A year ago, large futures commission merchants worried about the potential abuse of pricing power the newly formed CME Group might wield and smaller FCMs were looking to the benefits in efficiencies and access to products formerly traded in the opaque over-the counter (OTC) arena that the merger of the Chicago Board of Trade and Chicago Mercantile Exchange would bring. There was concern over the credit crisis brought on by the popping of the housing bubble — already well under way — the potential of a merger between the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) which threatened the benefits of principles-based regulation and the ever-present prospect of continuing consolidation in the industry.
And although CME Group now includes the New York Mercantile Exchange and controls roughly 95% of U.S. futures volume, among FCMs concerns over CME Group pricing power has become a secondary issue. “We know some large exchanges are trying to compete with us but what has been going on in the markets the last few months is more important,” says Newedge CEO Patrice Blanc.
The credit crisis, the remarkable volatility in the futures markets it brought and the uncertain fallout from it are major concerns. The crisis has affected the industry in many positive and negative ways. Volume and open interest were down the first half of the year but exploded along with volatility in the second half. Joe Guinan, CEO of Advantage Futures, says the Eurodollar market had decoupled to a certain extent from the underlying instruments that people rely on the Eurodollar to hedge, which has hurt fixed income volume.
“It started with the bankruptcy of Bear Stearns. Spreads had gotten to a level they are not supposed to reach, so even though the outright markets didn’t move a crazy amount, the bigger movements were in the spreads. We were seeing moves in the spread that were as big and violent as you would see in the outrights,” Guinan says. “People who would trade two-year/10-year, [five-year/10-year and 10-year/30-year spreads], for a living [had to reduce their size]. If they used to trade 30 lots vs. 20 lots now they would be trading 6 vs. 4.”
The huge volatility in agricultural markets provided added volume to that sector and brokers with a high concentration in commodities saw volumes grow in 2008. “We have had some tremendous commodity markets to trade,” says Dan O’Neil, executive vice president of optionsXpress. “Traders naturally gravitate to where the action is and we have had a lot of action in the futures markets this year.”
OptionsXpress has benefitted from added options volume and their customers have fared well during the crisis, which O’Neil attributes to the focus on options. “Our customers are a little more sophisticated, a little more accustomed to using options to protect themselves in markets like this.”
Volatility is a double-edged sword. While increasing volatility leads to greater volume, when it grows too great, it leads to a reduction in trading due to risk.
Gerald Corcoran, CEO of R.J. O’Brien, says the short-term and long-term impact of the credit crisis has been a tale of two cities. “Extremely high volume due to the volatility in the marketplace but you have to sleep with one eye open with the associated risk from these high volumes and volatility. Short-term for us has been good because of the intense volatility. Long-term history will tell us that this type of intense volatility is followed by a calming of the markets and we are prepared to see the marketplace settle down a bit in Q4 and Q1.”
And while the growth in volatility in the second half of the year has led to huge volumes, open interest is down. The last few months volume has picked up but there have been massive liquidations,” says Penson GHCO CEO Chris Hehmeyer. “Open interest is down 40% at the exchanges. There is a good chance next year—for the first time in 15 years—[will have] lower volume.
“You have massive deleveraging, huge customers who won’t be back: Countrywide, Washington Mutual, those firms where all heavy users of the futures markets. And a massive sell-off in commodities with massive liquidation by funds and much lower open interest,” says Hehmeyer. “I would predict negative growth for the futures business in 2009.”
Blanc, who predicted the possibility of deleveraging affecting volume a year ago, says that deleveraging has been offset by more institutions entering the listed exchange market.
“It has been a good year because banks, institutions, hedge funds, mutual funds, all the actors in the interest rate market are trading more and more listed products. It has been a flight to simplicity. Because our products are simple compared to OTC products,” Blanc says. “In the second half of the year we saw more volume due to volatility, but also because banks began trading more listed products and less OTC.”
While the movement of OTC products to listed exchanges, or at least on to the clearinghouses of listed exchanges, has the potential to hugely increase business for years to come, some in the industry are worried about how that takes place. Currently the Intercontinental Exchange, which is in the process of acquiring the Clearing Corp, would create a separate clearinghouse for credit default swaps (CDSs). The CME Group-proposed joint venture with Citadel would clear these products in the CME clearinghouse.
Tom Peterffy, CEO of Interactive Brokers Group, thinks clearing OTC CDSs is a great idea but wants CME Group to segregate those products from current listed products. “As a clearing member, I would be extremely worried if my funds were comingled with funds that had to do with [CDSs]. Even if we became a broker in [CDSs], I would still like it segregated,” Peterffy says. “I don’t want to jeopardize the funds of the clearing members that the exchange holds that are associated with the currently listed products.”
Hehmeyer agrees with Peterffy. “I am very worried that the CME is going to move credit default swaps [into the pool with other customers’ segregated funds] and put all of the futures business at risk. How are they going to margin it? Margining credit default swaps is tricky, it is not like futures, it is event driven. You leave for home on a Friday night and it is OK and you come in on Monday morning and CDSs (which trade from 1 to 100) go from 9 to 100 on Lehman Brothers, I don’t know how you margin that.”
Hehmeyer points out that he is 100% in favor of the CME clearing these products, but he is suspicious of the product and wants to make sure they cannot infect the clearinghouse. “I don’t want to adopt their problems. I am sure they are profitable for the banks, especially if you and I can make a trade and you mark it a profit and I can mark it a profit. That makes me suspicious.”
Clark Hutchison, co-head of exchange traded derivatives at UBS Securities, is concerned with the details. “That depends on what the margin for credit default swaps is. Futures from time to time are undermarginned to their risk and I wouldn’t want to see credit default swaps undermarginned. To me it is more about the margin that is being called day to day and how it is being managed. If they come out with inappropriate margin, inappropriate concentration and inappropriate rules, then it puts the control fund at risk and that would not be a good thing.”
Rand Financial CEO Mike Manning is confident the Merc will get it right. “They need to find a way to separate the risk and other requirements from mainstream futures clearers,” he says. “For clearing firms that don’t want to participate in that market, there is no way you want to assume a piece of that risk.”
The credit crisis has sharply reduced short-term interest rates, which is an important income stream to some FCMs, particularly retail. “All the FCMs are affected, the rates are very low,” says Hehmeyer. “FCMs will have to mind their costs. The interest rate environment is definitely a strong headwind for FCMs.”
Guinan says they have lost income from the float. “When you are earning 5.25%, it is different from when you are making 1.25% on the float.”
Corcoran adds, “Our income is correlated with interest rates and with a lower interest rate environment it will have an impact on our earnings. We are looking at 2009 as being a very low interest rate environment and we are taking the necessary steps to deal with that.”
IS BIGGER BETTER?
With the unprecedented volatility and risk in the market, there has been a movement of customers to large bank backed players with the pools of capital to weather the storm.
“UBS gained business as institutions and hedge funds looked for large solid institutions,” Hutchison says. “People enjoyed that we are a bank, they appreciated our credit rating and that we are not U.S. based to some extent. We have been a beneficiary of a flight to safety. The credit crisis has caused a great deal of volume and we have been a recipient of that volume.”
Blanc says, “We have seen large players disappearing. Bear Stearns is no longer there, they are now part of JP Morgan, Lehman is no longer there, and Merrill Lynch has been sold. There are less participants in the FCM community. The players are bigger and bigger. Scale is definitely the game in town and I don’t think it is over.”
But while there has been a flight to large institutions, there is another side of the coin. “No question you are going to have fewer but bigger institutions,” Manning says, but adds, “All the more reason that there will be more space for boutiques and entrepreneurs.”
Manning says that Rand gets considerable business from institutions wanting to diversify their business from their prime brokers. “Customers don’t want primary dealers seeing everything,” he says.
It seems counterintuitive and almost unfair that problems created by products hatched in the offices of large investment banks will push business to the surviving investment banks.
Russ Wasendorf Sr., chairman and CEO of PFGBEST.com believes this is particularly true of new forex rules. He says the new $20 million capital requirement of the CFTC (which he says will be $30 million effectively) will eliminate 65% of FCMs from offering forex.
“What they are doing is pushing all the forex interest in to the larger firms, especially the investments banks. The investment banks lobbied hard to get this rule. Why would they want to do that?” asks Wasendorf. “Because it eliminates the competition. This rule does not create a stronger regulation, this simply eliminates firms from doing business.”
He says that the smaller firms are much more transparent. “Take the investment banks; it took six months to see how much exposure they had to the subprime market. Good gravy, if they called us and asked how much exposure we had in any market we could tell them in 15 minutes. It is insane for regulators to try and push business to the larger firms that are more difficult to regulate and quite obviously, given recent events, look like they aren’t as well managed.”
Wasendorf adds that his opposition to the rule is a matter of principle and that PFG is not affected by the rule. Peterffy disagrees. “Strong capital on the part of the broker is required. I wouldn’t deal with any broker where $30 million represented a problem.”
CONSOLIDATION & CONCENTRATION
Most brokers agree that there will be greater consolidation. Not everyone agrees that it is a good thing.
“By this time three years from now we are going to have less than 100 FCMs,” Wasendorf says. “It could perpetuate the problem, especially when the regulators are pushing it. To survive regulation and to survive the efficiency challenges, firms are going to consolidate and then you get these behemoths that are more difficult to regulate.”
You may also get the problem of “too big to fail,” which is why the government needed to step in with the bailout. “Wouldn’t it be better to try and help the medium to smaller firms survive and to become competitors [rather than] push everything to larger firms? That would seem logical to me, but that is not what is going to happen,” Wasendorf adds.
Hutchison says that greater consolidation leads to greater concentration and with greater concentration, risk measures need to be adjusted. “I have always been an advocate of understanding risk and part of understanding risk is understanding concentration and part of understanding concentration is to make sure that it is either prevented or it is margined for,” Hutchison says. “I don’t think futures exchanges do a good job of monitoring concentration of clients or of FCMs. Monitoring concentration is an element of change that is needed. If you can’t change the number of players to alleviate the concentration, then you have to change the margin to alleviate the concentration.”
“Consolidation brings on additional challenges; it brings on the challenge of understanding concentration. If you run an FCM and I run an FCM and you have a client who holds 10% of the volume [in a market] and I have a client that is trading in the same [market] and my client holds 50% of the day’s volume, I don’t think that your client should be margined at the same rate as my client,” he says. “If you used to have a bunch of clients trading through 10 FCMs and now they are trading through four, each FCM is carrying a greater proportion of the day’s volume. That equals concentration and maybe that should be accounted for too.”
Hutchison says the issue of concentration of risk will become more relevant as the industry consolidates. “When people get concentrated, when people have risky positions, when people have illiquid positions I change margin requirements. Others do not. That applies in today’s markets where there are plenty of FCMs and that should doubly apply in tomorrow’s markets when there might be fewer FCMs.”
Several brokers we spoke with pointed out that there have been no defaults in the futures arena as a result of the credit crisis. Everyone is not so confident that the success of the industry’s regulatory model will free it from additional regulation.
“The futures industry has been heavily regulated over the last 30 years,” Wasendorf says. “It has been intensive and it has been well handled. The CFTC has done a better job than any other regulator in the U.S. government and that has been borne out by the facts of the situation. The CFTC has created a form of regulation, principles-based regulation, that should be the model for all regulation.” He adds, though, “Sure, we are going to get the wrath of it because we are a small industry and easy to pick on.”
Blanc says that any additional regulation should focus on OTC products. “There is a strong need to build strong regulation and maybe having fewer regulators. You have several regulators. Clearly it would be better with one. And maybe think about having a global worldwide regulator, why not?”
The idea of consolidating the SEC and CFTC is a contentious one but the credit crisis has put this back on the table. Hehmeyer supports the “Twin peaks” approach to regulatory structure suggested in the Treasury Department’s blueprint.
“The Treasury said that they strongly recommend that the SEC adopt the CFTC principle based approach to regulation. I don’t know that the futures industry can ask for more than that. The futures industry got everything that they could want from the Treasury report,” Hehmeyer says.
“The way to do it is to take markets and exchanges out of the SEC [model] and put it in the CFTC [model] and have the SEC control capital raising, 10Qs, public companies and have the CFTC side running exchanges, margins, portfolio margining risks and markets. You let the SEC lawyers who monitor publicly held companies continue to do that, but you take markets and exchanges out of the SEC and put it in to the CFTC and you rename them and combine them.”
While that may be one answer, there is a mistrust of how this would actually occur given the SEC’s size, budget and culture. Judging from the response of other brokers, the transition to a principle based approach will need to occur before a merger can be contemplated.
Hehmeyer has also been trying to mend fences within the futures community. Many FCMs believe the Futures Industry Association only represents the large banks, which has caused a schism. Hehmeyer says that if the futures industry does not speak with one voice there is a chance it could become victim to greater regulation for regulation’s sake.
The futures regulatory model has been validated during the credit crisis and futures brokers believe that is a story that needs to be told. “It is very important that the futures industry point out that the problems came from the regulated products on the securities side and that is what needs to be changed. That needs to be sung by everybody in the futures business — NFA, FIA, CME, ICE, everybody,” Hehmeyer says.
Despite the discord, Corcoran believes this will happen. “In the long run there will be a common voice for the industry and that is something that will happen in 2009. They are going to look at a futures tax again so there will be something that unifies the voices in the industry and brings them together,” he says.
FUTURE OF FUTURES
While there is a difference of opinion of how much of a hangover the credit crisis will cause futures volume in the near-term, brokers agree that the long-term effect will be greater volume as huge OTC volume will move into futures clearinghouses.
“Should we expect volume to be down next year? I would say yes,” Guinan says. “The big Wall Street firms and hedge funds [will] trade less next year.”
There are fewer investment banks and the transition of Goldman Sachs and Morgan Stanley along with Merrill Lynch being folded into traditional banks will affect how much they can trade. “In terms of a multiple for every dollar of value that they had as Goldman, they might have had $30 on their balance sheets. As a bank they won’t be doing that. The entire marketplace will be deleveraging. And not only the big firms but the big firms will force the same thing on hedge funds. They are not going to allow hedge funds to take the same leverage as they used to,” Guinan says.
He adds that this deleveraging also will affect the size local traders at firms like his will trade. While Manning doesn’t think the bull market in commodities is over, it may take a year for it to get back on track. “It will take 10 to12 months for volumes to come back. At the end of the day the Chinese are not going away and India is not going away and world population will continue to grow. Demand for automobiles and other manufactured items will return and that will result in renewed demand for commodities. But it is going to take a while to get back to those levels,” Manning says.