The first rule of crypto club is you do not talk about crypto club.

Banks are tiptoeing into the unpredictable and unregulated world of crypto, and they don’t want you to know about it. Clearing and trading services are invite-only for select clientele, with banks wary of offering their wares to a wider customer base.

A list of clearing firms that offer cryptocurrency derivatives services appears on CME Group’s website—yet only one bank, Macquarie, is featured. Conversations with dozens of sources across the industry reveal that almost every major US and European bank clears crypto futures, including cash-settled bitcoin and ether contracts. But most are doing so cautiously—even grudgingly—to help sustain key relationships.

Concerns over expensive capital requirements, reputational damage and counterparty credit risk are deterring banks that are clearing crypto derivatives from seeking new clients.

The former head of clearing at a tier one bank calls it a “badge of shame”, possibly in reference to cryptos’ links to criminality and high energy usage. Another clearing sales specialist warns that becoming known as a “crypto clearer…might also scare away other clients”.

A senior clearing source at one large European bank, which offers futures to select clients, describes crypto as a “risk asset on steroids” and says recent market moves “don’t help solidify the case”.

At least one bank explicitly rules out clearing trades with firms whose business model revolves mainly around bitcoin for credit risk reasons. Many clients of banks have asked for bitcoin clearing and have been rejected, according to multiple sources.

“If you consider doing it, it’s for your strategic clients,” says a clearing source at a large bank. “Anything else I would expect to be off the table for tier one banks.”

Yet almost every major futures commission merchant (FCM) offers the service: Bank of America, Citi, Goldman Sachs, JP Morgan, Morgan Stanley, ABN Amro, Barclays, Societe Generale and UBS are all understood to offer crypto derivatives clearing. Only one major clearing bank stands out as offering no cryptocurrency derivatives to clients: BNP Paribas. The banks declined to comment for this article.

The head of over-the-counter derivative operations at a tier-one bank, which also only clears crypto derivatives for established clients with large businesses that span multiple asset classes, says: “It’s like an accommodation thing for now. I’m sure as we get more used to it attitudes will change.”

Whether crypto is increasingly adopted or not, for now bank risk managers are playing it safe, both with size of margin add-ons charged, and the types of clients invited to trade and clear crypto. All banks charge considerably more margin to clients on top of the standard demanded by the exchange, ranging from as much as 40% more margin to the coverage of the entire notional.

“It’s actually been quite fun,” the OTC derivative operations head adds. “It’s given our risk managers an interesting intellectual challenge to think about risk methodologies for this asset class.” For now though, the bank’s risk management practices are “aggressive, a 100% [margin] charge, because it’s new, it’s not totally well known, and markets are reasonably volatile”.

Token efforts

Bitcoin, ether and other cryptocurrencies are increasingly piquing the interest of financial institutions as valuations have skyrocketed in an environment of compressed yields for mainstream investments.

Estimates vary on the size of the market. Digital currency analysis firm CoinGecko reports that total market capitalization of cryptocurrencies is $2 trillion, down from a high of $3 trillion last year—although many believe it’s invalid to apply a notion of market cap to an intangible asset such as crypto. The price of bitcoin, the largest and oldest cryptocurrency, peaked at around $68,000 in November 2021, before slumping to $42,500 on February 7.

For one large EU clearing bank, client interest in bitcoin ebbs and flows with price.

“The peak of attention was somewhere at the start of 2021, when it moved from $20,000 to $60,000,” says the senior source at the bank. “There was a big Fomo when everybody wanted to buy bitcoin. Asset managers were part of this trend. It has calmed down a bit since then.”

As the market has grown it has attracted brickbats as well as bouquets. A November 2021 report from the Law Library of Congress shows the number of countries that have issued cryptocurrency bans has increased since 2018. Last June, China banned financial firms from processing crypto transactions, sparking a blip in the price of bitcoin. In the US, bitcoin’s legal status has been called into question. In Europe, a top regulator has called for a ban on bitcoin mining. And technologists argue the cryptocurrency’s code could become vulnerable to hacking by quantum computers.

It is in this context that banks have cautiously moved into the space to service select clients, but are concerned about being seen as endorsing the nascent asset class.

“It is not a sustainable tool for payment,” says the clearing bank source, in reference to bitcoin’s massive energy consumption.

CME says overall there are at least an additional eight FCMs that support the clearing of bitcoin futures, compared to the 16 non-bank FCMs disclosed. The total number of CME clearing members is 65.

In response to why those additional FCMs are not publicly listed on CME’s website, a spokesperson for the clearer says: “Essentially it’s at the discretion of the FCMs, brokers and block liquidity providers to have their contact information listed on our website for bitcoin futures clearing and execution. Some FCMs/liquidity providers may only be willing to deal with existing clients so don’t want to be listed to attract additional new clients looking for two-way prices in bitcoin. This is why it’s at their discretion.”

Big risk…

Putting broad reputational risks to one side, there are other reasons banks have an incentive to keep their crypto activities under wraps.

In 2018, banks complained about the introduction of bitcoin futures to CME and Cboe, suggesting it was unnecessarily inviting great risk to members—even those not choosing to clear the product. They went so far as to propose the asset class be cleared separately from all others, getting its own default fund. Since clearing houses mutualize the losses of defaulted clearing firms, a separate default fund would protect FCMs that don’t clear the product.

One lobbyist wonders if many of the firms that initially fought against the launch of crypto products at CME, “now offer them, so maybe out of respect for them they’ve asked CME not to show they’ve changed their mind”.

A senior source at a large US bank says it’s possible approvals simply haven’t gone through for banks to be on the list. Alternatively, he suggests it could be because of how choosy the bank is in deciding who gets to clear crypto.

“Maybe it’s because it’s not offered to all clients, and only offered selectively,” the source says. “Smaller firms want to advertise though; they look at things differently.”

Yet the market servicing demand for crypto continues to expand. According to the Futures Industry Association, there were 16 listed crypto futures and options on offer at regulated derivatives exchanges around the world at the end of October 2021. Several futures-based bitcoin exchange-traded funds, led by the ProShares Bitcoin Strategy ETF in October, have bolstered appetite for crypto derivatives. However, not all fund providers are rushing to launch products, with at least two issuers shelving plans to release bitcoin futures ETFs.

In October, cryptocurrency exchange FTX finalized its acquisition of crypto derivatives platform LedgerX, which is regulated by the Commodity Futures Trading Commission. In the same month, Cboe purchased ErisX, giving it entry to digital asset spot and derivatives markets, including clearing and settlement.

In January, Goldman Sachs analysts said bitcoin could reach a price of $100,000 over the next five years, and blue-chip buy-side clients are already eyeing opportunities in the crypto space, with fund groups such as BlackRock known to dabble in bitcoin futures.

…brings big margin

But those who sow the wind have been known to reap the whirlwind. Crypto offers the prospect of large returns, yet investors face elevated counterparty risk—and banks are mitigating this risk by slapping on huge margin top-ups.

Currently at CME, bitcoin outright margins are set at 32% of contract notional value, down from 35% at the beginning of December 2021. At times last year, the required initial margin for CME’s bitcoin futures—which are cash settled and do not require physical holding of the cryptocurrency—reached around one-quarter the size of that pledged for its 10-year Treasury futures, on which the estimated margin is 1.4%.

At about $5 billion, the reported open interest for CME’s bitcoin futures was about one-hundredth the size of its 10-year Treasury futures around the time of bitcoin’s price peak in early November 2021. At 35%, an estimate of CME’s required initial margin on those contracts was then around $3.6 billion. The initial margin on its 10-year Treasury futures was $14.4 billion.

Regulatory capital for both bank and non-bank FCMs is calculated as 8% of required margin. FCM adjusted net capital would have been in excess of $140 million for CME bitcoin futures in November, compared with $578 million for 10-year Treasury futures.

At the end of January, the open interest value of 10-year Treasury futures, at $488 billion, was more than 200 times greater than bitcoin futures at $2.3 billion, meaning the required initial margin for bitcoin futures had reduced in size to around one-tenth of that for 10-year Treasury futures.

A CME spokesperson says: “Margins for bitcoin futures remain conservative compared to our benchmark models,” adding that bitcoin margin accounts for about 1% of margin on hand at the clearing house.

A clearing industry veteran says that the capital burden is bound to increase: “The size and use of crypto regulated futures are likely to grow. And the amount of capital you need to clear bitcoin futures is materially larger than other products.”

The veteran adds that ‘crypto-native’ investors with a greater appetite for bitcoin futures are probably willing to pay more for that exposure. But it’s less clear whether large institutional accounts such as BlackRock will be prepared to pay a premium. “Most large accounts will want to pay the same amount for any type of future.”

That raises a key question. How can the market grow if banks don’t allocate enough capital to it? Added to that, as the crypto derivatives margin burden expands, clearing capacity more generally has shrunk. In recent years, BNY Mellon, Nomura, Royal Bank of Scotland and State Street have retreated from the clearing business.

“US banks are going to have to take the capital burden,” predicts the veteran, “and they’re going have to admit they’ve taken it, and they’re going to have to take a lot more than the VIP clients they are accommodating right now.”

Supply and demand

For now, though, clearing banks are carefully approaching the space, with divergent but cautious policies (see table).

One clearing sales specialist at an EU bank was an early skeptic of crypto, but is coming round to its promise. Their bank asks clients to cover 100% of the notional value of bitcoin. For long positions, this effectively means that leverage has been removed from the product.

“The offer is there, but it’s quite expensive, 100% pre-pay, as it’s such a huge risk for a clearing broker,” says the source.

This is on the more conservative end of the spectrum, however. Most banks charge a significant add-on on top of exchange margin, but don’t remove leverage from the futures entirely. For instance, one European bank charges an additional 40% in base margin and doubles stress margin, while another bank simply doubles exchange initial margin.

This is mostly for risk purposes, as banks are unsure how best to model cryptocurrency, but also due to hefty capital requirements.

Adding to bank caution are the types of clients that banks allow to use cryptocurrency. Many smaller clients which are deemed to have inadequate controls are rejected.

For instance, the first clearing source at the large European clearing bank says bitcoin derivatives are only offered “selectively and on reverse inquiry”, and that it charges double exchange initial margin to clients. The senior source at the large US clearing bank says it rejects any clients that exclusively want to trade crypto, only accepting clients that are adding crypto to a wider portfolio of trading.

These factors could help to explain why every bank source that spoke to Risk.net described trading volumes as relatively small, and that it wasn’t a lucrative business. Most banks serve between 10 and 30 clients in the space, ranging from hedge funds, market-makers and some asset managers.

“I don’t know of many cases where clients take up the offer, because it’s just so expensive,” says the clearing sales specialist at the EU bank. “That’s the most difficult part about crypto; it’s such a speculative instrument and [client clearers] don’t want to burn their fingers. But if you have a big client and the client wants to clear crypto then of course you will do it.”

A senior source at a third EU bank agrees, saying it’s “never been a big fee earner” and that demand has “always been fairly limited”.

Where’s the capital?

With clearing banks wary of offering their services too widely, the opportunity may fall to non-bank FCMs to take up the slack. But they, too, have concerns over the level of capital required to support the business.

One non-bank FCM, Straits Financial, says the 8% regulatory capital requirement already means it scrutinizes whether the volume is worth doing for some clients. Its chief operating officer, Paul Fry, says: “We are seeing financial institutions, including ETFs coming in to hedge and roll positions once every couple of months. On $1 million in margin, our regulatory capital is approximately $80,000. As it scales up with exchange margins, FCMs have to look at their cost of regulatory capital and determine if that business makes sense.”

However, he believes that, “as institutional flow picks up, the exchanges will probably have to juggle between risk management and making it commercially competitive to ETFs”.

Bob Fitzsimmons, executive vice-president at Wedbush Securities, says the broker-dealer rounds up the margin it collects on crypto futures from CME’s minimum to 40%. Based on that level of margin, if the crypto futures ETF market hit $50 billion in assets under management, then FCMs would need about $1.6 billion in regulatory capital just for one side of the trade, assuming market-makers were on the other side, he says.

“So you’re saying, as an industry, we probably need additional capital in here to the tune of $2 billion to $3 billion,” says Fitzsimmons.

One way non-bank FCMs can finance capital is by raising subordinated debt. Fitzsimmons adds: “It counts as regulatory capital. But there are restrictions as to the length of time for it to count—it has to be over one-year term. And there are a number of other constraints, so that investors can’t pull the money out.”