Dodd-Frank: Game changer for futures brokers
By Gary DeWaal
The recently passed Wall Street Reform and Consumer Protection Act is a potential game changer for futures commission merchants (FCMs). But navigating a response to it is probably as treacherous as charting a course through the famous Strait of Messina between the legendary monsters Scylla and Charybdis: one bad maneuver and an exciting opportunity could easily turn into a costly mistake.
Let there be no mistake: centrally cleared over-the-counter (OTC) swaps processed through FCMs for ultimate customers are nothing new. Since May 31, 2002, the New York Mercantile Exchange (now part of CME Group) has been clearing energy OTC products on its Clearport platform. Currently 500,000 OTC agricultural, credit, energy, green and metals contracts of all types are cleared through Clearport daily, and other OTC commodity contracts are cleared through platforms offered by ICE Europe and SGX Asia Clear. Likewise, interest rate swaps have already begun clearing through the International Derivatives Clearinghouse as well as the CME, in the latter case in connection with trades initially executed through the new ERIS platform.
These facilities all share one important characteristic: they are open clearing systems where end users can access important OTC products that are ultimately carried at robust clearinghouses, and intermediated by FCMs.
The new legislation in the United States and similar regulation proposed by the European Commission to be overseen by the new European Securities and Market Association -- by mandating the central clearing and execution of most OTC swaps -- could increase by large multiples the amount of contracts available to FCMs to both intermediate on behalf of their customers as executing broker, but also to carry as clearing broker. This is the theoretically good news, but this theoretical good news is enveloped in many difficulties.
Efficiency means that somebody’s margin will be cut
First of all, change isn’t always easy and there is a need for some cultural change for dealers. They may very well not want to give up the large bid-ask spreads they have been deriving over the years in the sale of swaps bilaterally to ultimate clients. Instead, they may be tempted to delay and complicate implementation of the reform legislation. Moreover, dealers and their lobbying partners will try to convince regulators that only dealers can possibly offer cleared swaps to end users. They will propose standards to exclude brokers as much as possible, along the lines of the current LCH Swap Clear and ICE Trust models. Regulators must be mindful that this is nothing more than a plea for “business as usual” and resist efforts at closed clearing and execution platforms.
Operating profitably under the new rules
Secondly, even presuming regulators will encourage open clearing and execution systems, FCMs must figure out how to conduct this business profitably. This will be far more difficult than it seems. Why? First, there will be many new exchanges and swap execution facilities, not to mention clearing houses, likely to be created to offer these new products as well as the existing platforms. The costs of connectivity by FCMs will be very high with the likelihood that only a few of these facilities will be successful. This is in addition to the incremental costs FCMs will likely incur that are associated with new processing and risk systems necessary to accommodate this OTC business, as well as salaries for additional trained staff.
Moreover, the cost of capital in carrying OTC positions for customers will likely be higher than carrying futures positions, because even if capital requirements are at the same level as for futures (8% of margin requirements), swap positions typically have longer durations than futures positions and therefore, are likely to be held, in most cases, for a longer period of time.
Accounting for errors
Finally, errors will occur and FCMs need to accrue (either in practice or in theory) for the possibility of defaults by some of their own clients, let alone those of other clearing members for which they will be responsible potentially through the default mechanism of clearing houses.
The question is how will customers be willing to pay for all these costs? Certainly, the old model of charging customers a one shot prenegotiated flat charge at the initiation or close out of their position will have to be reevaluated, particularly in today’s near zero interest rate environment. Charges will probably have to include a component reflecting the length of time a position is carried. Customers should be willing to pay this enhanced charge because of the diminishment of the bid ask spread on OTC products that is likely to come about because of central execution. But while this might be accepted when these new products launch, institutional memories are short and competition will surely drive down commissions over the long term.
FCMs will have to carefully develop their business plans to accommodate this potentially large amount of new business. The potential new volumes are alluring, but the costs will also be quite high. FCMs will have to be selective in choosing which exchanges, SEFs and clearinghouses they support. Because if they choose the wrong ones, they could be at risk of not just wasting resources, but also of losing potential clients. This all might cause some interesting joint ventures to develop among today’s competitors as well as a further swell of consolidations.
Thus, FCMs must be clever like the legendary sailor Jason, who along with his Argonauts was able to successfully navigate Scylla and Charybdis. It certainly is possible, but there is no doubt that there are high risks as well!
Gary DeWaal is senior managing director and group general counsel for Newedge.