In a certain respect, futures exchanges and futures commission merchants (FCM) have always been competitors. But in a world where for-profit exchanges reach out directly to end users and brokers try and create their own markets, the two sides finds themselves further apart then ever.
But the battle field is a little different. Exchanges have consolidated power and delivered many efficiencies to brokers. This has separated the large investment banks, whose over-the-counter (OTC) business is threatened by the size of the new super exchanges, from the pure futures brokers who covet new markets, which the large scale of the new super exchanges can now deliver.
There used to be unanimity among FCMs of all sizes on many issues, but those battles over side-by-side trading are done and the new battles pit FCM against FCM as much as exchanges and brokers.
Perhaps the Chicago futures exchanges over-dramatized the New York vs. Chicago angle in the battle between the Chicago Mercantile Exchange and Intercontinental Exchange (ICE) to acquire the Chicago Board of Trade. But there is no doubt that the creation of CME Group was viewed differently by the pure futures brokers — many based in Chicago and most of whom supported the deal — and the New York investment banks who appeared to oppose it.
Many of the large futures brokers believe that the exchanges’ and FCMs’ interests are not aligned anymore.
“Clearly they are disintermediating the FCMs, but that is nothing new,” says Fimat Chairman and CEO Patrice Blanc. “I have been complaining about that for three years. The fact that the exchanges are merging together is definitely a threat to FCMs.”
Blanc says the need for scale in the face of the exchanges’ added power influenced Fimat’s decision to merge with Calyon Financial. “We are seeing more and more major listed derivatives exchanges merging or consolidating, it is a reason why Calyon and Fimat are merging because we need to grow bigger to be able to compete with the exchanges trying to disintermediate us.”
Even those firms in favor of the CME/CBOT merger acknowledge that the exchanges have been looking to go directly to some customers, a trend that will only grow with their added size.
“I know for execution purposes they have gone around the clearing firms to provide direct trading access to some of our customers,” says Mike Manning president and CEO of Rand Financial Services. “I am not thrilled with it but it is what it is.”
But to those FCMs whose only business is futures brokerage, the positives of the new CME Group outshine the negatives.
“The best way to say it is that the efficiencies have not gone away,” says Russ Wasendorf, chairman and CEO of PFGBEST.com (formerly Peregrine Financial Group). “We were gaining some important benefits. Clearing through the same clearinghouse and with the potential for the electronic market trading on the same platform.”
Rosenthal Collins Group (RCG) Chairman Scott Gordon agrees. “We are looking forward to the consolidation of the trading floors, we are looking forward to the consolidation of the trading platforms, it is a good thing. We are marching forward to reap the benefits of the merger,” Gordon says.
R.J. O’Brien, like RCG, maintains a full floor presence so the consolidation of the trading floor is an important efficiency. “We are very excited,” says Colleen Mitchell, president of R.J. O’Brien. “Once it’s all on Globex that is one less API we have to support. The floor consolidation will be another tremendous cost savings.”
Besides the obvious issues with disintermediation, the trend of having customers skip over their brokers, at least for execution business, has some FCMs worried. Mark Fisher, head of MBF Clearing, says algorithmic or black box trading going from the end user directly to the exchanges raises issues. “How are the FCMs going to be able to monitor the users of black boxes? How are they going to be able to [monitor risk on] these black boxes? Are these black boxes going to add to increased volatility or decrease volatility?”
Fisher says he does not know the answer but fears this could add an element of risk for FCMs.
The head of a large FCM shares Fisher’s concerns. “We are concerned that non-members can access an exchange in such a way that they are not being screened from a credit point of view. The CFTC went on record in May of this year [as showing concern for this]. The head of enforcement said that they thought very strongly that this was a risk to the market.”
While arrangements to allow end users to go direct to exchanges and have large users become non-clearing members have been around for a some time, the CME’s deal with the China Foreign Exchange Trade System and National Interbank Funding Center (CFETS) —and a similar proposal with BM&F — to become a super clearing member of the exchange is more alarming to FCMs. A proposal to provide exemptive relief to CFETS is currently under review by the Commodity Futures Trading Commission. The Futures Industry Association (FIA) opposes the relief. If granted end users of CFETS would not need to go to a registered FCM to execute their business.
The issue is important to NewEdge (the name Fimat and Calyon will take when their merger becomes final in January), as the combination of Fimat and Calyon will have a huge presence in Asia in general and China in particular.
There are very few firms with access to China and those FCMs who spent several years and many millions of dollars building those relationships in China and Brazil now stand to be pushed out of a market with four billion people by the CME.
“Why would anyone in Brazil want to do business with us if they can go to a Brazilian bank and be part of a super clearing agreement?” commented a head of a leading FCM.
No one is complaining that business is not good. Futures volume is setting records across multiple sectors and the brokers have been benefited. While the return of volatility in equities pumped up volume in equity indexes, the traditional commodity sector got a twofold shot in the arm with increased global volatility and the added distribution of electronic trading.
Traditional commodity brokers saw their technology investments pay off. “Our commercial agricultural business was just exploding,” says RJO’s Mitchell. RJO built their own technology several years ago and says it is paying off. “It has allowed us to get accounts that we would not have been able to get if we didn’t control our own destiny from a technology perspective.”
RCG is another firm that decided to build its own technology and believes it is paying off. “We made a commitment three years ago to build our own trading platform because we believe that is the future,” Gordon says.
While super clearing agreements could allow some huge non-U.S. customers to go directly to an exchange, most brokers don’t fear a larger trend developing.
“There are hundreds of thousands of futures customers that are divvied up between roughly 50 to 75 clearing firms,” Manning says. “The CME has only to deal with these counterparties whose job it is to collect funds from the hundreds of thousands of end users. They don’t want to disintermediate their clearing members. It is in their interest, it is in the interest of the whole process to have [us] in the middle to provide that service.”
Dan O’Neil, EVP of OptionsXpress, agrees. “I don’t think it is an alarming threat by any means. The exchanges recognize and value the role that FCMs play. It is hard to be the CME and chase around some guy in Pocahontas, Iowa who has a $2,000 debit balance.”
While the necessity of that role gives some FCMs comfort, for others it only highlights a flaw in the system.
“The fact that FCMs are still the tax collectors of those fees, is for me extremely unfair,” Blanc says. “That we are responsible to collect the fees from the users and give back those fees to the exchange is extremely unfair because we are not paid by the exchange to perform this function.”
Blanc says that often customers are not fully aware of what they are paying for and view the cost as coming from the broker. “It would be good if the exchange recognized that we are performing some function here,” Blanc adds.
One thing the large and small FCMs agree on is that if CME group attempts to press its advantage that would be a mistake and someone will rise up
O’Neil says, “There is a chance that the exchanges are going to use their new clout to raise fees but there is also a chance that they are going to be able to wrangle out cost savings and efficiencies out of the merger and choose to share some of those savings in the form of lower fees.”
But some FCMs aren’t worried. “Even very large exchanges can be shot out of the box by an upstart that develops better technology or greater efficiency or a cheaper way to offer the product,” Wasendorf says. Though at times it may look like one, Wasendorf doesn’t believe the CME Group has a monopoly; rather, they have earned their market share and will retain it as long as they keep earning it.
“If the CME thinks they can raise prices and not get challenged by an upstart or an existing exchange, then they are naive, “ Wasendorf says. But he doesn’t see that as likely, “There has never been any indication by the CME that they are going to use this merger as a mechanism to raise prices. On the contrary, the merger actually challenges the over-the-counter market.”
OTC is coming
Credit derivatives have been one of the fastest growing markets but are executed bilaterally between institutional couterparties. CME Group wants in; so do futures brokers.
“We are strictly an FCM,” Manning says, “All of our business is exchange traded so any new products offered by exchanges of which we are a member, provide a benefit to us.”
The futures brokerage arms of the major investment banks want in as well and there is a consensus among all parties that these markets will trade more and more on listed exchanges or at least with a clearing mechanism.
“If the exchanges go into the OTC market, it is good for us too. It would enable us to grow our OTC business,” says Blanc.
“The market is asking and regulators are asking that these products move to a more organized and cleared environment,” says one FCM leader.
And when these markets are more in demand, any broker would be at a disadvantage if they can’t offer it to their customers. “Any new product, whether it is a new futures product or a new kind of derivative, if it is going to be exchange traded and centrally cleared, that goes right to our core competency and gives us an opportunity to perhaps compete with these global firms on a small scale,” Manning says. “Goldman’s knees aren’t shaking at the thought of Rand getting into the OTC business but it does give us a chance to compete and more importantly it gives us a chance to offer it to customers that want to trade those things and if we can’t provide it, then perhaps they start looking at the global firm,” he adds.
But so far listed credit derivatives have not been a success for the numerous exchanges listing them. The banks aren’t trading them yet. But unlike other new sectors in the futures industry, potential players are ready for this, and because no one really has first mover advantage, where listed and or cleared credit derivatives become established is an open question.
Most insiders agree that credit is trending towards a cleared environment. Who will ultimately build the platform they trade on is unknown.
One possibility is that the Clearing Corp will come in as a clearing agent for OTC. It would have the advantage of being owned by most of the big banks that are currently trading in the OTC environment, though similar advantages with Broker Tech and Eurex US failed to move Treasury futures. Of course this time they would be starting off on equal footing.
“It could come from the CME, it could come from the Clearing Corp, it could come from Europe too,” Blanc says. “It could come from LCH Clearnet, it could come from Eurex.”
One of the reasons why everyone expects credit markets to move is this summer’s subprime meltdown. With numerous hedge fund blow-ups and multi-billion dollar losses by major banks and brokerages, there has been call to shine a light on the sector. The Enron implosion led to increased volumes in energy futures and the development of cleared OTC products and the same could happen in the credit market.
“What happened in July and August — and it is not over with — will have some consequence on the way the market looks at some products,” Blanc says.
Manning says that anytime you see these kinds of losses it benefits the listed and cleared market model. “Enron certainly helped the exchange traded derivatives when that thing blew up.”
O’Neil says the problems with OTC forex have led to a resurgence in currency futures trading. “There has been some pretty negative news out of the OTC forex sector and people see exchange traded products as more credible. Our currency futures business has been growing.”
While fallout can benefit the industry through the movement of certain products on to listed markets, Blanc says it also could hurt liquidity. “Are we going to pay the price for what happened this summer?” Blanc asks. “People are going to be extremely cautious about the level of risk they take in the market, especially coming from the big banks. When you are reducing risk, you are reducing leverage and when you are reducing leverage you can reduce the volume on those markets.”
One of the reasons a listed credit derivatives market has been slow to get off of the ground is because of confusion as to its structure and what regulator they would fall under. Regulatory wrangling allowed Eurex to list a credit derivative futures before ones contemplated by the CME and Chicago Board Options Exchange. This has led to renewed calls for merging the two U.S. regulators. Most FCMs acknowledge the problem and in a perfect world a one agency solution might be best but there is fear that the one regulator would look more like the Securities and Exchange Commission (SEC) — with its prescriptive rules and huge bureaucracy that can kill ideas through its inertia than the Commodity Futures Trading Commission, whose principles based approach has allowed vibrant growth.
But cooperation is necessary. New products are blurring the line between futures and securities and that trend is likely to continue. The SEC has begun incorporating portfolio margining but an arrangement has not been made to include futures and securities in a portfolio margin account.
Brokers like OptionsXpress who are active in both markets want to offer this to their clients. “The future is having all the products on a single platform. Any regulatory help we can get in terms of cross margining will be a tremendous boost,” O’Neil says.
Compromise sounds nice but the two regulators compromised on the rules for single stock futures and most brokers blame those rules for why single stock futures have failed in the United States. “If you try and create a hybrid between the two, you don’t get a hybrid; you get a bastard like the regulation for single stock futures. It is the worst body of regulation in our entire industry,” Wasendorf says.
Subprime fallout could slow the global push towards principles-based regulation. The most striking thing about the whole credit area is how little is known about it. Though it may be an oversimplification, the futures industry’s transparent centrally-cleared model seems to be the best medicine for these markets.
It has been another interesting and successful year, but with all the mergers and acquisitions, new markets and disintermediation, perhaps the biggest news is the extent to which the value of futures markets is understood on a global level.
Who will develop the next big market? No one knows, but for those markets to serve a purpose, they will need to be true markets for transparent price discovery.