On The Run Clearing

Is It Useful or Necessary?

My friend Al Warms tweeted this article at me. It’s about FTX, and their CEO Sam Bankman-Fried’s quest to bring on the run clearing to futures contracts. The article is light on the topic and big on the political donations Sam is making. Ironically, he’s donating to a lot of Republicans but he certainly isn’t one himself. However, it might be that he has calculated that the Republicans have a more fertile territory to have more forgiving regulation on crypto especially given the way Gary Gensler has run the SEC over the past couple of years. Prior to the SEC, Gensler ran the CFTC.

In each instance, he was/is one of the worst leaders in their history.

Ignoring the fluff about crypto and politics, what does on the run clearing really mean?

Bankman-Fried wants to get CFTC approval to margin every 30 seconds. To do that, FTX has to disintermediate the brokerage houses and go direct to the consumer. Their contention is because the blockchain is immutable, they’d know where the assets for margin are and how much is there. As I have blogged about previously, we discussed going direct in our Strategic Planning Committee meetings when I was on the CME board and we recharted the entire path of financial exchanges in 1999.

In crypto, like other assets, there is a lot of nuance. I do agree with FTX that the CFTC is a much better regulator than the SEC. However, there are going to be some crypto assets that look exactly like a security, and they should fall into the SEC regulatory camp. If we are just talking about trading a single commodity token, like Bitcoin, that sort of transaction should be in the CFTC and nowhere near the SEC.

People can argue about which tokens are securities, and which aren’t. There are too many to blog about. I don’t want to speculate on the principles here.

However, as an investor in Bitnomial, and former board member at CME ($CME), I do know a little about clearing. For those that don’t know, clearing is the back office at an exchange. It does the heavy lifting of guaranteeing that the money is really there to hold positions in the market and access the market. Clearing makes sure things settle and everything balances before the next trading day starts. It also ensures that when contacts expire, the right people get paid the right amount of money and if there is the delivery of a physical good, it gets delivered properly. Bitnomial is the only crypto exchange in the world where you can trade and accept or deliver physical crypto with the opposite party.

I find the Defi and crypto community inept in the understanding of clearing when I see them pontificate about the ability of Defi/crypto to upend the existing exchanges. The first question I always ask an entrepreneur who is building an exchange is “What are you doing about clearing and settlement?” Without it, you don’t have an exchange you have a trade matching system and those are off-the-shelf technology.

In some cases, you have to stop listening to the principals that advocate their position. I remember Fred Wilson talking about the role of a board member in several blog posts at his terrific AVC site. He says at board meetings someone on the board often has to step into the discussion and “let the company speak”.

With this issue, I think you need to let the market speak. What would the market say about the various styles of clearing?

Here is what FTX wants to do and I pulled this quote out of the linked article.

FTX’s exchange would be open 24 hours a day, seven days a week and settle user accounts every 30 seconds. If a user became too indebted, FTX would send alerts to the user for them to stay above a minimum threshold. If the user failed to keep their assets above that threshold, FTX would auto-liquidate other on-exchange assets to bring the user’s account back into compliance with its rule. Theoretically, if a user faced repeated margin calls without meeting the minimum threshold, they could lose all the money in their FTX account overnight.

Let’s break it down. Being open 24/7 wouldn’t be a gigantic lift for existing commodity exchanges. They shut down now for a period of time but mainly, that’s for maintenance on servers etc. It would increase their costs of operation because they’d have to employ talented personnel 24/7 to operate the exchange.

Settling accounts every 30 seconds sounds really sexy. Wouldn’t it be better to make sure everyone that has a position at that time in the market actually has the cash to back up that position? If you were advocating for it, it would eliminate spoofing and other nefarious practices that some firms use to goose price action. On the other hand, in a volatile market, it could exacerbate moves since people would have to blow out of positions as their margin dwindled.

What would the market say?

I think markets like order and predictability. Even in the craziest “fast markets” I traded in, there was predictability and order. If there was a bad print, the pit committee made sure it came out and they did a lot of due diligence before they changed the tape. When we got cameras, the diligence was easier. Today in fully electronic markets, it should be even easier.

I will tell you that most Congresspeople do not understand markets despite all the insider trading that goes on there. I lobbied them for years and you can count on one or two hands the Congresspeople that truly get the inner workings of them.

My friend Professor Craig Pirrong opined on the issue last March. He is an expert on central clearing and an academic. He’s studied this stuff for years. He cut his teeth in clearing during the 1987 crash as a PhD student at UChicago. What a time to be examining clearing!

Craig brings up a fantastic point. Markets are deeply coupled. More coupled than you might think. In single market places there can be several layers that affect the headline market. OTC markets, private markets, and dark pools are just some of the things that can affect the headline market. Markets that seem totally unrelated are coupled for different reasons. For example, because of the US government’s horrible policy on ethanol, when crude oil moves up and down it affects the price of corn. When stocks move, US bonds and Forex move. They aren’t independent silos even though they have separate supply and demand curves. Important to remember that often the same people who are playing big in one market are also playing big in others. ADM just doesn’t trade grains. It trades everything.

I have seen meltdowns in one unrelated marketplace affect others. The Chernobyl nuclear disaster is a case and point but so is the Hunt Brothers’ silver corner in the 1970s and the 2008 stock market meltdown. I was short hogs in 2008 when the stock market broke and guess what, hogs broke too. People needed the margin money so longs went to cash in everything. How does the FTX clearing system affect the market when things like that happen? It’s not clear to me and my mind is open to it because if it’s better we ought to really figure out how to apply it.

Craig also makes the point about “gunning the stops”. A stop order in a market is an order that becomes a fill at any price order if the market trades at the stop order’s price. I knew people that made an entire living sniffing where stops were in the market, setting them off, then fading the move and getting out when the market recovered its senses. HFT firms do this constantly now.

Gunning stops with 30-second margining could make the market really unstable. That would decrease the volume on the bid/ask spread, making the market even more illiquid.

As I said above, if the market were speaking the one thing the market loves is order. Illiquid markets aren’t orderly. When you watch traders interviewed on television during market meltdowns they usually will say the drop in price was “orderly”.

More restrictive price limits might help the situation, but price limits aren’t a panacea especially if you want to run a 24/7 exchange. In existing marketplaces with price limits, how many times have we seen a market open limit up or down and not trade for entire days? I have experienced it. I have seen markets not trade for three days.

If we look at what happened in the LME nickel market earlier this year and try to envision what might have happened with FTX’s proposed system I think the mess would have been messier and a lot harder to clean up.

If you start to extrapolate the FTX solution to OTC markets, it gets interesting. I don’t think those markets need 30-second clearing. But, having an independent blockchain mark to market seems a lot better than the investment banking brokerage house which is the counterparty do it. Ask Michael Burry.

I am the first to agree that there are expensive layers between the consumer and the market. In general, when we experience technological advances one of the benefits is getting rid of layers of distribution. It makes capital more efficient and it causes goods and services to become cheaper. This is a great byproduct of innovation and competition.

We have had brokerage houses for years, but that doesn’t mean we ought to keep them. Technological advances force them to prove why they are worthy. This is one reason besides capital efficiency that we have seen consolidation in the clearing firm sector.

One function that exchanges have traditionally outsourced to brokerages is vetting the customer. The customer deposits funds in an account, and the brokerage earns overnight repo interest on those deposits that are unused for margin. For the last couple of decades, that margin interest has been a negligible profit stream for brokerages but as interest rates tick up it becomes more of a factor to balance against the cost of operations.

On the surface, blockchain seems to have some real benefits to bring innovation to marketplaces. However, it’s not clear at all that the marginal benefits are greater than the marginal costs of changing over to blockchain despite the large numbers you see tossed around in the blogosphere. One point is since blockchain innovation is here, if it was cheaper, better, and more efficient where companies could make more money by using it they would have already done it.

I don’t see ICE and CME as total monopolists that are stuck in the mud. They do try and innovate, although because they are quasi-monopolists, innovation doesn’t happen as fast as it might otherwise. The one thing I know CME has done is invest hundreds of millions of dollars into its clearing system. It is the backbone of the business and a failure would put them out of business.

I do think FTX ought to step up and compete with the traditional exchanges. It will make them better, and all customers will benefit. It will make FTX better too. It’s expensive to build a traditional clearinghouse, and the regulatory hurdles largely make it impossible for new entrants to come in and compete. FTX should think about competing and building its own clearinghouse. They could still go direct without the fancy margining idea.

However, it’s not clear to me that the clearing mechanism FTX is proposing is a true benefit to the marketplace. The marginal costs look like they outweigh the marginal benefits and could potentially damage marketplaces that are orderly today.