At the start of 2022, over-leveraged crypto markets suffered a sobering shock, with most cryptocurrencies losing half of their value in weeks. In January alone, bitcoin (BTC) retraced by 30% from $42,000 to less than $30,000. Then, after a short-lived rally, in February, BTC crashed again, this time by 25%. It’s a pattern that repeats almost on a loop with traders who aren’t managing their risk appropriately, reeling from their losses.
Some argue that pullbacks like these are healthy market corrections. Liquidated futures positions flush out excessive leverage and risky speculators from the market. But with so much at stake in these brutal margin calls, others argue that there’s a better way to manage trading on futures markets.
Automated Margin Calls
The answer, according to FTX’s Sam Bankman-Fried (SBF), is automated margin calls. The regulated US-based cryptocurrency exchange wants the US futures markets to adopt its technology, bringing 24/7 trading and automated risk management to the traditional financial system and removing brokers from the equation.
It’s a proposal that has gained significant traction since it was issued by FTX earlier this year. So much so, in fact, that the Commodity Futures Trading Commission (CFTC) that regulates the multi-trillion-dollar US futures market, orchestrated a lengthy discussion with various industry participants from farmers and their representatives to financial services behemoths like JPMorgan and the CME Group.
There are advantages to automated margin calls
One notable feature of automated margin calls is that they allow traders to manage their own risk. By replacing brokers with computer algorithms, the intermediaries between customers and exchanges that have existed for the past 40 years are entirely removed from the equation. Margin is calculated every 30 seconds, and traders are automatically informed if they need to adjust their balances to avoid being automatically liquidated.
An automated risk system like this allows traders to take advantage of 24/7 markets, take out positions quickly and easily without any gatekeepers, and take advantage of reacting to events in real-time in around-the-clock trading.
A disinterested algorithm would cause more liquidations as real-time margin monitoring would automatically shut down accounts in 10% increments. However, SBF argues that these frequent liquidations would be smaller and more palatable to traders, and ultimately better for the industry as massive deleveraging events shaving 30% off BTC’s price would be reduced. Further, removing brokers from the transaction would allow exchanges to reduce their costs and pass those savings on to their customers.
Yet, leaving an algorithm in charge can be problematic
In the frenetic crypto markets where $8K candles are not uncommon and the price can correct by a third in 24 hours, managing risk is a massive responsibility. Traders often find themselves waking up the next morning to see their balances wiped out. While that’s a tough pill to swallow for the individual trader, as Nelson Neale, President of CHS Hedging (the futures broker of a leading US farming cooperative), points out:
“With an auto-liquidation scheme, a crypto trader goes to bed at 11 pm and wakes up at 7 am and, all of a sudden, he’s been knocked out of his position, or liquidated — a bad day certainly, but perhaps not as bad if we consider the same scenario for the American farmer. He goes to bed with a corn position to hedge his physical inventory at 11 pm, wakes up at 7 am, or probably a bit earlier, and he has no position. All of a sudden, the value of his inventory goes down considerably… He may have loan obligations he may no longer be able to commit to”.
With automated margin calls, the responsibility for maintaining margin falls firmly in the hands of the customer rather than receiving a warning call from a broker. Computer algorithms also notably lack human qualities like discretion and compassion. During the tumultuous events of March 2020 as COVID-19 panic swept through the financial markets, Citi Group suffered a technology glitch causing it to miss a margin call on its derivatives contracts with Intercontinental Exchange (ICE).
Using human discretion, ICE decided to give the banking giant a grace period so as not to dislocate the market even further. “It would’ve been cataclysmic at that moment in time ”, stated the exchange’s chief development officer.
In all fairness, FTX does issue frequent margin maintenance warnings. You just have to be awake 24/7 to see your phone at all times. When you only have 120 seconds to get past your 2FA and into your account to top up your balance, avoiding automated liquidation is a Herculean task.
How automated margin calls can become mainstream
If automated margin calls are so punishing, why would anyone want to trade in these conditions and, more to the point, take this cut-throat model from crypto to the mainstream? Well, as technology has proven at every turn, removing layers of middlemen allows for improved efficiency and cost savings. Yet, current tools aren’t sophisticated enough to accommodate the human participants involved in futures markets—or to prevent potentially catastrophic market events.
Traditional investors and institutions need highly advanced automated risk management tools that are simply absent from the crypto space right now. If proposals like FTX’s are to take flight, the industry needs to accommodate the needs of this type of investor and provide tools that allow for at-a-glance risk management and significant advanced warning.
For automated margin calls to work, all scenarios must be taken into account, from black swan events like March 2020 to the massive daily fluctuations of low-cap coins. Traders need interfaces that give them a single view of all their positions across multiple exchanges so that they can see their entire risk, while also benefiting from a level of service that respects the human element; akin to that of a broker.
Risk management is the single most important element in success, and it’s vital that the crypto industry invests in this type of infrastructure further before rolling it out to the mainstream markets.