Ahead of the curve podcast

Understanding Risk and Capital Management for crypto derivatives firms

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In this episode of Ahead of the Curve, Scott Sobolewski discusses why more and more crypto currency firms are looking to become regulated entities and the steps required to achieve this. A must-listen for any crypto firm that wants to carve out its niche in the market.

Hello and welcome to Ahead of the Curve, the podcast from Acadia,where we take time to get under the skin of the risk,margin and collateral industry to dig deep and presenttopical perspectives and insights on this hugely important sector.In this edition of Ahead of the Curve, we're back in the studioand on camera with Scott Sobieski, a partner and leadin Acadia's North American Quantitative Services division.Scott, it's great to have you with us. -Thanks, John. Happy to be here.Thank you for joining us. For this episode of Ahead of the Curve.We're going to take a look at how Acadia is using its expertiseand insight to support cryptocurrency firmswith risk and capital requirements for their derivatives trading activity.The cryptocurrency derivatives market has grown hugely in recent years,with some analysts estimating that notional volumesin crypto derivatives now total over $3 trillion.This growth has been led by institutional investors trading futuresand options based primarily on Bitcoin and Ethereum.The recent failure of some large crypto exchanges,such as FTX, has focused the minds of many crypto-focused firms,particularly when it comes to issues and processesaround risk and capital requirements. Scott, that's where your expertiseand knowledge comes in. Let me put this question to you first.What are the key issues here for crypto-focused firms?Crypto regulations have been a pretty big hot-button issue globally,particularly in the US. There's been, thankfully,some regulatory precedent in the derivatives marketas it relates to crypto, with that regulationfalling pretty clearly under the purview of the CFTC.What is the benefit of becoming a registered swap dealer?It allows firms to scale up their derivatives trading volumesand grow their client base, and grow the associated feesthat come with that larger trading activity.Becoming a regulated entity also builds client and investor confidencethat the firm has strong risk management practices in placeand can survive the next downturn in financial markets or crypto markets.That's what a lot of this is about, isn't it, Scott?It's confidence and building confidence in uncertain times.Correct. We certainly don't want the next FTX to happen to a firmthat doesn't have those strong risk management practices in place.The regulatory environment that we're talking aboutis focused in the US. Is it the same for Europeand for the rest of the world? -Yes. Very similar regulationsexist globally. In Europe, for example, the mirror,the European market infrastructure rules also govern large dealers and derivativesand make sure that those firms have heightenedregulatory risk management standards in place.Who's registered so far? -In the US?Just one. FalconX is a company that registeredas a swap dealer last April 2022. We know from discussionswith several other clients of ours that they were certainly consideringfollowing that path leading up to the FTX collapse last fall.I think that's put a bit of a pause on some of those registration processes,but heading into the new year here, we've certainly seen momentum startto build as some of the dust has settled in the crypto markets.Take me through Falcon's process and why they've becomea pathfinder in this process. -I think a lot of the financial headlinesrecently have been focused around retail investors in cryptoand protecting retail investors from certain bad actorsin the crypto markets. I think from an institutional perspective,there are lots of institutional investors out there that would like greater exposureto crypto as a diversifier across all the asset classesthat they're trading. Certainly, having a firm like FalconXbecome registered and regulated allows the institutional investorto have higher confidence that they can trade with that entityand that that entity will be around to survive the next market downturn.It's almost like acquiring the right level of respectabilityfor a market that people are interested in,but perhaps don't know enough about. -It's certainly those are the benefits.The ability to scale your operations. Essentially, the regulatorsare considering you systemically important at that point.That's the get. The give is that there are a lotof heightened regulatory requirements that you need to have in placeinternally as it relates to the calculation processesaround margin and capital adequacy. -This is where Acadia comes in, isn't it?Because this is where you have expertise already.How do you go about supporting firms in this situation?The two critical components of the swap dealer requirements.In the US, there's a margin component for non-cleared trading activity.That's where Acadia has thrived over the last decadein supporting firms in the calculation, reconciliation and exchangeof non-cleared initial margin. We've become the de facto tradestandard industry utility for where that calculationand reconciliation takes place. We've worked with several clientsover the last few years in helping them determinethe optimal margin calculation approach. If you're in the weedsof the uncleared margin rules, you'll know that there's this industrystandard model that ISDA has put out called SIMM,the standard initial margin model. Typically, that's used by a lotof the larger banks and asset managers in the worldto calculate their initial margin requirements.The fallback approach, the simpler approach,is the schedule approach or the grid approach,which is a regulatory-prescribed table of a risk weight multiplied by a notional.You'd think that the SIMM model would be optimal in most cases,but there are certain dynamics of the portfoliowhere the schedule approach could be the more optimal outcomeand result in essentially lower margin requirementson an ongoing basis. Depending on the portfoliocharacteristics, the size, and the directionality,we can help clients essentially test which of those two approachesis most optimal for their trading activities.If the schedule approach is the one that's determined as more optimal,it helps the client avoid needing to go downa very lengthy regulatory approval process if they're a registered swap dealeror a bank, subject to prudential regulationsin the US. -It's tailoring the process, then,for participants in this instance. -It's an infrastructurethat we've worked very hard to build over the last decadeto support calculation of margin requirementsacross every asset class. Crypto is just an additional asset class.How does the crypto margin process work? Just in a bit more detail.Is it just like a single margin call a day, just like any other derivative?Exactly. We've built out the analytics capabilities for crypto,in particular for Bitcoin and Ethereum, which we've observedto be the two most popular reference assetsfor derivatives, at least in the non-cleared markets.We've been able to source liquid market datato include in our calculations of margin from listed futuresand listed options at various exchanges globally.You mentioned Bitcoin and Ethereum, and I mentioned itat the very beginning of the podcast as well.Are they the only cryptocurrencies that you focus on,because there's a bigger world out there? Are there others?There are many altcoins out there in the market.Some have been quite popularised out there in the financial headlines,but from an institutional perspective, at least in terms of the clientswho are trading the large volumes that you'd becomeor have the need to become registered as a swapdealer, so far, at least, they've been primarily focusedon Bitcoin and Ethereum. -It's likely to bethat going ahead as well. -So far. Yes, that's the only demandthat we've seen for clients who are coming to usasking for support and solutions in the margin space.I just want to go back to the point you raised on FalconXon entrance into this market. What conversations are you having?Obviously, there has been the incident involving FTX shaken confidence,but you mentioned that others were beginning to look again.Do you think we'll see others join the likes of FalconXover the next six months. Year or so. -Certainly, and if you follow someof the financial headlines over the course of last summer,several other firms have been historically vocalabout their intention to register as a swap dealerhere in the US. Like I said, I think that has sloweda little bit towards the end of last year, but through our discussionswith clients and potential clients, we definitely see momentum buildingin that space, which is part of the reason why I'm here.Now's the time to start talking. I guess if you want to have a conversationabout becoming a registered swap dealer. -The critical juncture early onis determining whether you're going to pursuea model-based approach or the much simpler fallback schedule approach.Like I said, achieving regulatory approval for your margin modelis a very lengthy, resource-intensive process,not only in the US, but for a lot of other regulators globally.Knowing that you're going to see the benefits of using SIMMas opposed to the schedule approach is a necessary upfront test to dobefore you go down that very lengthy regulatory approval road.Scott, just one final question beyond margin,which is where we've been focusing for the conversation.What else should firms be thinking about? -We've spent a lot of timetalking about margin because that's been historicallythe biggest value add that Acadia has been able to bring to the industry,but more recently, the second component of the swap dealer requirementsin the derivatives world is on capital and maintainingregulatory capital adequacy at all times. If you're not familiarwith the term capital, you can think about itlike equity on a balance sheet. It's making surethat you have enough leftover equity to survive large potential losseson your portfolio during a stressed environment.Acadia has recently developed a capital calculation serviceto help clients make those standardised capitalcalculations very similar to the margin world.You have an option to choose between a model-based approachand your standardised, simpler, standardised approach.The capital world's a little bit more complex than that.There is a specific market risk and credit risk component,but similar to the margin world, we support clients in the developmentand validation of their models for capital.In the market risk space, value at risk modelis a very attractive, popular option. We've assisted many clientsin the last few years achieving regulatory approvalfor their VAR capital models. As it relatesto our hosted daily services, if the model based approach is not onethat's going to provide you with the returnson achieving a regulatory approval down a very similarly lengthy roadin the capital space, we also have the abilityto make a standardised capital calculation for both market riskand various components of credit risk and counterpartycredit risk, alongside the daily margin calculations that we're making.For crypto-focused firms, that attention to the capital spaceis as important as margin. -Exactly, and it's probably a bit moreof a foreign concept. Banks are used to makingcapital calculations and stress testing their capital adequacy,especially coming out of the 2008/2009 financial crisis.That was probably the biggest focus of regulationcoming out of the financial crisis. For newer firmswho are especially non-bank swap dealers, at least here in the US.That capital concept might be a bit more foreign,and they may not be resourced internally to make those sorts of calculationson a daily basis. That's where we've been adding a lotof value to clients more recently. -Scott, there's plenty to thinkabout there. Plenty for firms to be thinking about.Thank you for coming in and sharing your insightand your wisdom with us on Ahead of the Curve.Thanks for having me, John. It was a pleasure.You're very welcome. Thank you for listeningand watching Ahead of the Curve. We'd like to know what you think,so please do get in touch and share your thoughts.You can find out more about Acadia by going to acadia.inc.Until next time, it's goodbye.