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."