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Comment for Industry Filing 22-001

  • From: M. Todd Henderson
    University of Chicago

    Comment No: 69428
    Date: 5/11/2022

    Comment Text:

    Via Electronic Delivery

    Mr. Christopher J. Kirkpatrick
    Secretary of the Commission
    Commodity Futures Trading Commission
    Three Lafayette Centre
    1155 21st Street, NW
    Washington, DC 20581

    Re: LedgerX LLC d/b/a FTX US Derivatives (“FTX”) Request to Amend DCO Order of Registration (IF 22-001)

    Dear Mr. Kirkpatrick:

    We write in support of the application of FTX to clear margined trades in derivatives on an optionally intermediated basis. This application offers the CFTC the opportunity to embrace technological change in the way that derivatives are traded, bringing benefits of greater competition, lower costs, and less risk to individual investors and the system as a whole. We strongly urge the CFTC to approve the application.

    No one writing on a clean slate would design the financial markets exactly as they are today. (Except, perhaps, the duopolist incumbents who profit from the status quo.) The markets have been built up over time based on statutes nearly a century old. The complexity and path dependency of this system limits competition, and risk builds up in the system due to rules and practices rooted more in New-Deal-era laws and technological limitations than in our advanced modern society. This application provides the opportunity for the United States to step into the lead in the role of deploying new technologies that will modernize financial markets.

    We, the undersigned, come from a variety of fields—from law to business and economics—and have a variety of perspectives on the appropriate scope, intensity, and objects of financial regulation. We do share, however, a firm belief that based on decades of research and writing about financial markets, competition policy, and economic regulation, as well as public service and work with a range of industry stakeholders, that the application of FTX is consistent with the purposes of existing laws and regulations. It is also smart policy. Effectively deployed, FTX’s derivatives trading system will promote competition in the handling of derivatives trading, will spur innovation in financial plumbing more generally—which is needed not just in derivatives but throughout the entire financial system—and will lower capital-raising costs (by increasing opportunities to hedge risk) and simultaneously elevate efficiency, all while reducing risk for individuals, firms (e.g., farmers, insurance companies, and countless others), and the system as whole.

    While nothing is without risk, any potential risks presented by the application can be managed by the safeguards built into the proposed service, as well as the ongoing regulation and effective oversight by the CFTC. FTX is offering a new way of doing things, but, unlike other crypto outfits it is doing so in a transparent, regulated, and thoughtful way. Crypto has a bad name in some circles, as it is associated with an irreverent, even lawless, attitude. But FTX has proposed instead to deploy technology in a way that is respectful of the letter and spirit of the law. The CFTC will provide guardrails to ensure that the operation of the new service is consistent with congressional policy. This application is a seed that will propagate new ways of trading financial instruments in more efficient ways. Approving this application will give the CFTC, and the United States, the opportunity to lead and manage the transition to a more modern and efficient financial system. With the CFTC’s oversight and leadership, the transition can be done in a fair way consistent with Congress’ objectives.

    Importantly, FTX’s application is consistent with the development of a “National Market System” in the trading of equities. In 1975, Congress took the first steps toward modernizing securities markets with the National Market System amendments to the Securities Exchange Act of 1934. Congress presciently saw information technology as a means of ensuring that a competitive market for securities trading could be achieved in a fair way. Computer-linked systems would enable traders to see what was going on at various competing exchanges, giving more choice and reducing the concentrated risk and market-power that came with a monopoly or duopoly trading system.

    Over the intervening decades, technology delivered these promises gradually, resulting in a system today that offers the world’s best liquidity for investors at remarkably low costs (reflected in ever-shrinking bid-ask spreads). Stocks today are traded on dozens of venues of many different kinds. Technology has increased competition and improved the quality and reliability of service. Trading equities today is vastly cheaper and accessible to more Americans than it has ever been. The result is more economic growth.

    FTX’s application to clear margined derivatives directly, with optional intermediation, is consistent with this evolution in the equities markets. Today, the market for derivatives has not yet enjoyed the benefits from robust competition and is instead a duopoly, with each provider earning enormous supra-competitive profits. Traders must use intermediaries to trade, even when the services of a broker are not necessary or do not add value. Derivatives Clearing Organizations (DCOs) or Central Clearing Counterparties charge exorbitant fees for market participants to see the order book and to enter orders. The system is designed around large data centers—for equities, in New Jersey, and for derivatives, in Chicago—which means that there are huge investments required in trading infrastructure in order to get a fair deal.

    These redundant investments are rational for individual investment funds, but make no sense for the system as a whole. Society would be better off if this money were deployed in more productive and efficient ways. Moreover, traders pay for everything from server racks at data centers to microwave towers to route information back and forth from New Jersey to Chicago in order to ensure they trade at current market prices. The current system is costly and inefficient, based on outdated technology, and serves the interests of incumbent big firms, rather than investors. This application presents an opportunity to do things better, in a safe and responsible manner.

    The FTX application promises a cheaper, more transparent, and more resilient trading system. Anyone can access trading platforms directly, from any connected device. Investors that need brokers or other intermediaries can use them, but will do so only when they believe the benefits of doing so exceed the costs. This will reduce unnecessary costs of trading, while preserving the valuable service that some brokers offer.

    Other costs will be reduced as well. The full order book will be accessible to anyone, for free. Orders—including marketable ones—will be free as well. There is also no need for anyone to invest millions in the trading infrastructure race, be it fiber-optic cables, microwave facilities, or server racks. FTX houses its platform in the cloud, which exists everywhere simultaneously. Anyone can rent a low-cost node from Amazon Web Services (or other cloud provider) to achieve the latency features that at present are only available through huge investments in hard infrastructure. These savings alone would justify the application. But there are additional benefits that will reduce the systemic risk of the existing trading system.

    The biggest innovation in the application is the ability of FTX to offer a margin system that simultaneously lowers costs for traders (and thus the cost of capital raising) and reduces risk for traders and the system as a whole. The current model deployed in derivatives markets assesses the risk of individual trading accounts once per day, only on trading days. This means that risk inevitably builds up in the system. Asset prices do not change only at the end of the trading day, and market-moving events do not take weekends and holidays off. Trades made on the Friday of a holiday weekend may be seriously out of whack when markets open on Tuesday—nearly four days later— leading to some positions being significantly out of the money and other positions being substantially in the money. If margin calls come only in big chunks, the impact can be a cascade of sales to raise collateral, impacting prices. This can happen with intraday trading as well.

    In extreme cases, as was the case recently in the nickel markets, the buildup of risk throughout the system can cause a catastrophic situation leading to a shutdown of the exchange and the coerced liquidation of profitable positions that are just too out-of-whack for the clearinghouse to manage. Risk can build up like pressure in a volcano. As we saw during the Financial Crisis, when the massive pressure that accumulates is eventually released, the consequences can spread far beyond the immediate players. Every American suffered because the system did not adequately offload risk.

    The nearly constant risk assessment proposed by FTX (more than twice a minute, 24/7/365) enables excess risk to be purged from the system much more safely and efficiently, and way before it grows to levels that cause widespread harm. FTX measures full and actual risk in the system, in real time. Systemic risk vents off safely, a bit at a time. Moreover, the FTX approach will measure risk by collateral posted directly to clearinghouses, including when traders choose to go through intermediaries. The application proposes to measure and optimize actual risk to the system. This is better for everyone, not just investors and the clearinghouse, but also the financial system writ large.

    The one feature of the application that may raise the biggest objections is the direct-to-consumer interface. Some may believe that removing intermediaries from trading for some investors will increase opportunities for fraud and abuse. We are comforted, however, by those aspects of application emphasizing its robust know-your-customer process (KYC), as well as compliance with anti-money-laundering (AML) procedures. FTX US Derivatives actually goes beyond controls typically required by FCMs: customers who have deposited less than certain amounts to the platform are required to undergo heightened eligibility checks, including quizzes to demonstrate understanding of the product. Compliance with legal obligations (and more) is a fundamental premise of the application; were it not, we would be more skeptical of FTX’s proposal.

    Insofar as some believe trading derivatives is too risky for individual investors, this can be addressed by Congress. This could be through something akin to accredited investor rules used for some equity transactions. If certain investors are deemed to be incapable of trading within the systems—something FTX’s onboarding system is already designed to prevent—they can easily be prevented from doing so by regulators. This objection, while worthy of consideration for reform from Congress, should not be the basis for rejecting the application. FTX is proposing to increase access to financial products and services—to democratize derivatives markets—and it has strong incentives to ensure that individuals who are trading are able to bear the risk of their trades. If evidence to the contrary does arise, the CFTC will be well positioned to address it by responsibly adding guardrails where needed while not preventing much needed innovation and competition.

    In sum, we not only believe the CFTC should approve the application, we find it to be one of the most exciting developments in financial market infrastructure in some time. Figuring out how to harness the digital-asset ecosystem for social welfare gains, including modernization of financial plumbing, is a major challenge for regulators around the world today. We think that the CFTC can take the lead by approving the application and working with FTX to ensure that the obvious efficiency gains and reductions in costs and systemic risk from the innovations in margin analysis are not done at the expense of individual investors. To the degree any such risk is substantial, we are confident that, with the CFTC’s oversight, the implementation of the option for direct clearing of margined customer trades contemplated by the application will bring much needed competition to derivatives markets, while providing a test case for how financial markets generally can be modernized and democratized to the benefit of everyone. Except, that is, those few incumbents who will, for the first time in too long, have to improve the service they provide to compete.

    Respectfully submitted,


    John Donahue III

    M. Todd Henderson

    Robert J. Jackson, Jr.

    Steve Tadelis

    * * *

    John Donahue is the C. Wendell and Edith M. Carlsmith Professor of Law at Stanford. He is an economist (PhD from Yale) as well as a lawyer (JD from Harvard), who writes in the area of law and economics and is well known for using empirical analysis to determine the impact of law and public policy in a wide range of areas. Before rejoining the Stanford Law School faculty in 2010, Professor Donohue was the Leighton Homer Surbeck Professor of Law at Yale Law School. He is a member of the American Academy of Arts and Sciences, a Research Associate of the National Bureau of Economic Research, the former editor of the American Law and Economics Review and previously served as president of the American Law and Economics Association and the Society of Empirical Legal Studies.

    M. Todd Henderson is the Michael J. Marks Professor at the University of Chicago Law School and Booth School of Business. He served as a judge on the National Adjudicatory Council of FINRA for three years and continues to sit as a judge in FINRA cases. Professor Henderson is the co-author of SECURITIES REGULATION, 13TH EDITION, with Jack Coffee and Hillary Sale, as well as numerous articles on financial regulation. He teaches courses at the University of Chicago on a range of business and business law matters. Professor Henderson serves as an advisor and consultant to numerous financial and other business entities, and appears regularly in federal and state courts as an expert on these matters. Professor Henderson helped advise the digital-asset code of ethics and conduct promulgated by ADAM, and has testified in front of the Senate Committee on Banking on matters of financial regulation.

    Robert J. Jackson, Jr. is the Pierrepont Family Professor of Law, Co-Director of the Institute for Corporate Governance and Finance, and Director of the Program on Corporate Law and Policy at the New York University School of Law. Professor Jackson was nominated and unanimously confirmed by the Senate as a Commissioner of the U.S. Securities and Exchange Commission in 2017, a role in served in until 2020. As Commissioner, he was an outspoken advocate for protecting investors, consistently calling for more transparency in capital markets and championing evidence-driven policymaking. Prior to his nomination, Professor Jackson taught at Columbia Law School. He served as a senior policy advisor at the U.S. Treasury Department during the Financial Crisis and as a deputy to Kenneth Feinberg, Treasury’s Special Master on Executive Compensation. Earlier in his career, Professor Jackson practiced law at Wachtell, Lipton, Rosen & Katz and was an investment banker at Bear Stearns.

    Steve Tadelis is Professor of Economics, Business and Public Policy and the Sarin Chair in Strategy and Leadership at UC-Berkeley’s Haas School of Business. His research focuses on e-commerce, industrial organization, the economics of incentives and organizations, and procurement contracting. He also held positions as a Senior Director and Distinguished Economist at eBay Research Labs (2011-2013) and Vice President of Economics and Market Design at Amazon (2016-2017) where he applied economic research tools to a variety of product and business applications, working with technologists, machine learning scientists, and business leaders. He served as an expert witness for the FTC, the Canadian Competition Bureau, and several private companies on matters related to consumer protection, IP, and competition.

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