Who Back Stops the Back Stop?
Whilst growing flexUSD on CoinFLEX.com, we have been spending time on looking a few steps ahead to see how best we can make CoinFLEX as trusted and transparent as possible. What are the ways to ensure safety of funds? There are several initiatives we are going to put in place including being the first daily and publicly auditable stablecoin in the World (more news to follow on this shortly), but also we are looking at the market structure in traditional finance, and how this can be done in crypto markets via the same mechanism of central clearing counterparties otherwise known as CCPs.
How do CCPs work?
The debacle over the Nickel trade (news link below), where a lack of position limits, risk checks and lack of transparency on systemic leverage and concentration risk on a single contract caused a market to be completed shut down for over a week has created food for thought over how the central clearing system works in traditional markets and how that could look like for crypto markets.
When a customer trades on ICE, CME, Eurex or LME the trades are cleared and guaranteed by the clearing members of those exchanges and the clearing members as a whole are also the financially obligated members of a clearing house that sits between each of those exchanges and the customers. In the case of a lot of European Exchanges that would be the London Clearing House (LCH) or in the case of the London Metals Exchange (LME) its LME Clear.
LCH or LME Clear are corporate entities that are legally independent of the Exchange and have clearing members as their shareholders. Examples of these are ABN Amro, JP Morgan, Citibank and their cohorts.
So when considering who these back stop financial institutions are and what their legal obligations are is important in understanding where the buck stops.
For a simple way to see how this played out let’s look at an interesting story from 2018 when a little known power trader from Norway caused the European energy trade clearing house of Nasdaq to blow through their contingency fund. Einar Aas, a large independent (traded for himself) power trader with a long track record had an oversized spread position in two usually very correlated energy futures contracts. Unfortunately for him, and the clearing members, unusual weather patterns/conditions and an oversized position relative to market liquidity caused this position to blow out into huge losses. The losses were so large that they blew through the contingency fund at the clearing house and in fact caused an overall 100m Euro loss. Nasdaq informed the clearing members that they either as a collective made good not only on this 100m but to top up the contingency fund back up to its original level or face being completely disbarred from the Exchange.
Being a relatively “small” amount of money, the members topped up. What if this amount was of sufficient size that it meant the members could not top up. This leads to the Nickel trade, LME Clear and LCH.
Prior to the trading halt on the Nickel contract and with Nickel prices briefly at $100,000, rumours of the estimated losses by members including the Prime Brokers of the big short on that trade (link to details below) ran into double digit billions of dollars. There were lots of market rumours that LME & their clearing house were insolvent and that they would not be able to stand behind the trades. Looking at LME Clears 2020 accounts (publicly available and linked below), it has $250m of net assets. So in essence the market was probably right in that assumption except for the fact that the LME’s members are large financial institutions and would stump up the deficit as they would be obligated to contribute their portion of the default fund. However as far as I understand the structure, topping up beyond this default fund amount is not legally mandatory and as such there is significant credit risk here.
Even if we look at LCH, one of the largest clearers in Europe, they only have net equity of approximately $2bn. Which means if a members client defaults, the LCH will initially appropriate the margin funds for the defaulter, then can call up the defaulters own contribution to the default fund, then the LCH’s own equity and then the losses become socialised across all members (as happened in the Norwegian power trade).
Beyond this waterfall fund collection, there are no further legal requirements as I understand it. So any financial black swan event went beyond this number, and members refused to go beyond their own default fund contributions ($14.5bn in the screenshot below), then the LCH would also be technically insolvent if I am understanding the way they report numbers in the correct manner (from the 2020 accounts)..
Why are there so few clearing houses and why aren’t more coming in?
This is actually the most important question and why the way financial markets trades are margined and cleared needs to be improved. Looking through the LCH’s financial accounts for 2020, it’s soon apparent why. Despite being a dominant player (perhaps a monopoly on European Clearing), it only generates new profits of $200–300m. This is far a lucrative number that would cause others to set up under the same model given the risk/reward of blow outs.
Looking at the LME and LCH businesses it’s clear the model in play is the too big to fail model. As in, the market is reliant on the largest members preventing default, socialising losses and thus preventing the ensuing systemic financial risk. That means of course relying on the ultimate backstop, the Federal Reserve (Fed) or the European Central Bank (ECB). The ultimate back stop of the back stop.
So what’s the best model for CoinFLEX and crypto exchanges in general?
Firstly, one very important advantage that crypto exchanges have over traditional markets is in the frequency in which margin calls are calculated. Crypto comes from a background of not trusting a counterparty entirely in terms of funding margin short falls due to the volatility of the underlying and so have always operated on a per second basis. This means that for example, on CoinFLEX, our risk engines check margined positions every second and any under-margined accounts are auto liquidated into the orderbook in real time. This and the fact that crypto markets are open 24/7 ensures that market gap risks are protected against unlike in traditional finance (tradfi), or indeed BTC/ETH on CME, where the markets are closed for the weekend.
As flexUSD and other stablecoins grow from the current market cap of $180bn to $500bn and beyond, how do we and other money platforms create trust around the safety of funds beyond simply reputation. The model from tradfi shows how difficult it is to get one large or series of large clearing houses to stand behind the market in times of extreme market volatility and stress.
It’s clear that crypto is far from being too big to fail yet and so we can’t necessarily rely on the back stop of the back stop, namely the ECB, Fed or other Central Banks. It’s also far from clear if the current banks, commodities houses and clearing members that currently form the backbone of these clearing houses will be willing to step in and provide this role by authorising LCH or CME Clear or Eurex Clear to be intermediaries to CoinFLEX, Binance, FTX, Huobi etc
Perhaps this is where crypto innovation can come into its own. One way can be to create crowdsourced insurance products that generate yield for backstop liquidity providing. Maybe different tranches for different levels of risks with the higher up or first loss tranches carrying higher yields. flexUSD proves to be a very good starting point for this as it is naturally yield bearing base for the default fund.
So an Exchange specific or Market wide clearing fund should be entirely based on stablecoins and yield bearing instruments with additional yield coming from revenue share from transaction fees on Exchanges, just as the current traditional finance model works. flexUSD is obviously one candidate for this as it provides both stability and yield. There are no doubt others and a good mix of assets are required.
Real time per second margining and this crowdsourcing insurance fund through tokenisation could prove to be extremely lucrative not just for crypto lenders but also for yield starved traditional finance passive capital (insurance funds, pension funds, long term savers) to earn yield from a portion of their trillions of dollars of assets as well as provide the financial confidence rails for this asset class to grow exponentially in market capitalisation as crypto moves from two trillion dollars to ten’s of trillions of dollars in the next few years.
Interesting Links:
https://www.reuters.com/article/us-nordic-power-nasdaq-idUSKCN1LT28G
https://www.lme.com/en/company/about/governance/lme-clear-governance/lme-clear-financial-statements
