Last Wednesday, the Commodity Futures Trade Commission (CFTC) gathered leading representatives from traditional finance, crypto firms, and academia in Washington to debate a proposal from FTX to decentralize the trading of derivatives.
This all started in March when FTX US released a proposal that would modify their CFTC license to allow retail traders to trade crypto-derivatives on their platform.
Although all of this might sound boring on face value, the truth is that the consequences of the CFTCs decision are highly impactful in ways which we will get to below.
Without going through the long (and yes, boring) history of the derivatives market, it’s worth understanding that the industry, supported by Futures Commodity Merchants (FCMs), has consolidated significantly over the past 15 years. Starting with 171 firms in 2007, there now only stand 61. Much of this, like the consolidation of the banking industry, is due to the fact that the derivatives industry is slow to change.
Meanwhile, the approval of regulated bitcoin futures trading at the Chicago Board Options Exchange (CBOE) and Chicago Mercantile Exchange (CME) proved that institutions had a large desire to trade crypto derivatives with billions of dollars being traded. That, plus the fact that international exchanges such as Binance are engaging in derivatives while being unregulated in the US.
But why should traditional and unregulated exchanges have all the fun? Why shouldn’t US based crypto exchanges have the opportunity to also offer derivatives products on their platform? That’s the question that FTX has, and is the leading reason why FTX and Coinbase acquired the CFTC-regulated derivatives exchanges, LedgerX and FairX, respectively.
The main difference in FTXs proposal vs the existing model is that it would remove banks and other financial intermediaries from the market completely (aka put some companies out of business).
How Would They Do This?
The proposal would allow FTX (as well as other firms with similar Designated Clearing Organization licenses) to offer derivatives trading without the involvement of the FCMs which we covered above.
FTX would do this by removing the buddy-buddy nature of the current marketplace and replace it with an algorithm that makes decisions around margin requirements and risk management. The idea here is that it removes a lot of unneeded steps as well as potentially leads to less systemic blowups. It would also allow the trading to happen 24/7.
So, Whats the Big Deal?
Honestly, when it comes to crypto-derivatives, market participants and the CFTC seem fairly open to FTXs model concept, with the caveat that they delay approval so traditional participants can prepare and compete.
The main issue arises when the discussion moves into the idea of trading traditional derivatives products (think cotton, corn, or oil) on crypto exchanges.
You see, when traders are taking positions on crypto derivatives, it’s one thing if they get margin called or knocked out of a position over night. But if farmers, who take futures positions to hedge their inventory, get margin called while they are sleeping due to a 24/7 market and an algorithm, it could cause major issues around physical goods.
We agree with FTX that by offering a 24/7 derivatives market it doesn’t automatically mean that people HAVE to trade there. Farmers could still rely on the old methods.
At the same time, theres something nice about markets closing… The ability for people to take a break in their day and to have time to internalize information and make long term decisions, is probably beneficial.
We have a 24/7 news cycle. We have a 24/7 social cycle. And with crypto, we have a 24/7 trading cycle. Are all these things net positives? We don’t know, but for our physical and mental health, they might not be.