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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.
ZERO INTEREST RATES
Adding to the difficulty of lower volume due to large losses by customers and overall deleveraging is that the remedy for the recession — a low to zero interest rate policy by central banks — has made it difficult for brokers to earn interest on customer funds. As competition continues to squeeze brokers’ fees, they have relied more on interest or the float they could earn.
“It has been more difficult. Volume has been dropping. One of the main issues is that Treasury interest income on the customer segregated fund side [is down] so there is less revenue,” Blanc says. “When you have extremely low commission rates and no more Treasury income, what the industry is realizing is that clearing of [futures] was subsidized by Treasury interest.”
And while most of the heads of FCMs we spoke to believe that will change in 2010, it may not be until the second half of the year.
“As we have seen in certain parts of the world, like Australia, there is going to be tightening. Whether it is the next couple of months or not, we expect the UK and U.S. to do the same to ward off potential inflation,” Dan says.
Junya (Jeff) Nagase, president and CEO of Triland USA, expects business to improve in 2010 but adds, “Interest rates will remain low for most of 2010.”
Dan adds that MF Global was still able to generate interest income despite low interest rates. “In the last quarter, Fed Funds have had an effective interest rate of [18 basis points] and we still managed to drive a meaningful return.” Dan estimates MF earned $32 million in the third quarter from net earned interest.
And several FCMs have reported improving conditions as the year has gone on. “Things appear to be loosening up and growing,” says Joseph Guinan, chairman and CEO of Advantage Futures. “August and September were our two best months.”
Marc Nagel, COO of Dorman Trading, also has seen growth and believes Dorman benefits from being smaller. They have grown in the last five years from a small FCM servicing locals to one averaging three million contracts a month. “We have no committees [and] no chain of command [to go through]. We are trying to be a boutique for the retail trader.
“Like everybody else we hit a soft spot in the middle of the year,” Nagel says, but adds, “We are opening up accounts left and right. They look at us and say, ‘they are a little small but they give us the service we need and they have the products we want.”
However, Guinan adds that there is still a great deal of uncertainly following the credit crisis. In prior years he could take those better numbers in the second half of the year and use them to extrapolate growth in 2010. “The problem is that everything has changed. In the past you could better predict growth but since the credit crisis [hit], it is harder to gauge how and when people [will] come back to the markets,” Guinan says.
WHAT WORRIES BROKERS
Peterffy also is concerned with regulatory harmonization. “The CFTC and Securities and Exchange Commission (SEC) are entrusted with drafting legislation that they have to agree on and if they cannot agree they could go to court. That sounds frightening to me because we all will be frozen.”
Peterffy would like to see one merged and powerful regulator and certain sunset laws but fears with both agencies having input you could end up with a similar situation to single stock futures. They have not succeeded in the United States and many insiders blame the dual regulatory structure.
Nagase is concerned with the proposed added capital requirements for FCMs but says the biggest issue for brokers is liquidity and notes that while some additional regulation is necessary, too much regulation could hurt liquidity. “We need liquidity and stability,” Nagase says.
Dan is concerned with the direction the CFTC appears to be taking in terms of position limits. “You don’t control pricing and volatility by limiting participation, so what is going to happen — and you are seeing some signs of it from a U.S. perspective — is people are going to offset risk elsewhere.”
Dan adds that it won’t hurt MF Global because of its global footprint but it is still a bad trend. “The CFTC approach has been more reaction to pricing, as opposed to introducing greater transparency. I find it hard that anybody in Washington should determine how much BP should access the market. It doesn’t make sense.”
Dan adds, “What I am concerned about is politicians responding to populist trends to monitor market performance and they are not looking at a root cause. That to me, from a U.S. perspective, will drive business internationally or away from the regulated market.”
One sector that hasn’t suffered is forex trading, and that could bode well for the industry as it has already faced some added regulations.
“There have been two types of changes. The client facing changes have improved the reputation of the market, particularly in regards to margin restrictions,” says Betsy Waters, global director of dbFX. “The margin restrictions were geared to tiny micro accounts where investors were leveraging up to 400 times. These changes have helped to bring more credibility to the retail foreign exchange market.”
Waters adds that the capital requirements for the forex dealing firms has caused greater consolidation in the forex world and also has improved the space. “Investors don’t understand that they have counterparty risk. These capital requirements are making the counterparties more stable with less risk to the investors.Whether you can attribute the growth to new FX investors or simply market volatility, it certainly hasn’t hurt as forex is one sector that has done well in 2009. “Our business has been growing throughout this year,” Waters adds.
As we noted, the shift to cleared OTC offers opportunities to non-bank FCMs. Dan points out that firms that don’t do proprietary trading and have exotic products on their books are at an advantage. “We don’t directionally trade, we don’t compete with customers, we don’t have conflicts, and we try and be very transparent with what is on our balance sheet. The only level three assets (non liquid) we have are exchange memberships. That contrasts sharply with our bank competitors. Their level three assets as a percentage of their portfolio are 150%.”
Dan adds, “We don’t have any of that risk at MF Global. Our bank competitors have level three assets that could be commercial real-estate property, condominiums in Florida and all the things that have no liquidity. We want to be a compelling alternative to the banks.”
Although the move to cleared products could allow non-bank FCMs to better compete, Chocano says, “Major OTC dealers will most likely continue to be the dominating players in this space as clients will still want to face off to the largest liquidity providers with the largest balance sheets.”
Another move smaller FCMs or niche players are making is using their speed, not girth. Nagel points out that Dorman is the primary purveyor of a cleared hurricane product offered through Weather Risk Solutions on CME’s Clearport because after Lehman failed, another large bank needed 60 days to do its
“We made a deal within an hour and we are the primary purveyor of this hurricane product. It has not been terribly successful but you can come to us and get a decision.”
He adds that people like clarity, especially after the credit crisis where there were many failures from trading opaque products few understood.
“We are strictly a futures clearing firm. There is no complicated organizational chart,” Nagel says. “You can go to the CFTC’s Web site and see exactly what we have. All of our investments are at the CME clearinghouse or at Harris Trust in Treasury bills and cash, so there is a question of clarity here instead of size, which I think
That may be another seismic shift — when larger firms focus on institutional-only business while the smaller firms service the retail client.
The FCM world had been on a one-way track with continuous consolidation and the goal of acquiring scale as the clarion call. While having scale and a global reach are still important and everyone likes lower fees, it appears that there is room for the boutique firm in this new world. Bigger is not necessarily better.