Are there systemic risks in clearing bitcoin?

Thomas Peterffy, founder, chairman, and CEO of Interactive Brokers Group, has sent a letter to CME and OCC Clearing Members expressing concerns about the exchanges’s decision to begin offering Bitcoin futures in December.

Dated November 27, 2017, the letter notes:

This letter is to request that you urge the CFTC, CME, CBOE Futures Exchange (CFE) and OCC not to
allow clearing of bitcoin products through registered derivatives clearing organizations (DCOs) that also
clear non-bitcoin futures until the CFTC has examined the risks to the clearing organizations, their
members and the financial markets as a whole; and after considering public comment and the views of
other interested agencies such as the SEC and the Federal Reserve Board.

(Full letter: Letter-to-OCC-and-CME-clearing-Members-from-Thomas-Peterffy-11-27-17.)

Speaking to FT Alphaville on Wednesday, Peterffy said that while he thinks Bitcoin is an interesting product, its experimental status means it should be treated with extreme caution:

Clearing Bitcoins is a very important issue for members of the clearing organizations. Unfortunately at most firms, this is handled at a low level, in the back office and top executives do not pay much attention. The Banks and Brokers are about to commit mass suicide and nobody is paying attention.

The problem for Peterffy is that Bitcoin’s price movements are both arbitrary and large. Even a 30 per cent margin requirement might not be enough to prevent losses for the central counterparty. “Who is to say how much the price can move in one day?”

Petterfy is particularly worried about clearing contagion.

As it stands, the weakest clearing brokers have the least to lose and the most to gain by providing high leverage to customers, he says. If and when their customers come up short of funds, the risk is these entities default on the clearing house, forcing the clearing house to take over their position to make up the shortfall.

This usually then leads to forced liquidation of inherited positions, which pushes the price further in the distressed direction, causing even more customers and members to run out of money. And this, he notes, is how a Bitcoin sell-off could cause a contagion effect:

When the clearing house defaults, brokers who have no customers with Bitcoins will nevertheless be unable to continue to service their customers who have positions in US treasuries, currencies, stock index futures or agricultural products.

The brokers must pay their winning customers even if they cannot collect from the clearing house. Accordingly the brokers can never win, they can only lose in a default.

To mitigate the risk, Peterffy asks Bitcoin clearing operations be — at the very minimum — fully segregated from the broader activities of the exchange and clearing house:

Either we put the clearing of bitcoin into an isolated clearing house or another isolated legal entity, or the CFTC has to ensure every clearing member clears these contracts is a large regulated entity with regulatory capital of at least $10bn or some similarly large amount.

If nothing is done, he worries we could be headed for a quick revisit of 2008.

It’s worth noting not everyone agrees about the scale of the risk.

“Choose a big enough margin, and it’s not an issue,” Craig Pirrong, noted market structure and clearing expert from the University of Houston. “I looked at the data, and found that a 20 per cent initial margin, which is huge, by the way — crude oil is on the order of 4 per cent — would have covered 99 per cent of the price moves in 2016-2017. CME has talked about 25-30 pct. So that should be adequate.”

Related links:
Why Bitcoin futures and a shoddy market structure pose problems — FT Alphaville