How FTX plans to reshape the US futures market with crypto tech

FTX is looking to shake up the sprawling US derivatives market, marking the biggest intrusion to date by a crypto group into the heart of traditional finance.

The three-year-old exchange founded by Sam Bankman-Fried is seeking approval from the US Commodity Futures Trading Commission to offer clients bitcoin futures – contracts that allow users to bet on the price of the world’s most active digital token.

The proposed process will eliminate middlemen who have been acting as intermediaries between customers and deals for the past 40 years. The US accounts for the world’s largest futures market, with 29bn contracts traded last year, meaning that if the FTX plans are approved, the impact could be far-reaching.

Instead of requiring brokers to deposit additional funds, known as margin, when transactions go wrong, the exchange monitors the market 24 hours a day, seven days a week and adjusts customer balances accordingly.

This will rewrite the mechanics of futures trading and if it sticks, it will cover everyone who trades in the futures markets, from farmers who lock in corn prices to hedge funds betting on oil prices.

Automatic liquidation and margin calls

It is the heart of the existing system and the use of the FTX concept. Futures traders deposit only a small fraction of the total value of their position, which accentuates the potential profit and loss. The chips that market participants place on the table are known as “margin”. Margin is critical in equity trading because if a bet goes sour, the participant on the other side of the trade ensures that it is fully settled.

Crypto finance

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The key difference between the system and the FTX proposal is the margin approach. Under the current framework, when a bet falls too far into the water, a broker asks the trader to put up more money to support the trade by a certain date, a “margin call”. If the trader meets the margin call, their trade will remain open, otherwise the broker will liquidate their position and begin taking the profit that is used for the trade.

On crypto exchanges like FTX and Binance – international platforms that are largely unregulated – margin requirements on products like bitcoin futures are constantly evolving. Traders trade directly, not through a broker.

Crypto platforms will automatically start clearing positions if the user’s margin falls below a predetermined level. Normally, a user would receive an alert if their account was at risk – but given the volatility of digital assets, forced liquidation events like this can quickly put traders out of business.

Unlike crypto, which trades continuously, most traditional futures, such as those tracking commodities, close at the end of the week. However, since most trades are effectively always made during trading days, some small market participants said they were concerned about the loss within hours under the FTX proposal. A margin call, in contrast, provides some breathing room to meet funding requirements.

Case Study: May 2021 crypto ‘flash crash’

Automated liquidation is already widely used in the crypto industry, with $1.3tn worth of bitcoin futures traded last month alone. During periods of market volatility, traders can lose significantly faster, thereby increasing the rate at which the user is forced to exit.

The case study below is based on a “flash crash” a year ago that put many leveraged bitcoin traders on the wrong foot. The trader in this example placed $2,500 on a trade worth $250,000 and took out a 100-time leveraged position on Binance. When the market starts to decline, they need to put in more money so that they don’t lose their value even if it recovers quickly.

A brief crash in May 2021 resulted in heavy losses for many retailers. However, due to automatic liquidations, typically market participants can only lose as much as they bid on the trade, as opposed to liquidating debt.

The argument

The FTX plan has started a serious debate in the US after the CFTC opened a consultation in March.

Those who support the FTX proposal believe that it is the next revolution in the market, that the technology will inevitably grow in the market like the rest of society. It encourages competition, democratizes futures trading and, importantly, prevents small investors from accumulating unaffordable debt, with sometimes disastrous consequences, proponents say.

On the other side of the argument are those who say that the traditional system gives them time to make important decisions and earn more money. For example, a farmer does not worry about sudden market movements in the fields he opened to prevent commodity price inflation. They don’t need to raise more than necessary to give their customers peace of mind. The middlemen, switches and brokers at the heart of the system can use human judgment to mitigate potential issues in calmer times.

The CFTC is investigating each chain’s level to understand how it works and its implications, so it’s taking its time. A decision may not come this year. Can accept both models. But as investors explore bitcoin’s future, they may encounter more proposals.

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