A year ago futures commission merchants (FCMs) were looking forward to the opportunity of getting into the cleared over-the-counter (OTC) space as it clearly would be mandated in reaction to the credit crisis — which reached its zenith in 2008 — but were a little worried that the greater mandate for regulation as a result of the crisis would add to their compliance cost.
A year later, financial reform is law, but instead of expediting the move to OTC clearing, which had already been underway, the law may be slowing momentum as players wait for rules to be written. While the Commodity Futures Trading Commission (CFTC) has been speedily writing rules, those rules need to be commented on and made final. The mid-term Republican takeover of the House of Representatives could complicate matters as many in the GOP opposed the law and could attempt to overturn it or at least defund those agencies charged with carrying it out.
FCMs see the new world as a double-edged sword with the potential to access a new class of OTC products traded on exchanges or at least cleared along with a more onerous compliance structure. As they wait for rules, 2010 appears to have been a mixed bag, with some firms showing increased volumes, especially those taking advantage of volatility in the agricultural markets in the second half of the year, and others just getting by.
"It has been slower than 2009 and 2009 was slower than 2008," says Tom Peterffy, CEO of Interactive Brokers Group.
R.J. O’Brien (RJO) CEO Gerry Corcoran says the firm is up 19% year to date thanks to expansion in Canada and Beijing and an energized ag market. "It is commodity-centric and we also have established an FCM presence in Hong Kong," Corcoran says.
MF Global CFO Randy MacDonald says the firm returned to profitability as customers who fled to a risk-free environment returned. "The very firms whose risk management systems failed them and needed to take TARP money are the firms that received assets that year. Because they had government backing, people felt comfortable moving their assets from us to them. That trend reversed this year where we saw people move their balances back," MacDonald says.
Brokers operating in both the futures and securities spaces report that futures business has been robust, which is why such securities stalwarts as TD Ameritrade are looking to futures brokerage.
"We were born a securities broker and we continue to see people on the securities side looking to broaden their horizons," says optionsXpress CEO Dan O’Neil. "They are looking beyond traditional stocks and bonds and we are starting to benefit from having all the products on a single platform."
Marc Nagel, COO of Dorman Trading, has noticed that movement as well. "Everyone is trying to make money trading futures, especially S&P E-minis. When they moved to pennies in equities, it really got hard to make money there," Nagel says.
Waiting is the hardest part
"There is the inertia of waiting for the regulators to now take what the legislators said — go centralize this — [and execute it]," MacDonald says. "Go reduce the mystery of this by forcing it to be centrally cleared."
Newedge CEO Nicolas Breteau says, "It is true that we are waiting to see what the regulation will be, on both sides, Dodd-Frank and what the European Commission will put in place in Europe."
While the actual mandate may be slowing things down, that could give FCMs time to prepare.
"We are not a significant player in the bilateral OTC marketplace, so I don’t feel like we have been held up by the rule-making process," says Corcoran. "In some ways the rule-making process that has slowed things down has been beneficial for RJO allowing us to get our ducks in a row."
Others see something more onerous afoot. "Everybody pretends to be frozen because they [are] hoping that these things will go away," Peterffy says. "The banks don’t want to talk about it. They are basically hoping that somehow it will go away and changes in the House will make it go away. Obviously they make more money when they trade these products OTC than if it is on an exchange.
"I am puzzled how the banks can convince their customers that listing the products on exchanges could be bad for them. Why? It is not their money. It is the employees that work for the large corporations, pension funds, mutual funds and local governments who enter into these trades on behalf of the shareholders and the taxpayers not on their own behalf," Peterffy says.
Still it is the uncertainty that many brokers see as a bigger problem than the regulation, especially those facing multiple regulatory environments. Breteau is concerned about cross-border regulation. "The big question for us is, when will it come into force and the convergence between the regulation [in the U.S. and Europe]. We don’t want to be caught in arbitrage between the two."
But most FCMs are excited to join the cleared OTC fray. "It is good for our business, it is good for the industry," MacDonald says. "That you can have central clearing is a huge benefit to a firm like us. Things like swaps and [credit default swaps] that we don’t participate in today, we can participate in tomorrow."
But while all FCMs not affiliated with an investment bank have been chomping at the bit to get into the cleared OTC space, much of that optimism has been tempered with the mid-October announcement of CME Group’s interest rate swaps clearing solution.
CME set a $1 billion minimum net capital requirement for clearing brokers in interest rate swaps. Laurant Paulhac, CME Group’s managing director of OTC products and services, says, "[The capital requirement ensures] that the firms have a very solid balance sheet and as a result decreases the overall systemic risk."
FCMs looking to get in the game call it an artificial barrier. "They set the bar so that the largest 10 or 11 CME members are the only members that can participate in the swap market and we think these are artificial barriers that are blocking firms like RJO from participating," Corcoran says. "Why would we not be able to participate in this marketplace on an exchange that we have been a member of for almost 100 years?"
MF Global CEO Jon Corzine suggested that if brokers can’t access these markets at CME, they may be able to access them somewhere else (see Cover story).
Even firms that qualify at the minimum see this as a mistake. "We want clearing facilities to be open to all clearing members," Breteau says. "The futures industry model was extremely robust demonstrating its capacity during the financial crisis, and we would like to see the same principle applied to the clearing of OTC. It means access to clearing by all categories of members, full transparency on both execution and clearing. We would not welcome a system where the same kind of private club of dealers will continue to operate and just post some transactions on a central repository."
What is troublesome for FCMs potentially left out of the cleared swaps arena is that doubled-edged sword. Most expect to see their compliance costs rise and are hoping to offset that with access to new cleared OTC products. What may be troublesome for the banks is competition. "It is not about how much market share the newcomers will get, but what that competition does to the price structure. If the outsiders only grab 5% or 10% of the business, it will cause a large contraction of the prices for 100% of the business," Peterffy says.
Profits floating away
While the cost of compliance is an issue for FCMs, the biggest headwind facing brokers is the lack of interest income, or float, because of zero interest rates. While firms are affected differently depending on their business model, they all are affected. Those who survive may be those who didn’t assume rates would bounce back.
"Interest earned on customer equity always has been an important component of an FCM’s profitability and that is gone, at least for the foreseeable future," O’Neil says. "We are in a good situation here because we made a very deliberate business decision to not compete solely on price."
Corcoran says, "We’ve surrendered. Net interest income is not going to be part of the business model for at least two years, maybe three. We are redefining our business models and pricing models to overcome the loss of interest income. It hasn’t been easy and the only solace is that all our competitors have the same problem."
Even firms not as dependent on float are affected. "It’s not good for us," Peterffy says. "Traditionally, we pay interest back to customers. We only keep the first 50 basis points. But we are not even getting that. It doesn’t matter if it is a half percent or 20.5%, we make the same money. Peterffy estimates that lost income has cost his firm $100 million in 2010.
"All FCMS have been impacted by this because it has reduced the source of revenues," Breteau says. "We’ve seen in the past, models where some FCMs were making all their money through interest rates. The turnover was being nullified by overhead because FCMs were cutting prices everywhere because they were poaching each other’s staff and increasing compensation. That is an attitude of the past."
Nagel says, "We have negative interest. We actually have to write a check every month to the bank for charges because our compensating balances don’t cover it."
Scott Gordon, chairman and CEO of Rosenthal Collins Group (RCG), is somewhat philosophical regarding float. "There are things that we can control and things that we can’t control. From my standpoint, you focus on those things that you can control," Gordon says.
Corcoran says whatever approach a firm takes, they had better have a plan. "Who is going to figure out how to be profitable without interest income? Interest rates are not going up for a couple of years. RJO is addressing the net interest income shortfall by expanding our geographic footprint to bring in more transactional revenues and expanding the products we offer, such as FX and OTC cleared products."
Planning is key. One year ago Fed funds futures indicated that the key rate would be 1% now and between 2.25-2.5% by December 2011 (see Chartview). It is expected to stay put through 2011.
O’Neil adds, "It took a long time for us to get into this financial mess and it will take a longer time than anyone had previously expected to get out of it."
For Corcoran, the key word is profitability. Those that depend on float to achieve it are in trouble.
While regulation is what is on people’s minds, another growing expense is technology. Brokers see continued growth in high-frequency trading and the cost of technology to operate in that world. That cost is borne by all, even those who do not serve that space. Nearly every broker we spoke with is co-locating to exchange servers. "It is a table stake; you have to be co-located," Corcoran says.
Gordon adds, "As important as regulation is as a driver for the futures business, technology is equally important. We have had a strategy that we were going to have differentiating technology. That is something that we can control."
RCG is in the process of co-locating their front-end functionality as well as their execution, which is a trend from technology providers.
We noted a few years ago that the FCM playing field had changed. Instead of FCMs facing off against exchanges over cost and speed of electrification, a split developed between the large wirehouses on one side, and exchanges and non-bank FCMs on the other.
The banks wanted freedom to clear, the other FCMs wanted access to OTC products and the exchanges wanted into that game. Right now who will be able to access OTC markets is a question.
The playing field is changing as well. MF Global is attempting to become a dealer and eventually an investment bank while maintaining its retail business. RJO also is moving more to the institutional side but sees an opening in the middle market. "The large wirehouses are focusing on their large customers. There is a gap in this middle market space that is unique to RJO and MF Global. There really isn’t anyone behind us to fill that gap on a global basis," Corcoran says.
What is clear, is that a year from now we will still be asking questions regarding regulations and OTC markets.
On Dodd-Frank, Peterffy adds, "[A year from now] we will still be talking about how it is going to be put into effect. The deadlines will be postponed."
By Steve Zwick
European regulators don’t release segregated funds figures for FCMs, so we compile our list of the top brokers by calling market participants and those who they felt had the biggest books. In years past, we’ve managed to boil it down to five firms or so, but this year we found widespread disagreement over who the top five might be, so we’re listing the top eight.
Interestingly, regional differences remain, even in unified Europe. For example, banks like Santander (which we included in the list) and Banesto (which we didn’t) were mentioned quite frequently in southern Europe but less frequently in northern countries, while several French respondents mentioned Société Générale. With apologies to Jérôme Kerviel, we left Soc Gen out because we believe its presence is covered by the inclusion of Newedge, in which it owns a 50% stake.
This survey was less than scientific, and we welcome any feedback from participants who believe we have erred.
- Top Contract: Euribor Futures
- Year-to-date average daily volume (through October): 1,002,546
- 2009 average daily volume (for the full year): 753,356
- Top Contract: Eurostoxx 50 Futures
- Year-to-date average daily volume (through October): 1.48 million
- 2009 average daily volume (for the full year): 1.31 million
- Top Contract: IBEX 35 Futures
- Year-to-date average daily volume (through October): 24,786
- 2009 average daily volume (for the full year): 21,405
Top Brokers (in terms of customer funds, in no particular order)
- Goldman Sachs
- JP Morgan
- UBS Securities
- Deutsche bank
- Citigroup Global