed funds of all clearing members to create a guaranty fund. This fund will then be used to cover default losses that are greater than the resources the defaulting clearing member has to provide. Of the DCOs that offer margined products to customers, only two do not mutualize losses through the use of a guaranty fund. Rather, these two DCOs cover excessive default losses through holding private capital in a reserve and maintaining an accessible line of credit secured by a default insurance policy.
FTX US Proposal
FTX US has requested an amended order of DCO registration to permit it to clear non-intermediated margined products. Currently, FTX US operates under a non-intermediated model and clears futures and options on futures contracts on a fully collateralized basis. This amendment would allow FTX US to offer margined products to retail participants while only requiring that the participant post the margin required for a given position. As such, participants of FTXUS’s products would have two margin requirements: initial margin and maintenance margin. There would not be a mutualized guarantee fund.
Under FTX US’s model, the participant’s margin requirement will be recalculated every 30 seconds as positions are marked to market. If the provided collateral does not meet the required maintenance margin, an automated system will initiate a liquidation process. During liquidation, 10% of the portfolio will be liquidated at a time through the placement of offsetting orders on the central limit order book and can be stopped once the collateral exceeds the maintenance margin requirement. FTX US’s automated system also creates a full liquidation threshold based on a specified percentage of the notional value of the given position. Once this threshold is breached, FTX US will liquidate the remainder of the participant’s portfolio.
FTX US does not propose the use of mutualized loss-sharing in its default waterfall. Instead, in order to ensure full liquidation of the participants portfolio, FTX US intends to enter into agreements with backstop liquidity providers. The backstop liquidity providers will proactively establish a set number of positions to be accepted and will receive the remaining margin deposit for the given position once the full liquidation threshold is triggered. In addition, FTX US will also privately fund a $250 million guaranty fund. The fund is intended to cover any excessive losses sustained through positions beyond those positions accepted by the backstop liquidity providers and reimburse the backstop liquidity providers when the participant’s margin deposit is inadequate to cover the value of the participants portfolio when fully liquidated.
Issues for Consideration
The CFTC’s request for public comment includes specific questions and policy issues raised by the proposed method of use of a non-intermediate model. Although there are numerous questions presented, the following are highlighted as significantly important:
- Does FTX US’s approach, when considered in light of its proposed methodology for liquidating participant portfolios, adequately protect the integrity of the DCO?
- How should financial standards for the DCO be assessed in a non-intermediated model?
- What is the appropriate equivalent of the cover 1/cover 2 standard currently used for measuring required default resources?
- How should DCO resources be assessed in the absence of a mutualized guarantee fund?
- What retail/customer protections should apply in a non-intermediated model?
- Existing CFTC segregation rules for customer property would not apply. Should something similar be imposed?
- What disclosures should be provided to customers?
- Are there equivalents to FCM capital requirements that should be applied? In what way and to what entities?
- How does DCO default management differ in a non-intermediated, non-mutualized model model?
- Does liquidating positions without requesting additional funds from the participant present risks or concerns in a regulated market?
- What standards should apply to liquidity providers relied on in a non-intermediated model?
- Do default management tools currently contemplated for end of waterfall need to be modified (such as assessments, auctions, partial tear-ups, variation margin haircutting)?
- What potential broader market structure issues may arise from the establishment of a non-intermediated model for retail participants in which transactions are not fully collateralized?
- What potential impacts, if any, would these issues have on FCMs or on existing markets with FCM intermediation?
- Would there be positive or negative effects on market liquidity?
- By potentially expanding the number of people able to participate in derivatives markets, does a non-intermediated model have an effect, positive or negative, on price discovery and efficiency?
The full list of questions can be accessed here.
Next Steps
The CFTC recommends that potential public commenters review FTX US’s documents, available here, prior to providing comments. Comments may be submitted electronically through the CFTC’s Comments Online process. All comments received will be posted on the CFTC website. The comment period has been extended until May 11, 2022.
