FTX is looking to shake up the sprawling U.S. derivatives market, marking the biggest push yet by a crypto group into the heart of traditional finance.
The three-year-old exchange, founded by Sam Bankman-Fried, is seeking approval from the U.S. Commodity Futures Trading Commission to offer clients bitcoin futures contracts — contracts that allow users to bet on the price of the most actively traded digital token in the world. If the group is successful, it could reshape the mechanics of a market used by everyone from farmers fixing corn prices to hedge funds betting on oil prices.
The proposed process would eliminate brokers who, for the past 40 years, have acted as intermediaries between clients and the exchanges where trades are made. Rather than asking customers to put in extra cash, called margin, when trades go bad, the exchange would automatically monitor the market, 24/7, and debit customer balances accordingly.
This process is already used on mostly unregulated offshore crypto platforms such as Binance and FTX, but requires regulatory approval in the US market. America accounts for a large chunk of the global futures market where 29 billion contracts were traded last year, meaning that if FTX’s plans are approved, its effects could be far-reaching.
Automatic Liquidations vs. Margin Calls
At the heart of the existing system and FTX’s proposal is leverage. Futures traders typically only deposit a small fraction of their overall position value, magnifying potential gains and losses. The chips that market participants place on the table are called “margin”. Margin is essential in leveraged trading because it ensures that if a bet goes sour, the participant on the other side of the trade can be cured.
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A key difference between the incumbent system and the FTX proposal is the margin approach. Under the current framework, when a bet falls too deep under water, a broker will ask a trader to find additional funds to support the trade, known as a “margin call”, within a certain time frame. If the trader responds to the margin call, their trade remains open, otherwise the broker will start unwinding their positions and taking back the margin used to make the trade.
On crypto exchanges such as FTX and Binance, margin requirements on products such as bitcoin futures are constantly updated. Traders deal directly with the exchange rather than through a broker.
Crypto platforms automatically start unwinding positions if a user’s margin falls below a predetermined level. Typically, a user will receive an alert if their account is in danger, but given the volatility of digital assets, these types of forced liquidation events can wipe out traders extremely quickly.
Unlike crypto, which trades non-stop, most traditional futures contracts such as those that track commodities close on weekends. However, since most trade efficiently all the time during business days, some smaller market players have said they fear being wiped out during off-peak hours under the FTX proposal. A margin call, on the other hand, provides some leeway to meet funding needs.
Case study: May 2021 crypto “flash crash”
Automatic liquidations are already widely used in the crypto industry, where $1.3 billion in bitcoin futures transactions took place in the last month alone. Traders can be wiped out extremely quickly during times of market turmoil, with more leverage increasing the speed at which a user is forcibly liquidated.
The case study below is based on a “flash crash” about a year ago that caught many leveraged bitcoin traders off guard. The trader in this illustration took a 100x leveraged position on Binance by depositing $2,500 on a trade with a theoretical value of $250,000. When the market begins to crash, they have to pump in more and more money to avoid being liquidated despite the rapid price rebound.
The brief slump, which took place in May 2021, left many retail traders with heavy losses. However, due to automatic liquidations, market participants can usually only lose what they lose on the trade instead of going into debt.
The FTX plan has sparked fierce debate in the United States since the CFTC opened a consultation in March.
Proponents of the FTX proposition believe this is the next evolution of the market, as technology inevitably advances in markets as well as the rest of society. It promotes competition, democratizes futures trading and, just as importantly, protects small investors from piling up debt they can’t afford, which has sometimes led to tragic consequences, proponents say.
On the other side of the debate are those who say the traditional system provides vital “breathing space” to make important decisions and time to find extra money. A farmer, for example, would not have to worry about sudden market movements liquidating the positions he had opened to hedge against fluctuations in commodity prices. Customers would not have to put more funds than necessary, just to give them peace of mind. The intermediaries at the heart of the system, exchanges and brokers, would be able to use human judgment to iron out potential problems in times of volatility.
The CFTC is looking at every step of the chain to understand how it’s going to work and the consequences, so it’s taking its time. A decision may not come this year. It is possible that it allows both models. But as investors explore bitcoin futures, they might face more offers.
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