CME chief’s arguments at FTX hearing raise eyebrows

Terry Duffy’s criticism of exchange’s direct clearing proposal revives debate over ‘skin in the game’

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CME chief executive Terry Duffy’s claims that cryptocurrency exchange FTX has set aside insufficient financial resources to back its proposed direct clearing model for crypto derivatives – made at a US congressional hearing on May 12 – are raising eyebrows in the industry.

FTX’s proposed direct clearing service would see customers post margin directly to the exchange without going through a futures commission merchant (FCM). FTX plans to backstop its clearing house with $250 million of unencumbered cash held at Bank of America. It says that figure is equivalent to 10% of the total outstanding margin that the FTX US Derivatives platform expects to collect from customers and has committed to maintaining this ratio of default resources relative to margin.

In prepared remarks submitted to the House Agriculture Committee, Duffy argued that was not enough. “FTX will have insufficient financial resources to address default events,” reads the written testimony.

Duffy contrasted FTX’s approach with that of traditional derivatives clearing organisations (DCOs) such as CME, which “require clearing members to fund a mutualised pool of resources with knowledge of the risks they assume (in addition to a DCO’s own contribution known as ‘skin in the game’)”.

That argument was met with scepticism by some clearing executives. One industry veteran points out that CME contributes only $100 million of its own cash to its ‘base’ default waterfall, which covers futures, options on futures and over-the-counter derivatives other than interest rate swaps.

“This is the ‘skin in the game’ debate biting him in the ass,” the industry veteran says. “When CME introduced bitcoin futures, they did not increase skin in the game. CME’s skin in the game is notoriously low.”

CME requires clearing members to contribute to its guaranty fund, which provides an additional $5.2 billion of default resources. Taken together, CME’s guaranty fund and skin in the game are equivalent to less than 2.5% of the $212.7 billion in total margin collected by the exchange for futures and other base products.

CME can also call on its clearing members for $14.2 billion of extra funds, known as assessments, in the event a default exhausts its prefunded resources. This brings its total default resources for futures to just over 9% of total margin – still less than the 10% of total margin FTX proposes to pay out of its own pocket.

CME’s Terry Duffy

FTX founder and chief executive Sam Bankman-Fried also contrasted the composition of CME’s default resources with FTX’s proposal. “The $250 million that we have put into the guaranty funds, that’s our own skin in the game – none of that is mutualised. We also require margin [to be] held with the clearing house from all open positions,” he said at the hearing.

The industry veteran makes no secret of which approach he prefers. “Clearing houses have full discretion over the composition of their default resources – they can fill it up with their own funds, through initial margin charged to risk-takers, or they can push it on to other players in the system,” he says. “[Duffy], incredibly, emphasised that he wants to depend on the resources of others, not on initial margin or his own skin in the game.”

But the industry veteran warns against reading too much into the ratio of default resources relative to total initial margin. “It should be modelled to an extreme but plausible stress scenario,” he says, referring to the guaranty fund. “It depends on slippage and liquidity based on the ability to monitor and collateralise in real time. If markets suddenly freeze and become illiquid, maybe you have an issue.”

The regulators “need to sit down with FTX and model out all the different tail situations that would be extreme but plausible,” he says, “and those exact stresses should be applied to all clearing houses.”

The CME chief executive also criticised FTX for what he described as a “failure to use appropriate stress scenarios for sizing financial resources”.

FTX’s proposal is currently being reviewed by the US Commodity Futures Trading Commission, which has sought public comment on the plan.

Duffy’s broader point was that by cutting FCMs out of the equation, FTX’s direct clearing model also “eliminates potentially billions of dollars of loss-absorbing resources that are currently a feature of the derivatives market.

“FCMs, in the aggregate, maintain over $173 billion in adjusted net capital and other resources,” Duffy said in his written testimony.

He also criticised FTX’s plan to automatically liquidate customer positions if they are under-margined instead of calling them for additional collateral. “The FTX proposal to instantaneously auto-liquidate any customer who is under margin at any given moment in time, would jeopardise both market integrity and financial stability,” he said.

He argued this approach would be “a nightmare for the agricultural community”, citing the hypothetical example of a farmer having their hedges automatically liquidated in the middle of the night.

Bankman-Fried countered that FTX “[does] not have plans to launch into non-digital assets” at this time.

Also appearing at the hearing, Chris Perkins, president of CoinFund Management, warned against relying too much on FCMs to intermediate risk and absorb default losses. Despite exponential growth in derivatives clearing, “the number of FCMs has materially decreased over the last two decades from a high of 188 in 2004, to just 61 by 2022,” he said in written testimony. “Meanwhile, segregated client assets have skyrocketed, rising from about $60 billion in 2002 to more than $470 billion today. The obvious result of these two trends is concentration of risk, leaving market participants with fewer choices to access futures markets.”

Perkins, who was previously global co-head of futures, clearing and foreign exchange prime brokerage at Citi, also argued that existing clearing house margin practices – including calling for daily or intraday collateral topups – were ill-suited to the fast-moving cryptocurrency markets.

“During periods of stress, it is common for clearing houses to justifiably call their members for intraday collateral (which generally must be met in one hour according to clearing house rules), leaving unsecured FCMs scrambling to recoup collateral from their clients, often an impossible task,” reads his written testimony. “Unfortunately, this laborious process simply does not reconcile with the speed and volatility of crypto derivative markets.”

Editing by Kris Devasabai