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It’s not often you get to be a fly on the wall at a meeting of all major participants of an industry. But had you logged on to the YouTube channel of the Commodity Futures Trading Commission yesterday, you could have been that fly. There, at the Chicago headquarters of one of the key US financial regulators, representatives of the most important financial services companies in the world gathered to discuss the future of their business. JPMorgan and Goldman Sachs were there; the Chicago Mercantile Exchange and the Intercontinental Exchange were there, and so were Blackrock, Fidelity and many more, all of them key players in global capital markets. A single discussion dominated the agenda: disintermediation. 

A few months earlier, a newcomer to the group had tabled a proposal with the potential to upend the way derivatives trading is conducted. FTX is an exchange founded in 2019. It’s focused on crypto but has designs on expanding into other markets. Last year, it acquired a regulated broker-dealer in the US and last week began offering stock trading to select customers ahead of a larger roll-out. Unlike traditional exchanges, it has direct relationships with end-users – it acts as both broker and exchange, vertically integrating two activities that are normally kept separate. And that’s a model it wants to bring to derivatives markets, hence the topic under discussion – disintermediation.

We’ve discussed shifting power dynamics within the capital markets industry here before. Many years ago, the bond and equity traders of Wall Street firms were undisputed Masters of the Universe. Over time, a combination of technology and regulation relegated them to a less dominant role in the capital markets ecosystem. In their place: global exchange groups that bring together execution platforms and clearing houses under the same roof. The clearing role in particular affords them a tremendous source of power because that’s where risk is centralised. As the moderator at the meeting in Chicago said:

“In the 1990s… people would come to Chicago and what they wanted to see was the trading floor – they wanted to see those guys running around in those colourful jackets, screaming and yelling at each other. Nobody ever wanted to visit the clearinghouse – it’s a pretty sleepy place … [But] clearing was the place to watch, clearing was where the risk lived. It’s important to understand how the trade gets done… but everything after that point is at the clearing house.” 

Clearing houses have long been part of the fabric of financial services. The first can be traced to the rice markets of Osaka and in the West their origins can be traced to my own home city of Liverpool (known more for its mark on pop history than for its mark on financial infrastructure). Clearing houses fulfil two main functions:

• They protect buyers and sellers against the risk that the other party doesn’t deliver on their side of the trade. This solves a key problem in derivatives markets where contracts can expire weeks, months or years after a trade is initially negotiated. 

• They promote efficiency by netting positions of counterparties and providing anonymity of trades.

Each of these functions is achieved by the clearinghouse stepping into the middle of a trade – becoming the buyer to every seller and the seller to every buyer. Hence the concentration of risk. To mitigate it, clearinghouses demand that counterparties put up margin as prices fluctuate. 1

The cotton brokers of Liverpool learned the hard way how important margin can be. For years they resisted a margin scheme, nervous that it would reduce trading activity and the associated brokerage commissions. One American speculator, Morris Ranger, paid brokerage fees totalling £330,000 over a number of years between 1978 and 1883. But then, in 1883, he went spectacularly bankrupt trying to corner the cotton market. With debts of £400,000, Ranger ended up taking down a number of brokers with him. When it became apparent that he had been insolvent long before but, with no obligation to post margin, had been able to carry on trading throughout, many brokers reconsidered their position. They set up a Settlement Association. Every two weeks, the Association would establish a ruling price of futures, and cash would be transferred between members defending on whether prices had moved in their favour or against them. 

Over time the model evolved. Coffee brokers in Le Havre innovated a model to guarantee trades and grain brokers in Minneapolis refined it to intermediate them. As they took on more risk, clearinghouses needed more resources. But they are peculiar organisations – part utility, part for-profit corporation and part club – with a range of different stakeholders and associated conflicts. Over the years, a loss-sharing model emerged that balances the interests of these different stakeholders. It’s known as a default waterfall and in the event of a default, it works like this:

1. First, margin provided by the defaulter is used;

2. Then the defaulter’s stake in a pooled fund all members of the clearing house contribute to – the default fund;

3. Then a tranche of capital contributed by the clearinghouse – its “skin-in-the game”;

4. After this, the rest of the default fund is available.

The waterfall has withstood the test of time. In the past 50 years, only three clearinghouses have failed: the French Caisse de Liquidation des Affaires et Marchandises in 1974, the Kuala Lumpur Commodity Clearing House in 1983, and the Hong Kong Futures Guarantee Corporation in 1987. These failures have some elements in common: All three cleared long-dated derivatives contracts, they saw unusually high volatility in the underlying asset price in the weeks before their failure, and failure was ultimately triggered by unmet margin calls by the clearing members.

That’s not to say there haven’t been cases of stress. When the spread between Nordic and German power prices blew out in 2018, Norwegian trader Einar Aas was caught on the wrong side. He failed to make a margin call and was put into default. After his positions were liquidated, his clearinghouse found itself sitting on a loss of €114 million in excess of the margin it had required him to deposit. The clearinghouse took a small loss of €7 million but the bulk of the hit was absorbed by the default fund. The episode raised questions around whether the clearinghouse had quite enough skin-in-the-game but the waterfall did its job.

More recently, the clearinghouse operated by the London Metal Exchange (LME) suffered a widely-publicised near miss. Nobody from the LME was present at the roundtable in Chicago, but memories of the incident hovered over the room. When a ‘Big Shot’ investor accumulated losses on a short nickel position of around $8 billion, rather than allowing the waterfall to do its job, the exchange simply cancelled trades. It’s possible there wasn’t enough in the default fund to pick up the tab. Numbers aren’t available for end 2021, but at end 2020, there was $1.36 billion in the overall default fund, including the LME’s $23.2 million skin-in-the-game. 

Earlier this week, Ken Griffin, founder and CEO of hedge fund firm Citadel, reiterated his outrage over what happened:

“That was one of the worst days in my professional career in terms of watching the behaviour of an exchange. We didn’t have any meaningful position in nickel at all… But to see an exchange close and then cancel hours worth of activity was just incomprehensibly wrong. You cannot do that in a market that is integrated with other markets… There’s all kinds of adverse consequences that come from exchanges changing the rules of the road after the fact… Every time you see these sorts of regulator interventions – or in this case an exchange acting in a way that I can’t understand – you undermine market integrity… When you interfere with markets on an ex-post basis, it’s incredibly destructive to the meaning of markets.”

One man who is passionate about the meaning of markets is Sam Bankman-Fried (SBF), founder of FTX. And he reckons he has a solution – a risk management system that assesses risk on a real-time basis.

Unlike what happened in LME nickel markets, where risk was monitored on a daily basis, Bankman-Fried’s proposal is for customer trading positions to be reviewed every few seconds to determine whether they have adequate resources to run their trades. His clearing model would require customers to transfer sufficient collateral to the FTX platform before they commence trading, where they would be subject to an automatic derisking feature that sells off collateral to maintain minimum margin requirements. Through this feature, customers would be incentivised to manage their account collateral and risk positions proactively. The model does away with margin calls, replacing them with credit from collateral sitting on the platform. 

The model works best for assets that trade continuously, 24/7. Crypto markets trade like that, which is where the idea was born. Indeed, the recent volatility in crypto markets provides a stress test for the model. But Bankman-Fried has a vision that all markets should ultimately trade like this. And in an environment where everything gets faster, the direction of travel may be exactly that. Interactive Brokers offers its Pro accounts the ability to trade US stocks between 4am and 8pm ET. Robinhood recently extended its hours with the promise that it is “working towards offering 24/7 investing.” 

Bankman-Fried points out the inconsistency of pushing towards ever decreasing latency in markets during opening hours, while at the same time allowing markets to close for chunks of time when news is nevertheless available. “Latency has to be low compared to the release rate of new economic information… Right now, yeah, NYSE’s latency is a fraction of a millisecond, but…it’s going to be closed overnight… I don't think that it’s the most important thing to really get the architecture to be as low latency as possible, but I think having it always open is actually pretty important.”

Many market participants would disagree. The popularity of private markets to raise capital indicates that some people would rather that markets are closed more often than they are open. But if crypto is the way you would design a new market from scratch, and traders increasingly overlap across other markets, then elements of its design may bleed into the architecture of traditional markets.

Incumbents have a default aversion to change and that was on display at the Chicago meeting this week, with many participants hostile to Bankman-Fried’s derivatives clearing idea. They also have a competitive position to defend: the CME Group currently facilitates at least 92% of US exchange-traded derivatives volumes. But the sands of power in capital markets rarely remain still and, as a new entrant, FTX is already making an impact. Capital markets infrastructure continuously evolves; to see what happens next, clearing is the place to watch.