Regulators Have a Shot at Bringing Competition to Derivatives Market

While tech giants like Amazon and Google have drawn much of the Biden administration’s antitrust attention, a more significant — but as yet ignored — antitrust problem is flying under the radar in the less obviously sexy area of derivatives trading.

While derivatives may seem like the kind of thing that only matters to Wall Street fat cats, futures trading is, in fact, how everyone from farmers to retailers to insurance companies hedge their risks. By spreading risk, derivatives lower the costs of risk taking and thus are the secret ingredient that has driven a great deal of recent American prosperity. Ensuring derivatives markets are competitive, innovative, and secure should be a national priority. Recently, much derivatives trading, especially in new asset classes, has moved overseas.

Deep within the plumbing of derivatives markets lie two companies — Intercontinental Exchange (ICE) and Chicago Mercantile Exchange (CME) — that dominate the industry. According to recent data, they process more than 97 percent of all U.S. derivatives trades. Experts have long known that a large market share alone is not sufficient evidence of a troubling monopoly (or, in this case, duopoly). But that presumption goes out the window when, as here, monopoly power is artificially obtained and protected by virtue of a privileged regulatory position. Congress compounded that problem with new rules created by the Dodd-Frank Act that inhibit innovation. The consequence is a monopolized and constrained market that needlessly disadvantages U.S. investors and consumers and puts all U.S. financial markets at greater risk.

Against this backdrop, the Commodity Futures Trading Commission (CFTC) is currently being asked to consider a proposal for a new approach to derivatives trading — one that demonstrates just how significantly the incumbent derivatives markets inhibit competition and innovation. (The CFTC is holding a roundtable discussion on the application on May 25.) FTX, already a licensed exchange, requested an amendment to its U.S. license that would allow it to offer its customers to trade crypto futures on margin, and to use a new approach to real-time risk management that has proved robust in international markets.

At one level, FTX’s proposal is modest: it would merely permit FTX to trade derivatives on margin, something the incumbents have been doing since their inception. But FTX’s application also proposes a superior technological approach that creates the ability for traders to access the exchange directly, rather than being forced to use an intermediary. Importantly, and unlike the incumbents, the FTX model removes the need for traditional intermediaries to post their own capital to carry risk for the exchange.

At a recent congressional hearing, CME’s CEO lamented that, if the FTX application is approved, CME will have to “deploy[] the same model.” That may be a problem for CME, but what it really shows is how valuable FTX’s innovations are. Indeed, the only thing standing in the way of implementing FTX’s model is the intransigence and influence of the incumbent monopolists.

Incumbents rarely welcome the advent of disruptive competition, and CME and ICE are no different. The status quo is incredibly profitable for them, even if it’s not optimal for everyone else. In particular, the incumbents have reaped enormous rents in part because they have been able to use their market power to offload risk onto intermediaries, known as futures commission merchants (FCMs). 

FCMs are banks that the CFTC requires customers to use when buying and selling derivatives. FCMs hold collateral for margin trades and they stand ready to make others in the system whole in the event of default by traders. Over time, the clearinghouses (CME and ICE) have required FCMs to put up more and more collateral (to bear the costs of the system), while reaping most of the profits for themselves. The net result is the misalignment of incentives, since every innovation or additional customer brings with it risks born largely by the FCM “gatekeepers” without a corresponding prospect of earning the benefits.

In proposing to make FCMs optional for traders, FTX threatens the incumbents’ lucrative — but problematic — arrangement. On the one hand, FTX’s model would better disperse the risk of collateral shortfalls by implementing real-time margin calls and automatic liquidation of any insufficiently collateralized trades, further backstopped by third-party liquidity providers and a guarantee fund of $250 million of FTX’s own capital. At the same time, by bypassing FCMs (for customers who choose to do so), FTX would mitigate the misalignment of incentives inherent in the incumbents’ intermediated model, providing better access to derivatives markets and ensuring that further innovations are more likely to be adopted. FCMs would still have a role to play in the system as sources of customers and to handle account management and other services.

When Congress required the use of centralized clearinghouses in the Dodd-Frank Act, it did not specify how risk collateral should be allocated among clearinghouses and FCMs. The situation today is not the product of congressional choice or market dynamics, but rather the selfish interests of the incumbents, who are well-positioned to influence the rules of the game. The campaign they and their allies have launched against FTX's proposal in comment letters and public statements is revealing of the threat new competition poses to their business model. So far this effort has proved effective, even leading one member of the House Agriculture Committee to offer the histrionic allegation that the Iranian Revolutionary Guard would benefit from FTX’s application.

It remains to be seen whether FTX has truly invented a better mousetrap, and whether investors looking to hedge risks in crypto trading (as well as FCMs looking to build more valuable customer relationships) will find it attractive. But the CFTC cannot and should not make a judgment about what the market wants — especially one based on the self-interested protests of incumbent firms. Instead, regulators should doubt the incumbent’s Chicken Little claims and permit FTX a chance to bring competition and innovation to derivative markets.

M. Todd Henderson is the Michael J. Marks Professor of Law at the University of Chicago Law School. Geoffrey Manne is the president and founder of the International Center for Law & Economics.