Comment Text:
I am in independent trader and have been active on LedgerX since mid-2020. While my "day job" could best be described as software engineer, I have a long interest in financial markets, have been investing since I was a teenager, and have a deep interest in derivatives in particular. I am currently an active trader on this exchange, was one of the first to begin API trading when they opened it up to non-institutional clients, and currently have a substantial portion of my liquid assets involved in making markets on the exchange.
LedgerX (now FTX US Derivatives) fills an incredibly important role in that it is the only place where most US residents are able to trade derivatives on assets such as Bitcoin and Ethereum.The team at FTX as well as the CFTC have done a fantastic job in creating a safe, regulated market where Americans can trade with reasonable assurances of safety around contract delivery, and the exchange has proven that it is able to run a professional operation over the last few years.
Margin trading is a staple of financial markets everywhere, and the US has generally adopted a fairly conservative (in a good way) approach for retail. I am writing this letter to lend my support for the proposal that FTX has brought to offer margined contracts. Traders on the exchange have a very active public community on Discord, which I participate in. Margin trading is far and away the number one request. I have reviewed the proposal and will make some comments on specific questions momentarily, but first I want to make a case for why margin trading is essential.
As an active trader and market maker, I see firsthand every day the effects of non-margined contracts. Obviously mispriced orders can sit on the order book for hours before getting filled. This is in large part because without margin, it is incredibly capital intensive to make markets. If you want to sell a call, for example, you must have the full collateral on deposit. Without some level of (sensible) margin, larger market makers are unlikely to be attracted to the exchange, volumes will remain low, and so on. This is of course sad for the exchange, but the reason the CFTC should care is because it's bad for the less sophisticated retail investors.
Regarding the Request for Comment, I want to start by saying that the document was incredibly well thought out, and it's hard to express how happy I am to see that the Commisison is considering the proposals carefully and asking the right questions.
Regarding the DCO rules questions, I believe that the Cover-3 standard proposed in the letter submitted by FTX on February 8, 2022 is conservative and well within the spirit of the law. Additionally, the real-time nature of the liquidations should tend to smooth out the risks as different traders will have various account positions. The comparisons with the CME and OCC were quite interesting to me as ALL clearing members represnted only around 20% of initial margin in both cases. I believe the FTX proposal is conservative and adheres to the spirit of the regulation.
I don't think the non-intermediated model holds any special hidden risks, but all derivatives exchanges set position limits to limit the risk of a single large market participant. FTX putting its own capital on the line should be incentive enough to prevent unnecessary risk taking. Question 1b regarding the distribution of particpant exposures and number and size of market makers is quite interesting. I think it would be in the best interests of the exchange to take this into account, but any regulatory statement would by necessity be rather broad. I am not aware of such requirements on other exchanges though, and if such a metric were developed, it may also need to account for liquidity as measured by spreads rather than just the size and number of market makers.
I do not think Regulation 39.12(a) serves any risk management purpose for the reason given in the RFC, and believe the integrity of the DCO should be reasonably protected by the real-time margining system. It is worth ponting out here that FTX.com and numerous other exchanges have been employing such systems, generally without incident (except for a few notable poorly run exchanges operating in a completely unregulated manner). Additionally, regarding the recurring question about risks posed by smaller but more frequent defaults, such systems are already employed in regulated US securities markets by firms such as Interactive Brokers. IBKR somewhat famously does not issue margin calls, but has a similar real-time risk management system that automatically forces liquidation when an account has insufficient margin, so the FTX proposal is not without precedent.
Regarding questions 7 and 8, I would definitely appreciate disclosures from FTX regarding how funds are treated, including periodic reports on their financial health. Several traders on the Discord group have raised similar questions indepentently of the margin discussion. However (getting to question 8), it is pointless to comment further without financial disclosures. I would suggest disclosing 1) the total deposited member assets, 2) timely (if not real-time) liquidation information, and 3) timely (if not real-time) information on their capaticy to absorb defaults. I think that while there will be some differences as FTX is not an FCM and some parts of Regulation 1.32 would not apply, the general principle of daily (or better) holdings of customer funds should be upheld. Please keep it simple though ;)
I'm inclined to say the investment of praticipant funds should also be similarly restricted as per Regulation 1.25, at least by default. Though I think it's natural to offer opt-in non-risk-free yield programs, just as brokerages like IBKR do for lending out stock to short sellers. While I would not personally opt in, I think it's fine to give customers a choice of, say, a Bitcoin lending program where your assets are lent to qualified institutional clients in similar fashion.
On the question of 1.17, yes, I think the composition of the capital is not to be ignored. For example, you wouldn't want all the assets in long dated CDs with an early withdrawal penalty or lockout. I don't really have any further comment than this though other than to say "good question."
I'm so glad that you brought up the question of liquidity. I believe pretty strongly based on my experience as a trader that enabling margin will dramatically increase liquidity. However, I do think a safeguard is required to avoid liquidations at extremey poor prices. The width of the spreads is the most obvious metric. FTX and many others have demonstrated that real-time liquidations work on futures markets. Deribit has further proven that it can work on a liquid options exchange. But on the less liquid exchanges, automatic liquidations can be quite damaging temporarily. I think backstop liquidity providers could play an interesting role here.
One additional factor that could help is a liquidation fee and fund. If you are liquidated, many exchanges charge a fee, part or all of which is placed in a liquidation emergency fund. I am confident that there are several ways to ensure the continued solvency of the DCO.
The Commission asks in its final questions what the impact on the market would be, and I am confident that it would be positive. I have had a front row seat as LedgerX grew, and as more traders and capital came in, volumes increased and spreads tightened. From a risk management perspective, I believe that opening the markets for more people encourages the more even distribution of risks. There are not many sizable market makers operating here right now precisely because there is no spread margin. Additionally, US residents generally lack access to cost effective hedges in retail-friendly size, so independent/amateur market makers such as myself have few options to hedge crypto exposures. Enabling margin on LedgerX would do wonders for correcting the inefficiencies in the current market. (And yes, if you've been reading carefully, you'll recognize that this would actually be detrimental to my own profits in the short run, but it's the right thing to do.)
Enabing sensible margin will make the markets much more efficient and end users will get better fills (direct cost savings). Crypto markets are volatile and commissions on other exchanges are off the charts (LedgerX has one of the only fair pricing models out there for US residents). The CFTC would to a great service to those under its jurisdiction by enabling margin trading so that small investors under its regulatory purview can get the best pricing.
Thank you for your time and consideration, especially if you actually read my tome. I noticed a lot of form letter comments and hope this one cuts through the noise.
