Three Questions for Financial Market Infrastructures in the Shadow of FTX

Introduction 

When an unfortunate event happens, it is natural to ask ‘could something like that have happened to us?’ The distress of the FTX group,¹ and the subsequent bankruptcy filing of many of the entities within it,² was clearly unfortunate. FTX’s customers – possibly over a million of them³ – were unable to access their funds, and their eventual recovery is uncertain. The sums involved are large: over $10 billion of assets and liabilities were affected by the bankruptcy filing.⁴

The FTX group included an ‘international’ crypto exchange, FTX.com; an exchange dealing with United States persons, FTX.us; and a crypto hedge fund, Alameda Research. Alameda traded crypto assets on various exchanges, including on FTX. In addition, the group conducted other businesses including venture capital, real estate, and other investment activity. Efforts to manage the group’s assets and liabilities are ongoing and will likely last several years. Criminal cases against some of the group’s principals are pending, so their fate is not yet known either.

Given this, the full story of why much of the FTX group filed for bankruptcy is subject to speculation. It is not possible to know if other groups could suffer a similar fate. However, a prudent person could still consider the general issues around the FTX group that have attracted comment. There are many of these, so attention will be focused here on three important questions that exchanges and CCPs might reasonably have asked themselves in the aftermath of the group’s failure.

Are client assets properly segregated?

Segregation is the separation of some assets from a larger collection. For financial market infrastructures, or ‘FMI’s, the term is usually used in the context of separating customer assets either individually or together, with the implication that they are held for the benefit of customers. The expression ‘legal segregation’ is sometimes used to emphasise that the assets concerned will not be part of the estate of the segregator in bankruptcy.

Regulation often requires financial intermediaries to legally segregate customer assets,⁵ and even when it is not mandatory, segregation of client assets is frequently conducted as a good practice that enhances stakeholder confidence.

It has been alleged that FTX.com did not legally segregate customer assets as its terms of service required, and instead lent many of them to Alameda Research.⁶ The shortfall of potentially ‘missing’ client assets at FTX has been estimated at $8 billion.⁷ Client asset segregation was a key issue in an earlier substantial intermediary failure, that of MF Global: billions were at stake there, too.⁸

The sheer size of the possible issues is a wake up call for FMIs to review their client asset segregation. It is important to carefully understand exactly when client assets are segregated and whether this matches a firm’s contractual commitments. The questions here can be delicate – is cash which is ‘in transit’, or are assets which have not yet settled, legally segregated, for instance? Required client margin may be protected, but margin excesses may not be.⁹

Can we get enough cash if needed?

The proximate cause of the failure of financial institutions is often funding liquidity: the inability to meet claims when due. A key issue is that the clients of many financial institutions have demand repayable claims. Funds held in retail bank accounts can often be demanded with no notice, for instance. Usually, clients do not exercise their right to be repaid: account holders are often content to leave money with their banks for years. However, client preferences can change quickly if confidence in an institution is lost. The demand for withdrawals can then be tens or hundreds of times the usual level. This is especially the case if effective mechanisms protecting client assets in bankruptcy are not in place.¹⁰

Once confidence was lost in FTX.com, the demand for repayments spiked. One estimate is that clients made “around $6 billion of withdrawals” in 72 hours.¹¹ This highlights the importance of the liquidity profile of FMI assets. Put simply, the question is how quickly can money be found if necessary?

To see the issue, suppose that clients send US dollar cash to an intermediary, and that the intermediary invests all of the cash in US government bonds in a legally segregated account. The assets are safe from solvency risk, and remote from the bankruptcy of the intermediary. However, US government bonds settle on the day after trade date, so-called T+1. Thus, cash from selling them is not available today, and hence cannot be used to meet today’s cash needs.¹² Intermediaries need to monitor both the risk of loss of any investments they make and the time required to liquidate them, in order to ensure that they can meet demands for cash promptly, even in stress.

Who ya gonna call?

The history of financial markets is replete with unfortunate events like the distress of FTX. As a result, regulators often require that intermediaries have a plan for various plausible kinds of trouble. They should be able to answer the Ghostbusters question: if a bad thing happens, who are you going to call, and what will they be obliged to do?

One key aspect of this is having sufficient resources and tools to address the failure of the holder of a big position. Large positions are particularly dangerous for FMIs.¹³ Margin provided by the counterparty is the first loss-absorbing resource, so it is important that this is adequate to cover the costs of closing out most defaulters, large or not. For positions that are large compared with market liquidity, prudence often suggests taking additional margin, sometimes called ‘concentration margin’. Intermediaries might wish to examine their practices in this area given the comment around the size of FTX.com’s net exposure to Alameda.¹⁴ The standard that systemic CCPs should have sufficient financial resources to absorb the losses caused by the failure of the two counterparties with the largest and second-largest exposures in extreme but plausible conditions, is a well-known benchmark here. Defaults also need to be managed and the CCP’s book balanced, so having a plan, such as calling in a default management group seconded from members, is important here too.

Another key aspect is having a credible plan to address the failure of a key service provider. Intermediaries often rely on various entities as settlement banks, counterparties, market makers, investment providers and default managers, among other functions. FMIs should have comprehensive and effective plans both to address the failure to perform of these entities and to continue to provide essential services despite the failure. The call(s) here might be to back-up providers of services, to clearing members who are contractually bound to absorb losses, and/or to liquidity providers.

Who can ask? All of the questions discussed above, and many more, are prompted by the international regulatory standards known as the Principles for Financial Market Infrastructures or ‘PFMI’.¹⁵ ‘Who ya gonna call?’ appears in the further guidance on the PFMI¹⁶ as the requirement to “identify scenarios that may potentially prevent” FMIs from “being able to provide its critical operations and services” and make a plan to effectively address them.

A prerequisite for robust FMIs is people with sufficient authority to demand accept- able answers to these questions. Effective governance is therefore key. As the PFMI say, this should ensure that “major decisions reflect appropriately the legitimate interests” of the FMI’s “direct and indirect participants and other relevant stakeholders.” The proper protection of all stakeholders’ interests is therefore the thread that connects all of our questions.

For further information on WFEClear: The WFE’s Clearing and Derivatives Conference 2023, see https://wfeclear.wfecm.com/

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1 The term ‘FTX group’ will be used to refer to the group of companies controlled by Sam Bankman-Fried: this is consistent with the usage in the Voluntary Petition for Non-Individuals Filing for Bankruptcy, case 22-11068-JTD, filed 11 November 2022 in Delaware., henceforth ‘the FTX filing’.

2 Notably, not all of the entities in the group filed for bankruptcy. Among the survivors was the CFTC-regulated derivatives exchange FTX US Derivatives, also known as LedgerX.

3 Bloomberg quotes FTX as having 1.2 million customers as at end 2021: see https://www.bloomberg. com/news/articles/2022-12-08/ftx-s-collapse-ensnares-thousands-of-customers-throughout-asia.

4 See the FTX filing for details.

5 For instance, in the European Union, Article 39 of the European Market Infrastructure Regulation or ‘EMIR’. The latter identifies two different segregation models for client assets, omnibus and individual client segregation and requires that, as a minimum, clients are offered the choice between them. For more details of this and client clearing in general, see J. Braithwaite, The dilemma of client clearing in the OTC derivatives markets, European Business Organization Law Review, 2016.

6 See, for instance, Testimony of Mr. John J. Ray III to the House Financial Services Committee, 13 December 2022 available at https://democrats-financialservices.house.gov/uploadedfiles/hhrg-117- ba00-wstate-rayj-20221213.pdf.

7 See Financial Times, ‘We kind of lost track’: how Sam Bankman-Fried blurred lines between FTX and Alameda, 3 December 2022, which quotes the $8B shortfall.

8 See the Report of the Trustee’s Investigation and Recommendations in re MF Global Inc., 2011, at pp. 122-123. This report is available at https://www.cftc.gov/sites/default/files/idc/groups/public/@ newsroom/documents/file/mfglobaliinvestreport060412.pdf.

9 Article 39(6) of EMIR states that “When a client opts for individual client segregation, any margin in excess of the client’s requirement shall also be posted to the CCP and distinguished from the margins of other clients or clearing members and shall not be exposed to losses connected to positions recorded in another account”. However, excess margin from clients who do not opt for individual segregation may not be fully protected.

10 The failure of Northern Rock is a good example here: deposits in the UK at the time were insured, but only up to a low threshold, and fast repayment was not guaranteed. Faced with the loss of access to their money for weeks, depositors rushed to withdraw their funds from Northern Rock after confidence was lost in 2008. This was a classic ‘run’ on the bank: see Hyun Song Shin, Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis, Journal of Economic Perspectives, Vol. 23, No. 1, 2009.

11 Reuters, 8 November 2022, available at https://www.reuters.com/business/finance/crypto-excha nge-ftx-saw-6-bln-withdrawals-72-hours-ceo-message-staff-2022-11-08/.

12 There is a ‘same day’ repo market in US government bonds that might allow a Treasury bond to be converted to cash more quickly than T+1, but this market might not be deep enough to meet a large, sudden demand for cash, especially if conditions are stressed.

13 See, for instance, the issues around the failure of Einur Aas at Nasdaq Clearing in 2018 and the holders of large short Nickel positions at LME in 2021.

14 The SEC complaint against Sam Bankman-Fried, case 22-cv-10501, and a Presentation to the Official Committee of Unsecured Creditors, January 2023, in the bankruptcy filing both suggest that Alameda was exempt from aspects of FTX.com’s margin requirements, and that the affected amounts were substantial.

15 See Committee on Payment and Settlement Systems, Technical Committee of the International Organiza- tion of Securities Commissions, Principles for financial market infrastructures, 2012, available at https:// www.bis.org/cpmi/publ/d101a.pdf.

16 See Resilience of central counterparties (CCPs): Further guidance on the PFMI, 2017, available at https:// www.bis.org/cpmi/publ/d163.htm.