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One year ago, as we were preparing for this story, the financial world was turned on its head and no one was sure how it would all end up except for the realization that a new world with a heavier regulatory burden would emerge.
While much has happened in a year, including a market crash and unprecedented recovery, there is still a lot of mystery as to how this all will end up. The new administration is working on rebuilding the entire U.S. regulatory foundation with an early focus on the over-the-counter (OTC) swap arena, which caused so much chaos. Futures industry leaders are all for it, though some worry that there has been a greater focus on the one regulators structure, for futures, that managed to weather the storm without holding a tin cup up to Washington.
Gonzalo Chocano, global head of futures for Bank of America Merrill Lynch, says, “It was a bit of a perfect storm. Even though the futures business behaved spectacularly during the recent crisis, a lot of end users were deleveraging, so futures volume suffered.”
“There is a lot of truth to the idea that markets need to be more transparent. Not our markets, the listed derivatives markets, they already are transparent. But it is clear that OTC markets need to be more transparent and less vague,” says Patrice Blanc, CEO of Newedge Group. “At the end of the day it is good for the buy side, it is good for the public, it is good for investors. So we completely support this.”
Blanc adds, “The listed derivative markets worked extremely well last year during the crisis. Nothing bad happened. It stayed open and liquid, FCMs were up and running. Our market worked very well, so the first thing I would say is don’t break something that is working well.”
Those concerns have been echoed by FCMs across the board. “The industry came out of the crisis really well,” says Scott Gordon, chairman and CEO of Rosenthal Collins Group (RCG). Gordon points out that there is a focus on risk management in the industry in general and at RCG in particular. “RCG was tested along with the rest of the industry. We came through exceptionally well.”
Thomas Peterffy, chairman and CEO of Interactive Brokers, is a little more introspective. “Futures regulations looked pretty good because it exempted all those contracts that caused the problem,” Peterffy says, referring to the OTC derivatives that fulfilled Warren Buffett’s ominous description of “financial weapons of mass destruction.”
Futures brokers have been predicting the shift to cleared OTC for the past two years but the credit crisis added urgency to the transition, which may be a game-changer for some FCMs.
“Moving all the standard OTC products to a centrally cleared model is good for MF Global,” says Bernard Dan, CEO of MF Global. “That breaks the eight or nine bank monopoly that controlled a lot of the OTC business in the interest rate swap world. That is going to create an opportunity that we can clear other participants. That is good for us.”
Dan points out that non-bank FCMs can offer things the banks can’t. “There are clients that we know that want an alternative to the global banks because we can provide anonymity that the banks can’t provide. They know we don’t compete with them so they feel comfortable giving us order flow.”
Gordon agrees. “We received some interest from customers who in the past would want the biggest [broker]. There has been interest from people, institutions, who in the past would not talk to a non-bank FCM,” he adds.
While regulatory efforts to require OTC products be cleared offer opportunities for brokers, there are some potential hiccups and it is not clear the profit margin will be there.
“One of the main issues is, show me the money,” Blanc says. “Show me if putting those trades on a central clearing organization is [going to help us] in terms of revenue.”
Newedge already is in the cleared OTC business, as are many large FCMs and profit is generated, like in forex, through the bid ask spread. “Few people are talking about this,” Blanc says. “The margin is in the mark up, the spread between two banks or between a bank and a counterparty. So if the money stays in execution, who is going to pay to clear the trade? Who is going to be able to generate enough revenue to pay for the change we will have in IT, in operations, in how we are going to margin these products and so on. That is a big issue.”
It is clear why the transition to cleared OTC has been so slow. “When we do it, the juice is in the execution. We are clearing the trade but we are also executing the trade. I can execute a trade and give it a mark up and send it for clearing on Clearport. I am not making money on Clearport,” Blanc adds.
Another issue is in the structure itself. Last year, some FCMs were concerned that once the CME Group clearinghouse accepted OTC products, particularly the risky credit default swaps that helped to blow up AIG, it could endanger the integrity of the clearinghouse. They wanted a separate structure to handle the newly cleared OTC products.
“I would still like that,” Peterffy says. “They still talk about putting it all together. It would be much more fair to do it separate.”
Blanc also is concerned. “We need to make sure that the exchanges or clearinghouses that are going to take this additional business are not going to jeopardize or put the market at risk by taking in some exotic or toxic products.”
Peterffy adds that there has been discussion about having anywhere between $300 million and $5 billion per clearing member required. “That would indicate to me that they would put these contracts in a separate bucket in the clearinghouse,” he adds, noting that type of capital requirement would eliminate all but the largest players.