Crypto Exchanges Set Their Sights On The Sleepy Futures Industry

The U.S. futures industry is slow to change and has seen its footprint consolidate around fewer firms over the years. The number of futures commodity merchants (FCMs) as of the latest period, March 2022 stood at 61 firms, compared to 64 in 2017, 116 in 2012, and 171 in 2007. FCMs are dedicated firms that can transact at derivatives exchanges.

Much of this consolidation was regulatory-driven under the watch of Gary Gensler, the same man now at the helm of the U.S. Securities and Exchange Commission (SEC). Gensler led the Commodity and Futures Trading Commission (CFTC), the derivatives industry’s primary regulator from 2009-2014. Now, with the launch of CME GroupCME bitcoin futures in 2017 and other crypto futures and options contracts in subsequent years, crypto derivatives gained a foothold in the U.S. and validated the hypothesis that institutions have a steady appetite for trading crypto futures, driving as much as $6.7 billion daily volume this year. CME crypto futures open interest - capital tied up to support futures trading activity - has ranged between $2 billion and $7 billion so far this year.

This honeypot has caught the eye of crypto exchanges.

Blood in the Water

Three acquisitions of CFTC-regulated entities over the past 18 months by FTX.US, the U.S. affiliate of Bahamas-based FTX, by publicly-listed giant Coinbase (NYSE: COIN), and by the Cboe exchange illustrate how news of the CME Group crypto success traveled fast. These firms plus crypto exchanges Kraken, Gemini, and Coinbase want to popularize crypto derivatives trading at the retail level.

One of their bigger objectives is to see the U.S. capture a large portion of the crypto perpetuals and futures markets - two types of derivatives contracts - which today trade at crypto exchange Binance and unregulated exchanges abroad.

Lucky for U.S. crypto exchanges, the CFTC under Chair Rostin Behnam communicated to Congress early this year the agency’s request for funds to have a bigger role overseeing spot crypto in addition to crypto derivatives. The agency clearly wants to have the muscle to handle this growing industry.

Canary In The Coal Mine

These turf battles are now spilling into the open. A March 2022 FTX.US proposal to modify the firm’s CFTC license and become authorized to offer margin derivatives products to retail clients is now in front of the CFTC awaiting approval. In layman’s terms, these contracts would let Robinhood-type investors borrow funds to make leveraged bets on the future price movements of assets such as bitcoin or ether. The rewards can be substantial, but so could the risks.

Much of the traditional futures industry strenuously objects this particular proposal as presently constituted, and sees it as a Trojan horse that would give FTX.US leeway to pursue growth in any asset class, not just crypto.

The first of two battles in the month of May over this proposal took place last week. FTX’s CEO Sam Bankman-Fried appeared before the House of Representatives’s Agricultural Committee and was joined by the CEOs of the Chicago-based CME Group, the Atlanta-based Intercontinental Exchange (ICE), and the Futures Industry Association (FIA).

A visibly angry Terry Duffy, CME Group’s CEO, came out guns blazing during his initial five-minute testimony railing against the FTX.US proposal while sitting just inches away from Bankman-Fried:

“Under false claims of innovation that are a little more than cost-cutting measures, FTX is proposing a risk management clearing regime that would inject significant systemic risk into the U.S. financial system.”

After that initial salvo, Duffy used just about every question raised by the Committee to give multiple reasons why the FTX.US proposal was a bad idea and why the CFTC shouldn’t be conducting (and Congress shouldn’t let it carry out) this type of interpretation of its mandate to regulate futures activity. Mr. Duffy’s voice reflected urgency and alarm, while that of Bankman-Fried came across as composed and matter of fact.

Some of the specific points raised by the CME Group and supported most of the time by ICE and FIA during the hearing, included:

• The Direct-to-Investor model where exchanges onboard clients without help from FCMs is bad for consumers (even though CME Group admitted it too had pursued the same model until it was reportedly ordered by the CFTC to abandon it)
• Auto-liquidation of clients when they have reached a margin call is not good for investors and can augment cascading sell-offs
• FTX.US has at least one backstop provider to provide liquidity when needed, but that arrangement lacks clarity or a binding commitment on the part of that entity
• The proposal has analytical gaps that show its lack of thoroughness following the risk management and compliance practices under what are called Principles for Financial Markets Infrastructures (PMFI)

The list of objections against the proposal was lengthy and mirrored what traditional finance firms and advocacy groups brought up in their comment letters on the CFTC site by the May 11 deadline. Most institutional comment letters were short, one to four pages. The CME Group comment letter was in a category of its own at more than 40 pages long.

Conversely, the CFTC received hundreds of letters from retail users - most in support of the proposal - and many institutional letters in support like those of crypto exchange Gemini, trading firms Susquehanna, Virtu, and DRWDRW, and investment firm Softbank. The arguments in favor of the proposal praised things like:

• Direct-to-Investor is good and desirable
• A risk management approach that checks sufficient funds 24/7/365 every second is better at responding to market risk than current solutions and it lets regulators see exposures at any time
• Auto-liquidation has been battle-tested and works as intended
• More choice - the CME Group has a de-facto crypto derivatives monopoly in the United States - is a good thing and is needed
• Free market data contained in the FTX.US proposal is great considering that data is big business for most exchanges ($152 million data revenue on $1.3 billion Q1 2022 revenue for the CME Group); with free data there is greater transparency and equal access to insights

During the next May battle - a May 25 live CFTC roundtable from 9:30AM to 4:00PM ET - academics, industry participants, and others will be able to make their voices heard in favor and against the measure. We anticipate more intense efforts from the CME Group and like-minded established futures firms and advocacy groups asking for a disapproval of the proposal or at least a conditional approval with more limits and requirements before it is implemented.

In the runup to the hearing tomorrow, a CME Group spokesperson reiterated to Forbes some of Duffy’s hearing comments, that “FTX is proposing a ‘risk management lite’ clearing regime that would inject significant systemic risk into the U.S. financial system.” Furthermore, they added that approval of the proposal would result in the removal of up to $170 billion of loss-absorbing capital from the cleared derivatives market and “more importantly” it would eliminate the model of mutualized risk and market participant capital requirements. FTX did not yet respond to a request for comment.

Key Takeaways

The CFTC has not decided whether it will support the FTX.US proposal and has welcomed all feedback, but the mere fact that it has engaged with FTX.US during “tens of thousands of hours” and exchanged more than a thousand documents, as stated by Sam Bankman Fried last week means that the commission is taking the proposal seriously.

This prospect of change is likely the reason why the CME Group comes across so strongly against the proposal. Duffy’s pleas to the Agriculture Committee members and separately to Chair David Scott (D-GA) during closing remarks revealed a level of desperation that is rarely seen. Calling it an existential threat to the CME’s current model is not an overstatement. As an additional point, crypto exchanges have millions of retail clients on their books, whereas the CME Group has none, but there are thousands of retail customers who trade actively at a CME Group platform through FCMs.

Duffy’s responses also let us know that it doesn’t have to be FTX.US who aims to carve up areas in which CME Group operates. It could be any like-firms that use the same broader license that could be granted to FTX.US. Thus, these firms would compete with the CME Group but with less restrictions and lower costs to users than at the CME Group, which would cause a massive flight of clients to these new entrants if it didn’t respond in kind.

Last week, the CME Group stated clearly that it too would adopt the Direct-to-Investor model without FCMs if the FTX proposal is adopted. However, given its institutionally focused setup, it would need to make some dramatic changes and investments in areas such as client onboarding and customer service.