Streetwise Professor

March 11, 2022

Direct Clearing at FTX: A Corner Solution, and Likely a Dead End With Destabilizing Potential

In a weird counterpoint to the LME nickel story, another big clearing-related story that is causing a lot of consternation in derivatives circles is FTX exchange’s proposal to move to a direct clearing model that would dispense with FCMs as intermediaries. Instead of having an FCM interposed between a customer and the clearinghouse, the customer interfaces directly with the FTX Derivatives Clearing Organization (DCO).

What is crucial here is how this is supposed to work: FTX will utilize near real time mark-to-market and variation margin payments. Moreover, the exchange will automate the liquidation of undermargined positions, again basically in real time.

The mechanics are described here.

FTX describes this as being the next big thing in the derivatives markets, and a way of addressing systemic risks. Basically the pitch is simple: “real time margining allows us to operate a pure no credit/loser pays system.”

FTX touts this as a feature, but as the nickel experience demonstrates (and other previous episodes demonstrate) it is not. Margining generally can be destabilizing, especially during stressed market conditions, and the model FTX is advancing exacerbates the destabilizing potential of margining.

The mechanical means of addressing margin shortfalls on a real time frequency increases the tight coupling on the exchange, and is tailor made to create destabilizing positive feedback loops: prices move a lot leading to margin shortfalls in real time that trigger real time trades that accentuate the price movement. It is like seeding the market with huge numbers of stop orders, which are inherently destabilizing. Further, they can create incentives to manipulate. Anyone who can get some idea of where the stops are can “gun the stops” and trigger big price moves.

This instability potential can be exacerbated by the ability of traders to hold collateral in the form of the “underlying” (i.e., crypto, at present). Well, the collateral value can fluctuate, and that can contribute to margin shortfalls which again trigger stops.

Market participants can mitigate getting stopped out by substantially over-margining, i.e., holding a lot of excess margin in their FTX account. But this is a cash inefficient way of trading.

It’s not clear to me whether FTX will pay interest on collateral. It seems not. Hmmm. Implementing a model that incentivizes holding a lot of extra cash at FTX and not paying interest. Cynic that I am, that seems to be a great way to bet on higher interest rates! Maybe that’s FTX’s real game here.

I would also note that the “no leverage” story here reflects a decidedly non-systemic view (something that I pointed out years ago in my critiques of clearing mandates). Yes, real time margining plus holding of substantial excess margin reduces to a small level the amount of leverage extended by the CCP/DCO. But that is different than reducing the amount of margin in the system as a whole. People who have borrowing capacity and optimal total leverage targets can fund their deposits at FTX with leverage from other sources. They can offset the leverage they normally obtain from FCMs by taking more leverage from other sources.

In sum, FTX is arguing that its mechanism of direct clearing and real time margining creates a far more effective “no credit” clearing system than the existing FCM-intermediated structure. That’s likely true. But as I’ve banged on about for years, that’s not necessarily a good thing. The features that FTX touts as advantages have very serious downsides–especially in stressed market conditions where they tend to accelerate price moves rather than dampen them.

Insofar as this being a threat to the existing intermediated system, which many in the industry appear to fear, I am skeptical. In particular, the cash inefficiency of this mechanism will make it unattractive to many market participants. Not to be Panglossian, but the existing intermediated system evolved as it did for good economic reasons. It trades off credit risk and liquidity risk. It does so in a somewhat discriminating way because it takes into account the creditworthiness of market participants (something that FTX brags is unnecessary in its system). FTX is something of a corner solution that the market has not adopted despite the opportunity to do so. As a result, I don’t think that corner solution will have widespread appeal going forward.

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  1. Direct settlement? Why not add collateral? That way we can change Shakespeare: “Once more into the shit house!”

    Jesus wept!

    Comment by Sotosy1 — March 12, 2022 @ 10:34 am

  2. This could work if the collateral is fully trackable i.e. digital dollars each one with its own full transaction history. That would make the 2008 situation theoretically impossible? FTX not being concerned with capital efficiency of their clients is not surprising – that term does not exist in the crypto space.

    Comment by LinkScalper — March 16, 2022 @ 4:52 am

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