It has been a strange year for the futures industry. Despite increased volume and open interest, there has been unease because of the uncertain nature of the regulatory structure. The specter of Dodd-Frank and what it could mean for the industry has been an annoyance, but a common refrain from within the regulated futures industry is that its market structure worked flawlessly during the financial crisis. However, as we roll out our 2011 Top Brokers feature, a scandal is hitting the futures industry that extends far beyond the failure of a large member firm, striking at the core protections the industry has been patting itself on the back over since the financial crisis hit. An apparent shortfall in segregated funds at MF Global calls into question those protections.
On Oct. 31, MF Global Holdings Ltd. filed for Chapter 11 bankruptcy protection sending MF Global Inc, into liquidation. But the fate of the eighth largest futures commission merchant at the time as measured by customer segregated funds is not what is causing so much concern. Rather, an apparent shortfall in customer segregated funds scuttled a sale to Interactive Brokers Group and began a disorganized liquidation process, which had customers trying to see who had their back and discovering no one did.
"It’s the most disruptive and disorganized transition of business that I’ve ever encountered," says Marc Nagel, COO of Dorman Trading.
Newedge CEO Nicolas Breteau says, "The industry needs to step up and restore the confidence in [client] protection. That is really the first lesson that we take from it. How do we as industry participants make sure that we are very transparent in how we protect customer funds?"
Thomas Peterffy, chairman and CEO of Interactive Brokers Group, calls it an ongoing crisis of trust. "Up until MF Global, the crisis was more on the securities side than on the commodities side."
Breteau says "it is a reality" of Dodd-Frank. "The cost of running the business is higher but let’s face it: It is a legitimate response to what we are facing. Our world has changed so there is no way after the events we have witnessed — one of them just happened in the heart of our industry — that we can shy away from those responsibilities. It is a duty we have to our clients to increase supervision and control."
Newedge is preparing to be a player in the cleared over-the-counter (OTC) trading world and has taken an active role in trying to shape the rules. "We contributed a lot in terms of writing letters to the regulator in order to express our clients’ views on topics," Breteau says.
OptionsXpress EVP Futures Dan O’Neil says, "[Dodd-Frank is] a huge law with countless provisions. We have legal and compliance people looking at it day and night, and we’re certainly going to be ready for the new rules it puts forth."
While some FCMs are preparing for its inevitability, others are weary of its uncertainty. "We are waiting for the rules to be finalized," says Rosenthal Collins Group CEO Scott Gordon. "There is [definitely] uncertainty with respect to what will ultimately come out but there is not much we can do about it so we are just going about our business."
Thomas Kadlec, president of ADM Investor Services, agrees. "We don’t know what the final rules are going to be so we have not invested a great deal of time and capital in the process," Kadlec says. Peterffy adds, "We wouldn’t want to spend any time and energy until it is finalized."
A year ago Peterffy argued for CME Group to set up a separate clearing pool for cleared swaps, which they did, but is unsure whether IB will get involved. "We have been considering doing it but every time we look at it we say let’s wait until final regulations come out. It depends on transparency; we are extremely risk conscious. We always prefer trading on exchanges with transparency than over-the-counter without transparency," Peterffy says.
Kadlec and others are worried about unintended consequences and he points out there already have been additional requests from regulators. "We are getting many more questions from the exchanges and the CFTC in terms of looking at customer positions and how we go about our day-to-day business," Kadlec says.
For some FCMs it’s a matter of how the rules will affect their core business. "There’s very little of Dodd-Frank that’s been passed thus far that will affect us," says Nagel. "We’re of course affected by things like position limits, which [recently were passed], but we haven’t seen them yet. It’s not like we know exactly how we’re going to be affected."
He, too, is worried about unintended consequences. "What remains to be seen about Dodd-Frank is whether or not there are unforeseen consequences to the actions they’ve taken. On the whole, this may be a negative for our industry. There will be a lot more regulation, a lot more compliance, a lot more money spent on those things than customers who are actually protected," Nagel says.
A year ago the non-bank FCMs were complaining that CME Group set too high a capital bar, $1 billion, for them to get involved in cleared swaps. Recently the CFTC lowered that bar to $50 million but there appears less enthusiasm for entering the space. Newedge still is working on being a player though Breteau is taking a cautious approach.
"We have been vocal about the level of capital required and making sure that the space not be kept as a private club, but that it would be open to numerous participants, the same way we compete on the listed side. That is the best way to guarantee transparency and efficiency in the market," Breteau says, while adding, "Reducing capital doesn’t mean a small firm should be entitled to clear as much as it wants. What really matters is the quality of controls that are in place."
Peterffy is concerned that lowering the bar will add risk. "I think $50 million is dangerous. We have $4.7 billion in capital so we prefer people who have [more] capital because if the clearinghouse loses capital then the members are assessed. The little guys only can be assessed to the extent that they have something to give."
Peterffy is most concerned over the movement of trading onto transparent exchanges. "We need trading to take place on exchange platforms; all trades [should] be reported to clearinghouses, and not too many clearinghouses because too many clearinghouses are just like too many firms. When you have too many central clearinghouses they are not really central anymore."
While there is still resistance there is also a sense of inevitability and, of course, the MF Global situation is a game changer.
"As leaders of this industry [we need to] reflect on what additional level of transparency and supervision could we bring to our clients because as industry leaders, we have a duty to [do so]," Breteau says.
Profits floating away
If there is anything that has grown more inevitable than regulation it is a low interest rate environment. And while many brokers may have lessened their dependence on interest income (the float), it has been an important profit driver for firms. No one could have predicted a zero interest rate environment lasting from 2008 through 2013.
"Every firm is dependent on float. It’s part of our business model.We certainly make money on transactions, but float is hugely important to us, as it is to every FCM," Nagel says.
Gordon adds, "It is just something that FCMs have to deal with. We are prepared for the environment whatever it may be. We constantly are tweaking our operating model and if anyone doesn’t do that they are going to struggle."
The bottom line appears to be that interest income will not be part of a viable business model for the near term.
IB returns interest income to customers after the first 0.5% and does not depend on the float. "A broker should be able to provide their services in exchange for a commission," Peterffy says.
Like some other firms, optionsXpress’s profitability is not dependent on float and O’Neil points out that this environment will not last forever. "[The float] isn’t dead, interest rates won’t be down forever. Interest always will be an important component of profitability," he says.
However, not everyone agrees. Breteau says even when rates eventually come back up, they may not be the driver of profits they were in the past. "The rules in terms of segregation will continue to evolve. The rules in terms of what banks and brokers will be allowed to invest in with client money will continue to be more and more stringent," Breteau says.
The MF Global situation likely will lead to much tighter rules on seg funds and brokers will not be as free as they have been in the past to earn interest on their customer funds held in segregation.
After Dodd-Frank and before MF Global, regulators began to focus in on high-frequency trading, and the industry worried that this source of liquidity would be the next target. Most FCM leaders we spoke to see high-frequency trading as a net positive, yet some were a little more open to putting down some rules of the road.
"They make it easier for individual traders to enter trades and establish positions, and to get out of positions at favorable prices. We have not seen any evidence that they’ve had a negative impact on the markets at all," says O’Neil.
Kadlec believes the controversy is overblown. "If the trade is done on a regulated exchange in a proper manner and there is true price discovery I don’t know what the controversy is," he says.
For Gordon, this is an issue where a rash judgment could have serious unintended consequences. "Over time there have been calls to limit one kind of trading or another," he says. "It is often unclear what the effect of that particular type of trading is. If you restrict [high-frequency trading] there easily could be unintended consequences that hurt the liquidity of markets."
Breteau sees the value in increased volume. "There are good high-frequency traders and bad high-frequency traders, but there is nothing inherently bad about this category of client. They improve prices, bring liquidity into the market, bring competition and efficiency to the market," he says. "However, we should have more industry-wide controls. We have invested in diverse [risk management] technology at Newedge.We also are extremely vigilant [over] what level of control the high-frequency trader has."
Breteau adds, "We have seen rogue trading in big institutions. I don’t want the next one to happen in [a] high-frequency trading organization."
Peterffy, whose firm derives a portion of its profits from market-making activity, has a more dramatic recommendation. "We believe that high-frequency traders should be incentivized to register as market-makers and they should be compelled to take on affirmative obligations," Peterffy says. "If you are not a registered market-maker your order should be delayed by one tenth of a second. If you are a registered market-maker [with an] affirmative obligation your orders go to the markets immediately."
He adds that this would solve the two problems associated with high-frequency traders: "They leave when the market is under stress and they initiate runs in the market. When the market looks to run, they jump on it."
What comes next?
In recent years the futures industry has been forced to deal with a crisis not of its making, which resulted in a more stringent regulatory model that perhaps unfairly affected business. Today there is a crisis that strikes very close to home as the sanctity of customer segregation has been challenged.
The early reports have not been good as many end-users have expressed a feeling of abandonment by exchange and regulatory leaders. There is much more at stake than the reported missing MF Global segregated funds, estimated to be $633 million; the integrity of the industry is based on the notion that when a clearing firm comes under pressure, customer funds are safe and secure. It is what industry leaders — whether exchange officials, regulatory officials, lobbying groups, FCMs, vendors or legal professionals — have been touting for years, particularly in the face of the recent financial crisis. It has led one industry professional to ask whether it all was just a mirage.
The future of the industry may depend on leaders stepping up and proving all this talk was not merely a mirage.
Additional reporting by Michael McFarlin.
By Steve Zwick
We began the year wondering if the European Union could get its regulatory reforms in order, and closed wondering if it could keep itself intact. On Jan. 1, the European Securities and Markets Authority (ESMA) replaced the Committee of European Securities Regulators (CESR), and ESMA boss Steven Maijoor soon promised a smooth road for European regulatory reform despite the bumpy periphery.
"It is all about transparency, stability and international co-ordination," he said at the International Capital Market Association’s (ICMA) annual meeting in May, identifying his three priorities for the summer: Implementing the Alternative Investment Fund Managers Directive (AIFMD) and the European Market Infrastructure Regulation (EMIR) and overhauling the Markets in Financial Instruments Directive (MiFID).
Those efforts are still progressing, but have been eclipsed by the existential threat posed by Greece and Italy.
European regulators and exchanges don’t release segregated funds figures for FCMs publicly. We compile our list of the top brokers by polling market participants and then confirming information with the FCMs. This survey is not scientific, and we welcome any feedback from those with a different view.
- Top Contract: Euribor Futures
- Year-to-date average daily volume (through October): 985,438
- 2010 average daily volume (for the full year): 963,198
- 2009 average daily volume (for the full year): 753,356
- Top Contract: Eurostoxx 50 Futures
- Year-to-date average daily volume (through October): 1.6 million
- 2010 average daily volume (for the full year): 1.45 million
- 2009 average daily volume (for the full year): 1.31 million
Top Brokers (in terms of customer funds, in no particular order)
- Goldman Sachs & Co.
- Newedge Group
- JP Morgan Futures Inc.
- Deutsche Bank Securities Inc.
- Citigroup Global Markets Inc.
- UBS Securities LLC