Financial big shots question algorithmic liquidation causing flash crashes, SBF explains mechanism and fires back sarcastically, what are they arguing about?

The U.S. Commodity Futures Trading Commission (CFTC) held a public roundtable meeting in Washington D.C. on May 25, where representatives from the derivatives trading industry gathered to discuss the "no-intermediary trading" proposal put forward by the FTX exchange. As expected, FTX founder SBF faced strong scrutiny from traditional futures merchants and brokers. What are the concerns raised by the traditional financial sector regarding this proposal? SBF has something to say in response to these concerns!

In March of this year, FTX submitted a proposal to the CFTC to use algorithms to replace traditional Futures Commission Merchants (FCMs). The approach involves requiring clients to deposit collateral and calculating margin positions on a rolling basis. If the margin ratio falls too low, FTX will start liquidation within seconds.

The two sides engaged in heated debates during the roundtable meeting.

Opponents of the proposal, such as CME (Chicago Mercantile Exchange) and FIA (Futures Industry Association), believe that algorithms cannot handle "unexpected situations" and that human intervention is still necessary at times. On the other hand, proponents argue that 24-hour real-time liquidation can provide better risk management capabilities.

SBF stated that this approach would require clients to deposit collateral/margin with the Derivatives Clearing Organization (DCO) before establishing positions, which differs from the current setup where DCOs are responsible for managing clearing members (FCMs), who are in charge of margin calls.

"The way I envision it is that clients would deposit margin with the DCO before establishing positions, and this margin would serve as collateral, instead of relying on the credit of FCMs. In this model, the DCO can efficiently operate risk management models, which means anyone can trade." However, the opposition clearly disagrees.

CME Executive Director Sean Downey believes that replacing human intervention with algorithms is based on many assumptions and overly relies on the margin system, but margin and capital are two different things. Insufficient capital in the system can lead to cascading liquidations and flash crashes when volatility exceeds the "price range."

[Note*1]: FCMs can accept futures trading orders, collect margin from clients, and provide trading and settlement services to other intermediary institutions.

Where is the crux of the matter?

Currently, the traditional way of clearing futures involves FCMs being responsible for collecting and margin calls, providing anticipatory funding services in special circumstances or for special clients to ensure their positions are not liquidated.

Although the opposing party does not agree with algorithmic clearing, it is interesting that both sides agree that algorithmic automatic clearing can be applied to cryptocurrencies. The real controversy lies in whether applying algorithmic automatic clearing to other commodity clearings will cause market turmoil.

According to FTX.US's policy explanation, if FTX's proposal is approved, the CFTC-regulated DCO (Derivatives Clearing Organization) can provide users with the aforementioned services. In other words, DCO can apply this clearing method to other commodities in the future, which is what the opposing party is truly concerned about.

In addition to the significant benefits of eliminating FCMs, physically delivered futures are not entirely suitable for automatic clearing. As mentioned earlier, once the volatility exceeds the price range, liquidation may be triggered, potentially causing a flash crash or spike in commodity prices.

Nelson Neale of the National Farmers' Cooperative Committee stated that although automatic clearing is well suited for cryptocurrencies, it is not a good solution for those who rely on stable energy or food prices.

"Under the automatic clearing method, (price volatility) can be very bad for crypto traders (meaning liquidation), but for American farmers, the situation would be far worse."

SBF has something to say

Although the roundtable discussion was not short, it still could not fully address all parties' opinions, so SBF supplemented with a tweet after the meeting. In response to criticism of insufficient system capital, SBF countered that FTX had capital deposited: "We have deposited capital in this system. Recently, we have deposited $250 million in the system, so capital is not the issue."

SBF also emphasized that FTX has a "price stabilization mechanism" (Price Bands) in place: "Price bands can prevent flash crashes. We have price bands in place, I don't know why some people think we don't."

Next, SBF spent a lot of time explaining the differences between FTX's algorithmic clearing and traditional models.

SBF stated that the practice of depositing margin in advance actually better protects customers, avoiding systemic risks, with FTX's existing tens of billions in assets serving as collateral (margin).

He also agreed with ICE's viewpoint that the system should allow third parties to provide credit to clients with clearing risks.

However, SBF emphasized that the emergency credit in this system uses third-party assets, not funds from other users in the system, and because it is "real-time clearing," there is a certain time limit for adding margin.

"To be honest, when DCO risk managers are on the phone with large clients in the traditional model and believe the client's credit choice not to add margin is actually risking other clients' assets, that idea is quite scary!"

In addition to margin, SBF reiterated that FTX also has a reserve fund: "To reiterate, FTX does not rely on credit, so there is no need for additional capital to support credit, but we still have initial margin and a reserve fund."

Strangely, these comments seem to have forgotten an obvious fact that our proposal clearly states that in addition to margin, we also have a reserve fund."

SBF urged that FTX's automatic clearing mechanism is not against traditional FCMs.

He also understands that when it comes to "physical delivery," the automatic clearing mechanism may not be suitable for every commodity, but what's important is to return to market mechanisms and let customers choose the exchange and clearing mechanism themselves.

SBF's lengthy tweet was mainly to clarify doubts and explain the operation process and motives behind these mechanisms, but for some incomprehensible comments, SBF still made a few sarcastic remarks.

Regarding CME Executive Director Sean Downey's statement that the traditional clearing mechanism works well and has had no issues to date.

SBF responded with a "LOL nickel," where LOL means laughing out loud, and nickel is a reference to the recent halt in trading by LME due to a nickel crash.

He also seemed dissatisfied with the notion that a roundtable meeting before self-certification is necessary.

Self-certification refers to the process where if the entity is a DCO regulated by the CFTC, the DCO can launch new products before obtaining approval by providing written documentation proving the new product complies with regulations and the necessary pre-approved documents.

If both conditions are met and the CFTC finds no violations, the DCO can launch the new product one working day later.

When CME launched Bitcoin futures in the past, it followed this approach.

SBF sarcastically remarked, "I'm glad to hear that competitors believe a roundtable discussion is necessary before self-certification, so I guess they would agree that every time they self-certify to launch new trades, they should have a roundtable discussion?"

Furthermore, he criticized those who did not fully understand the automatic clearing mechanism but began arrogantly commenting: "They all talk about the need for a price stabilization mechanism! This is to protect users when there is a sharp volatility within a minute. But some people know less about the crypto market than FTX users, and it's ironic to hear them arrogantly comment on protecting users today."

Both sides have different clearing logics and are still seeking consensus.

Overall, the clearing directions of both sides differ.

For traditional finance, the volatility of derivative products "usually" is not as high as that of cryptocurrencies, and customers seek capital efficiency. Therefore, they hope to review user credit through FCMs. As long as customer credit is sound, and FCMs can provide clearing funds on their behalf, this clearing model is acceptable.

However, for the volatility of the crypto market, the clearing system designed by FTX requires margin collateral and real-time clearing. The advantage is that there is no need for third parties, so there is no risk of FCMs using other clients' funds for speculation.

If we were to use the analogy of operating a hotel, the traditional financial mindset is akin to confirming the identity of guests and having a claims process, so even if a guest's funds are insufficient, the hotel can advance the fees and earn interest.

On the other hand, SBF's idea is that guests might damage the equipment in the hotel room, so they require a deposit. The hotel will only return the deposit to the guest after confirming that the equipment has not been damaged upon checkout.

Therefore, SBF believes it is important to return to market mechanisms and let customers choose the exchange and clearing mechanism themselves, but innovation is bound to spark opposition.

As SBF summarized in his tweet, FTX has done some things right. "I think if what we are doing can make everyone here debate, argue, and learn, then we must be doing something right. Without the hard work of Zach, Brian, Julie, and the entire team, we could not have come this far."