It has been a challenging year for futures commission merchants (FCMs). One dominated not by the usual issues of technology builds, disintermediation, transitioning to cleared over-the-counter (OTC) trading and the continuous challenges of a competitive landscape, but by a customer base weary of the very structures they have depended on and assumed were rock solid. End-user confidence in the industry took a double-barreled hit over the last year with the Peregrine Financial Group (PFG) failure occurring eight months after the MF Global debacle.
Futures invited six industry leaders representing the entire spectrum of the FCM community to talk about the state of the industry. Here is what they had to say.
Futures Magazine: Let’s start off by talking about the elephant in the room: The impact of MF Global and PFG on your business and the industry.
Gerry Corcoran: The largest impact of the MF Global and PFG disasters really surrounds the regulatory response. We have seen shock and awe in terms of a regulatory response to what occurred. In most cases the strengthening of the rules and regulations surrounding the protection of customer assets [was] good. In fact, the industry played a large role in forming and shaping the rules and regulations that came out. I personally don’t believe the industry volumes that we see that have diminished in a macro sense relate to MF Global or PFG at all.
Scott Gordon: You also have to go back to the trust issue. Those events created an issue with customers, and the concept of customer confidence is a big one.
Salomon Sredni: I agree; I don’t think the volume drop is related to that. I don’t think it helped, but the biggest issue is [that] volatility in the marketplace in general has greatly diminished. It diminished on the equity side and on the forex side. Every competitor in the business would attest to that. By the way we didn’t do any business with MG Global or PFG so we didn’t suffer ant direct losses. Those two cases were a black eye for the industry and it shook customer confidence. Before that I would hear, ‘nobody lost any money trading futures.’ Those two instances, in a short period of time, shook the confidence of prospects and customers.
FM: Why don’t you think the volume was impacted?
Tom Kadlec: If you take the FX volume, [those firms] were not big players in the FX market and our FX volume was off materially. Energies the same way. We are a commercial ag company; our volume is pretty good in that space. Why? Because we had a drought year. I’m sure there is some volume effect, but it is one of a number of things. If we had an interest rate yield, I am sure Joe Guinan’s business in the interest rate sector would be much [better]. I go back to customer confidence. I spend 25% of my time talking about our process to customers, to brokers, reassuring them that we have a wholesome product, that we are a firm that doesn’t proprietary trade, that has integrity in terms of our process. That is up materially; we spend more time doing that than anything else, and hopefully as an industry collectively with the exchanges and the regulators we can restore that confidence. That will affect volume.
Joe Guinan: Some of the decrease in volume is tied to MF Global. You can’t handicap it. I don’t think it is huge, maybe 10%, and some of the decline in volume [because of] MF Global is because some players have left the futures market. Some other players, maybe prop shops — especially European prop shops — don’t have a lot of money back and with reduced capital they have less ability to trade. To Gerry’s point about the regulatory reaction — I would call it overreach — there has been some villain hunting going on ever since the economic downturn post-Lehman in the fall of ’08. At a macro level, society is still trying to find the guys who caused the great recession; the financial institutions, Wall Street, whoever it was, there is still a search to find a and punish those people. From that perspective MF Global happened at a bad time, and it doesn’t help our industry at all when it appears that someone like a Jon Corzine might escape this unscathed. That doesn’t help the industry because just like Dostoyevsky’s “Crime and Punishment,” people like to think that there will be justice in the end. It is a stain on the industry if we emerge from this without the public feeling like there was appropriate punishment.
Some of the volume drop-off was caused by MF Global, but to Tom’s point, interest rates have been a huge source of volume, especially in Chicago. The short-term interest rate products have been a huge volume contributor historically and for the past few years they’re a declining percent. That is the big thing that is hurting us. That is fueled by some of the post-recession [rules] such as Dodd-Frank, which is tremendously inhibiting big banks’ ability to trade.
Peter Johnson: It is always tempting to make linear connections between certain bad or unfortunate events and subsequent results, which in this case sounds like it is decreased volumes. To Joe’s point, I don’t think we can forget about the European sovereign debt crisis and OTC clearing [work] that has been going on for two-and-a-half years and has been costly and time-consuming. In addition to what Joe said about banks paring back their trading, they might be shutting down their prop trading activities or moving them into their asset managers. It has been a huge distraction just in terms of the infrastructure build to get ready for everything that is coming. Deadlines are now approaching and this is complicated new stuff for everybody. It is not just the buy side — it is the sell side, it is exchanges, it is vendors and so this is a very big infrastructure build. Increasing cost — in terms of the new regulatory requirements that we need to adhere to, but also with zero interest rates and all the uncertainty of the markets — is reducing profit opportunities. MF Global and Peregrine have contributed to a lot of other things that are ultimately changing the pricing model of the futures industry, which is something that we all are going to have to address.
SG: On the regulatory front [there are] some different perspectives. One is you have the post 2008 financial crisis, Dodd-Frank: What is the regulatory [reform] going to look like? And then you have MF Global and PFG coming to light. Then, third, what do the regulators do with respect to [high-frequency trading], changes in market structure and all those things? It is a really complicated picture, and it is not clear yet what the outcome is going to be.
PJ: On a positive note, that complexity Scott refers to, in addition to the cost and uncertainty, is going to be a good thing for futures volume. It is going to be expensive, it is an infrastructure build and futures are known, they’re easy and they’re liquid. The CME recently announced the launch of a swap futures contract; you have the Eris Exchange and all of a sudden you are seeing a lot of alternatives to OTC clearing, which are going to be more appealing than they had been in the past because of the cost and complexity of all this stuff.
SS: On top of that you are not going to get any help from interest rates any time soon. So you are searching for yield. You have to go somewhere for yield. So it is only a matter of time before people start trading whatever products are available so they can get some yield on capital.
PJ: Again, given the nature of OTC clearing, as it takes hold some clients are going to be looking to hedge their various exposures with listed products, futures instead of the new costly products.
FM: A few years ago smaller FCMs were looking at cleared OTC products as a way to compete with the largest FCMs; given what has occurred, is that desire still there?
GC: RJ O’Brien is sitting on the sidelines at this point on OTC cleared. It is a very complex product, it is a new build as Peter has mentioned. We like to participate in markets that we are very knowledgeable and very experienced at and we know very little about OTC cleared. We are hopeful that it will be a successful product in the industry as a whole. We measure ourselves in terms of decades and not years, so at this point RJ O’Brien won’t be participating in OTC cleared products.
SG: I would echo that. We are a futures group and we might understand a little bit about the products but we are going to stay with what we know best, which is futures and futures cleared products.
GC: To be clear I am talking about IRSs and CDSs, energy on Clearport and products like that we do participate in.
TK: We measure our capital based on our return on equity model. Peter talked about the large capital allocated to OTC type products. He didn’t mention regulatory cost; there is a huge regulatory burden in terms of knowing your customers and other things that is a stretch when the return is [uncertain]. I would side with Gerry and Scott; we are a futures firm — it is what we know, it is what our parent is very involved and engaged in and it is something we can do. If we can watch how the industry progresses and be a participant when it makes economic sense then we will look at it. But cost of capital is something that all of us are guarding very carefully as returns have come down because of interest rates and because of price pressures in terms of commissions.
FM: How big of an issue is customer confidence? Are you spending more time reassuring customers that you have proper risk controls in place and are protecting segregated funds?
SS: I speak to customers, but the challenge is that what happened at PFG was fraud. Ultimately, you can set up all the controls you want, but if you have a crook at the top what happened at PFG could happen again. So ultimately, when I talk to customers, what they have is our track record. We are a public company, we comply with [Sarbanes Oxley], we have a clean regulatory record; if you look at PFG, it was a mess. There were red flags all over the place. Assuring customers that what happened at PFG can’t happen again is tough because ultimately it is a matter of trust. Now a lot of good changes have happened. We as an industry failed because we didn’t have the right oversight.
SG: It has been a year now since MF Global and there is no question that customers are more diligent now. The issue becomes one of educating them. Prior to a year ago not too many customers understood the make-up of segregated funds. Even though the drumbeat has lessened a little bit, there was a time when our senior team was spending 50% of their time talking to customer [regarding] what we are about.
PJ: From my side, you are dealing with some of the world’s largest asset managers and hedge funds. They are looking at futures clearing and OTC clearing as one and the same. They want to make sure they are clearing their products, whether they are OTC or listed futures, in the same place going down the road. So you are seeing these large institutions conducting [request for proposals] to get the latest on FCMs’ capabilities with regard to futures and OTC clearing. The questions are the same; ‘Are our clients’ assets going to be safe?’ They have a fiduciary responsibility to ensure that’s the case. We end up doing a lot of on-site visits. We have the equivalent of a Treasurer that looks after client funds. She [and] our legal and operations people demonstrate the checks and balances that exist in our world to ensure client funds are safe. It is first and foremost in any large asset manager’s thinking in selecting a clearing broker.
JG: That same process goes on to lesser degrees with even a retail client. A retail client years ago might have thought of all futures brokers as equal and [cared] about who is going to give him the best rate by a penny, a nickel, a dime--that is where he would open his account. Now that sort of due diligence Peter mentioned that big money managers are going through, retail accounts are absolutely going through. It is not just who will give me the best rate, it is ‘tell me about your firm.’ They will want to meet the CFO, meet the treasury people, meet the compliance officer. I sense that some of what decision-making people are going through nowadays is a lot more of a thorough process even on an individual futures account.
[Because of] the tragedies — and it is horrible that people had to lose their money — a lot of firms have disappeared and the firms that remain are a higher caliber, better managed, more ethical [type of] firm. It is a tragedy that people had to lose money, but it is not a tragedy that the industry perhaps is weeding out firms that were poorly run; we end up with a better industry. We also wind up more aware now how inter-related we are to each other.
FM: Some of you have said the regulation has been overdone but also that some of the regulatory response on MF Global was appropriate. Give examples of the good and bad.
GC: First, the story continues to unfold as the CFTC [Commodity Futures Trading Commission] just recently released a new proposed rulemaking that is 438 pages, which the industry is digesting and trying to absorb. A lot of good things have happened, and we share those with customers all the time to represent the things that have changed to improve the safeguarding of their assets. Shortly after MF Global failed, the CFTC passed the revision to rule 1.25 on how FCMs can invest customer assets. MF Global was widely reported to have invested in sovereign debt that in some part related to the failure of the company; the revised rules don’t allow those types of investment. It pushed to investment spectrum way to the short side, the very safest investment an FCM could invest customer funds in, so that right off the bat was very important.
TK: Did that affect you? The change in 1.25?
TK: It didn’t affect us.
GC: No, because we invested our funds along those lines.
GC: It restored customers’ confidence that when we speak about only investing in the safest instruments and they ask ‘well, how do we know that?’ they know because it is the regulation and we have to file our portfolio twice a month with the regulator. So I agree with you, it didn’t change the behavior of conservative firms like ours, but it did restore [customer] confidence and them knowing for certain that their assets are invested at the FCM in safe products.
TK: I use that to point out that rule had no effect on us. We were very conservative before so it had no effect on us. We don’t believe in taking principal risk with customer assets. I do agree that transparency and disclosing our portfolio [are] good things.
SS: At least [for] everyone around this table, it had no impact. The reality is we didn’t take customer funds and invest them in sovereign debt. I think all of us here would view that as irresponsible.
SG: People around this table neither did what MF Global did nor what PFG, did but the industry is suffering because of [their actions].
PJ: [We invest using] very conservative guidelines, short-duration type investments. The one restriction that did impact us was the ability to do internal repos, which a lot of big banks did. But it wasn’t a huge impact and something that we were easily able to adapt to.
SG: Some of the things that have been put into effect would have prevented either what MF Global did or what PFG did, and that is a positive. There [are] both good and bad there.
PJ: The main point there is the electronic verification.
GC: I do participate in the working group with the NFA and the CME, and we hope to have the daily verification of bank accounts by early December.
SS: The regulators have put in place third-party verification that I thought quite frankly was in place before but it was circumvented because it was not belts and suspenders. So now should you confirm stuff directly with the banks? Of course. Should you make sure that assets are reinvested in conservative instruments? Of course. What happened at PFG and or MF Global could not happen today or should be caught by what was put in place.
JG: I don’t think the industry did a good enough job highlighting that PFG came to light because of the post-MF Global procedures put in place to verify bank balances. It was that procedure that outed the PFG problem. It wasn’t random that that came up.
There are also unintended consequences from what I would call regulatory overreach. For example, in the repo market where you have delivery vs. payment, if I wanted to do a repo transaction I might want to do $500 million of repo and I could have done that up until the new rules; now I can only do 25% of my repo with any counterparty. So when we called some of the big firms and said ‘we want to do a repo with you, we can only do this much per day,’ some of the big Wall Street firms said ‘pound sand.’ They are just saying that is too small.
Another example of unintended consequences is the rule that requires you to not reduce your excess seg by more than 25% in any day without having to notify your DSRO plus the CFTC and NFA. Historically what many FCMs did is they would leave as much cash as they had in the pool. If a firm had $20 million of excess cash they would leave that excess on top of the customer segregated money, giving that customer seg the maximum protection that firm had. On the seventh business day of every month, we have a CME collect for the exchange fees, we have a $5 million bill every month, so if I have $20 million in excess sitting there and the seventh the CME collects my $5 million I will drawdown by 25% and have to notify everyone. The unintended consequence of this new CFTC rule is I have to leave not as much money as I can in excess seg.
SS: I hear what you are saying and I know it is a tough world out there but I get a little concerned when we as industry leaders say that regulators are overreaching at a time when quite frankly some pretty horrible stuff happened — that we as an industry failed the customer. From my perspective, no regulation is perfect — but on balance it is my opinion regulators reacted with measures that are appropriate given what happened. The things they put in place go a long way in giving comfort to clients that there are systems and procedures in place that would prevent what happened. Retail customers are looking for us to lead.
PJ: Two other unintended consequences that I would point to are a narrowing of the competitive field in the FCM space; it will be more pronounced in the OTC clearing space given the capital requirement, but it also will have an impact on futures-only FCMs. Clients are going to have less choice when dealing with our markets. The other unintended consequence is on the back of some of the client protections that are being put in place, which are good things, but people need to realize that the interest income revenue stream — FCMs make their money in three ways: Execution, clearing commissions and interest income — has accounted for upwards of 50% of the overall revenue stream for many years. Zero interest rates for the past couple of years haven’t helped but [added] restrictions [regarding] 1.25 [and] LSOC (legal segregation with operational commingling) are going to add [more] constraints to FCMs in terms of being able to earn what had been significant revenue streams. You hear estimates of an 80% drop over the past two or three years in that revenue stream. That creates a pretty significant pricing model issue for the industry.
FM: Interest income has been a major issue for FCMs, and after MF Global many customers expressed surprise at how FCMs earn interest on their money. Is it time to end the float?
PJ: There was nothing underhanded about that revenue stream. When FCMs price business for clients we show them a commission schedule and an interest rate schedule. So that is negotiated with clients; there is nothing back-door about that.
SG: The economic model of an FCM was turned upside down by several things. [Some are] lack of interest income, rising technology costs, which we are all faced with, [increasing] regulatory cost and unknown regulatory costs; the confluence of those turned the model upside down. Like any other business, when faced with an economic model that doesn’t work, you modify. We cut expenses, we raised commissions, we raised service fees [and] we are repricing our services. We have assumed that we are going to be in a low interest rate environment for a while. We are very transparent about how we price, why we price, what the cost of capital is, what the cost of technology is. We lay it out for them.
TK: Having gone through a very similar drill that I am sure [we all have], it is a return on equity model and it has to do with commission rates. It has to do with how much interest rates are, fees and the ability to say ‘no’ to some relationships and the extent to which people recognize they need to pay more to get meaningful service and protection of their assets. The industry is slowly but surely repricing each one of our models, which are all different.
GC: I echo Tom and Scott’s sentiment. A new model is emerging, at least for the middle-market FCM. We are educating our clients about return on capital, the regulatory expenses we are incurring and the technology costs we are incurring to provide the services that we provide them every day, so pricing is changing. [Sometimes] I worry that we are not pricing aggressively enough because we are in some way holding our breath for interest rates to go higher, but it is an expensive business to be in today and [the] service levels we provide our customers are high; that is why we still are vibrant in the industry. So our clients are expecting changes. Not all customers warrant a rate increase but some do. We are passing along costs to clients that we used to absorb: Bank fees, wire fees, postage fees, many direct costs related to a client’s transactions are now moving over to the customer side of the ledger. It is the only way for FCMs to get a respectable return on capital these days.
PJ: Clients understand that too. They want us to make money; they know why we are in business and are willing to pay the extra cost to make sure that their funds and their clients’ funds are protected. As Gerry suggested, we are in the process of finding the new equilibrium. That is an interative process that will take time. It probably means we are going to have to start passing on some costs and I think clients are generally ok with that.
JG: I agree. At our company we [took] the first step in that direction in ’09, starting with the smallest clients, and carried that out from there into looking at the entire client base. One of the things we found was that [we] had a client [a few years] ago who was a high-volume client and paid a fair amount of commission. Well, five years later he is doing 10% of what he once traded but his commission rate never moved. We have been right-sizing commissions for the past [couple of] years. The other comment Scott made was about technology. The CME made the decision to launch [its new data center] DC3 back in ’06 but it [actually] launched this year. Our expenses are $130,000 per month; that is a significant new cost that we didn’t have the year before. We didn’t get to shed any expense over at Equinox or Telex; we just added a new expense.
GC: [This] is a good time for me to jump in and point out that the exchanges are extraordinarily aggressive right now in passing cost on to the FCMs in very difficult times — both direct cost and also tying up our liquidity and capital in how they margin the FCMs and how they ask us to contribute to the guarantee funds that guarantee the exchanges themselves. That model needs to be addressed between the FCMs and the exchanges because the FCMs can’t be the shock absorber forever for every time the exchange wants a new initiative or needs to shore up their balance sheet.
FM: Has there been a pushback against the exchanges?
GC: Some of these things are emerging and [with] some of them the rubber band is ready to break.
JG: It is an iterative process.
PJ: If you look at the percentage of client commissions that the FCMs keep vs. what the exchanges keep [it is a] pretty shocking disparity, I am not going to throw a percentage out, but it is pretty lopsided.
FM: Is this because of a lack of competition?
JG: We have $1.5 million of our money up as security deposit at New York Portfolio Clearing (NYPC) and we only have $200,000 of customer margin; normally it is skewed the other way. I don’t want to just quit [but] we are looking at this as a bad use of our capital. At the time we became a member of NYPC, we became a member of ELX; I like helping a competitor. Fostering a little competition is a good thing, but now a couple years later they are not doing much volume, [and] it is wasting $1.5 million of capital. Gerry’s point is hitting home; we are looking at the same thing.
FM: Does the industry need more exchange competition?
SG: ICE and CME are pretty toe-to-toe competition.
PJ: There is competition in some sectors and we absolutely need more.
JG: Certainly in the energy space you see ICE and CME doing battle aggressively with each other.
FM: Do you see that reflected in your cost?
JG: The 5¢ fee we pay for give-ups at the CME and the 6¢fee we pay for give-ups at the CBOT does not exist at Nymex. One of the reasons it doesn’t exist is that they know they are competing against ICE and they don’t want to add a cost there. So I smell a little bit of that coming into play.
FM: MF Global led to calls for an insurance fund, a third-party depository or holding seg funds at the clearinghouse. How do you keep customer funds safe?
JG: I will start with the last one because I have a very strong opinion. Our company had $100 million in a reserve primary fund when it broke the buck on Sept. 15, 2008. This investment we made in the [CME] reserve primary fund cost our company $1.3 million. The CME selected eight or so money market funds [it] allowed us to invest in through its IEF (interest earning facility) facility and one of them was this money market fund that happened to lose $785 million of Lehman paper. So they make five basis points of income for overseeing the program. The CME had 15 FCM customers who had $7.5 billion in the reserve money market fund when it broke the buck and for that five-basis-point-fee it seems [as if] the due diligence should have been [better]. I would argue that the CME is the worst possible candidate to manage other people’s money.
TK: While I agree with Joe, I would add that if we are going to be responsible for customer debits and responsible for customer servicing, we have to be on the reward side and earn whatever interest there is and control the assets. There is a liquidity function here that we have to have control of; we have to understand where the assets are so we can manage this liquidity. If you add a third-party provider and ask them for permission [to move customer funds] that you are ultimately responsible for, it doesn’t make sense to me.
SS: I ask ‘what would the customers want?’ My guess is they would want a third party that doesn’t have any skin in the game to hold those funds, basically providing insurance.
SG: If the premise is protection of customers’ funds is of paramount importance (everyone nods), there are so many ways to look at this. When you talk to customers, they will say, ‘I like this idea’ or ‘I like that idea,’ and they are complex. We should explore all of these and there should be a dialogue between FCMs and exchange and regulators and customers, but it is not a simple solution. People say ‘I want lower taxes’ and ‘I want better health care,’ you say that is great, how do we effectuate this? The devil is in the details. We are starting a dialogue; the process is going to take some time. There is an insurance study that is being funded by NFA, CME and FIA. That is a great place to start. That is on insurance, but on the custodial front I have heard 10 different solutions all of which sound simplistic but are very complex. We need a dialogue and that is what is emerging.
FM: Could this become moot as these new NFA rules on daily electronic confirmations go into effect?
SG: Whether it is moot or the drumbeat dissipates, at the end of the day it is [whether] our customers are satisfied with the protections that are put in place. We can talk until we are blue in the face as brokers, but in the end [the customers] have to feel comfortable. That is a process that is going to be ongoing for a while. And we all should be prepared to have those dialogues as a group, individually [and] across disciplines.
SS: I don’t think it is moot because you look at the equity side, they have something called SIPC.
FM: What are your customers saying?
SG: We have 30,000 customers and there is no common set of answers. Groups of customers — even with a group of commercial hedgers or professional traders they’re not all the same, they have different needs, there isn’t a one-size-fits-all solution.
PJ: I agree with Scott. It is great that we are having these discussions, but the reality is we can’t do everything; or if we do do everything we can’t pay for it because pretty quickly the cost will exceed the benefits. So there is a balance to strike. [It is about] the protections and controls that are going to give clients the confidence to continue entrusting us with their money. That is the objective, that is what clients want, that is what we want. There are a lot of great ideas floating out there but you can’t have it all and you don’t need it all, but we certainly need to move in the direction [of] a much safer environment.
SG: There will be changes that come through.
FM: What specific Dodd-Frank rules are adding burdens?
GC: There have been a few items out of Dodd-Frank that were intended for the swaps market but the futures industry got folded into them. One of them is [rule] 1.73 [which is] related to pre-trade risk management, and it became law despite the fact that the industry [expressed reservations] to the proposed rulemaking. The concept has a lot of common sense: Before a trade is put on we want to have some certainty that the person making the trade and the counterparty accepting the trade have credit capabilities to back the trade. [With] how business is conducted today in the futures markets, principally in the give-up and execution side of the business, it is impossible to do [that]. Had the industry not received relief from the regulators, it would have really ground the futures execution business to a halt and impacted major hedge funds and institutions on their ability to choose the broker they wished to execute with. So that was an unintended consequence of Dodd-Frank that impacted the futures industry. There have been a few of those. In some cases the regulators say, ‘oh, you are right,’ in other cases they have drawn the line and it has cost a lot of effort to get some relief in those areas.
JG: [Another case] like that where they gave us last-minute relief had to do with the margins between members and non-members. A week before, they finally said, ‘If you are a member of the exchange we will give you a break on all your margins regardless of whether that particular trade might be a speculative trade or not.’ It was supposed to go into effect the first week of August and it would have required us to segregate a client who trades 90% Eurodollar spreads that are getting a hedge rate [if he trades] a couple of E-minis that are speculative. It would have required us to have that guy trade into two different accounts and one account would have to be set up differently, and GMI systems don’t currently allow that to occur. Only a week before that was set to occur did the CFTC grant relief.
SG: There is also the issue of proposed regulations and the unknown of whether they are going to remain as is or be modified.
FM: There are a lot of questions regarding high-frequency trading, whether it gives certain users an unfair advantage and whether additional rules need to be implemented.
JG: One of the things I have been pushing to the CME is [that] they adopt a system like ICE, where if you go down to a sub account level and say this guy can’t buy more than five at a time and his max position is 50. At the CME their risk system only allows you to margin based on the total margin. At the risk of telling one exchange to copy another that is what we are asking. Each of them should study [the] other and take the best practices that are out there.
GC: High-frequency trading provides great liquidity in certain markets; on the other hand there is the uncertain fear of a catastrophe, of a flash crash or Knight Trading type of event, and from my perspective I hope that regulators are looking into HFT’s internal controls and systems so these type of events can’t occur.
TK: I agree with Gerry wholeheartedly. Liquidity is incredibly important to our customers. We don’t cater to high-frequency traders; however, they are there and they happen to be this [year’s] bogey from the events of Knight Capital. A couple of years ago it was funds and now it is high- frequency traders. The regulators need, the exchanges especially, to provide an equal playing field for all customers and to the extent that they can do that, it is a risk-based game and people should be allowed to trade.
SS: I agree with those comments. It is very easy to make [high-frequency traders] the bad guys, but the reality is that they are providing great liquidity and they are almost always there, so we have to make sure the right controls are in place. But we have to be careful what we wish for because they provide great liquidity and that is why people come to our markets. If we start taking away [access] to those providers of liquidity it could backfire on us.
PJ: We tend to blame things on high-frequency traders that are not exclusive to [them]. When we talk about high-frequency trading risk and the flash crash — they are criticized for being opportunistic about the liquidity that they provided and turning off their systems when they saw the market free falling, but we are talking about rogue technology risk or rogue algo risk. You have a lot of systematic hedge funds, CTAs, asset managers that are using electronic trading capabilities; you have pretty sophisticated algorithms to execute their strategies and any one of those systems could misfire if not properly constructed. If you don’t have the right controls around it, it may cause a problem similar to flash crash. High-frequency trade, as the name implies, is very high-frequency, so maybe once there is a problem it tends to magnify the extent of the problem. But electronic trading and the nature of what we do have changed so dramatically in the last 10 years that the technology tools available to a community of clients far beyond high-frequency traders, [and] you are running technology type risks with [all] types of traders so they have gotten a little bit of a bad rap. Not to say that I don’t think there should be controls in place. There probably should be greater controls that the industry should consider and there should be exchange-hosted risk controls across the board that are very inconsistent today.
FM: Some customers argue that high-frequency traders have an unfair edge and place orders to affect price but are not open to risk. Is this a problem?
JG: I don’t have a problem with all sorts of people entering different orders and battling it out. One guy’s algorithm might do well for three months and then he is losing money because another guy’s algorithm is outfoxing him. The marketplace is the right place for those guys to fight. I like what CME did with DC3 (new Aurora, Il. data center). They made sure that the cable length from every single cable inside their facility to the matching engine is the exact same length. My hat is off to them for the incredibly fair way they established that facility. You go over to Equinox or Telex and people would try to go to a lower floor to get closer to the matching engine, so that aspect of what the CME did is great.
SG: It is the risk management issue that needs to be focused on: The rogue algorithm that gets out of control.
TK: Our customers are fine with their times and we monitor them and ask for feedback. That is not an issue for them. I have a little problem with orders [with an] intent to deceive. If people are putting in orders that don’t have an intent to be filled, I do believe that can be a challenge to a house like ours that uses these markets primarily for economic hedging. When we put orders in, we mean it. I would challenge Joe a little bit on the intent of professional traders in terms of what they are trying to accomplish.
JG: That is one of the problems with the pro rata distribution. If you look at a market and see 8,000 on the bid and you know there is not 8,000 that want to buy there: One guy is bidding for 1,000 because he really wants 50. That is an endemic problem with the exchanges as long as we have pro rata. I don’t like it; a lot of my clients love it but that has been around for a long time and if you have 8,000 on the bid and you hit the bid for 1,000, a lot of times you will turn it offered. This is a legitimate [issue] that needs to be looked at.
SS: As humans we try to oversimplify everything in the world and nothing is quite that simple. The guys that are duking it out through technology in a millisecond type environment, they’re fighting a technology war. Those guys are smart enough to know that the other guys are putting in orders that are real. For most customers that are not high-frequency traders, the negative impact that high frequency trading is having on their orders is not that dramatic. To me, it is an easy target. High-frequency traders are adding liquidity and are helping our markets be smoother, and we have to be careful what we wish for.
FM: How about the change in the customer make-up?
GC: At RJO we cover all of the space from the self-directed retail to the middle market to some [very] large hedging type customers, and we haven’t seen a change in the mix of the business. Hedgers need to hedge, middle market people need exposure to the markets and self-directed retail clients pretty much want active markets; we have had them in the grain markets this year so they are very active. We haven’t seen any type of real manifestation of customers leaving the marketplace as a result of MFG or PFG.
JG: The clients that left are the clients with specialties. If a guy was focused on trading the short end of the yield curve, a lot of those guys had to throw in the towel and retire. If a guy trades the Treasury products, the five-year vs. the 10-year, some of those guys threw in the towel because of some of the craziness that went on in those spreads over the last three or four years.
SS: Clients that love the futures market, love the futures market. And when they are trying to create or generate income there is not a better place to put it right now. If you know of any, let me know. The challenge they are having is with volatility levels coming down; it is much more difficult to make money so you have to be smart about where to take a trade. The challenge is not a change in demographics. What is causing the decline [in volume] among other things that were discussed earlier, is the decline in volatility.
FM: Are there any new asset classes or products that are emerging?
JG: The best move for the industry will occur if the euro (currency) falls apart because then you will go back to multiple sovereign currencies and multiple interest rate products in every country. Throughout the 1990s one of the really fun aspects of the marketplace was all the fixed-income convergence trades. You bought Italian bonds and sold German bonds and you had this very strong convergence play. If the euro does fall apart, as I think it will — it was a stupid idea and stupid ideas have a way of eventually not working out — then you are going to have 17 nations that both have their own currency and own fixed income markets, and futures to accompany those markets. That is going to be a fantastic era, I don’t think it will happen in the next few years but that is the next big opportunity and the CME’s establishment of a London entity is probably taking a long-term [look at] that potential opportunity.
SG: There is a dearth of new products. Whatever is out there now is a variation on a theme that is out there. Having said that, customers, [brokers], exchanges and regulators all have enough to do with the number of products we have.
TK: We benefited greatly from the demise of MF Global and taking on new customers, and part of that duty is to make sure they are being serviced properly and they are being managed properly and they are on board; it is not done overnight, it is a process that is still [happening] to this day. Other product [opportunities] are the fact that the Asian marketplace is opening up — we have offices there, there is a fair amount of interest in that area to trade U.S. exchanges and there is certainly a lot of money over there looking for righteous fills and perhaps a more modern recording system, and that is something that we are excited about and looking into.
PJ: OTC clearing is likely to drive further innovation in the futures space; we have the swaps contract. There hasn’t been a successful credit futures product and the market feels that there is room for that. A couple of other asset classes, real-estate and weather, feel like there could be significant demand materializing and going forward. OTC clearing, which is simply a result of our world having changed, that is usually where people are identifying opportunities.
FM: There has been a lack of volatility in equity and fixed income markets this year. Are there any sectors due to have a breakout?
SG: I am not an economist but I have been through enough cyclicality that when everyone is saying peace has broken out in the world or that volatility is going to remain low for an extended period of time — there is too much going on in the world from a geopolitical standpoint, from a macroeconomic standpoint — to say that the status quo will remain. I have no idea directionally what the markets are going to do but I am fairly certain within the next couple of months that there will be viable markets. I am fairly certain that the low volatility environment we are in now cannot last too long.
JG: Just to pile on and agree with Scott, look at the fixed income market. While the Fed is very happy to stand up and say short-term rates will stay where they are until the middle of 2015, that says nothing about where long-term rates will be. In 2013 the unexpected that could happen is number one, you could have significant job growth and number two, you could have significant wage inflation with that job growth. Anecdotally there is a lot of evidence out there that while the unemployment rate in aggregate is relatively high at 7.8%, the unemployment rate among college graduates is well under 5%. It is not at the 2.4% it was at before the economic downturn, but there is an arguably good chance that wage inflation picks up long before unemployment breaks 7% and with that all hell could break loose because then you might get a [very] steep yield curve. People might start selling bonds and selling [10-year notes]. You could have the five-year go from 76 basis points to 150 basis points in three or four months just based on the fact that people no longer view us as stuck in a zero [interest rate] environment. As Scott is saying, it is when everyone throws in the towel and says this is it, nothing can happen, that is when you are likely to get some unexpected things.
FM: What will a typical FCM look like five years from now?
SG: That is a really difficult question because if you has asked that question in 2007 and asked where will [we] be at the end of October 2012, I would not have predicted where we are. I can’t predict five years out. We can make business plans based on the next 12 to 24 months, but a five-year period is [tough]. There is a paradigm shift going on in the futures business [in terms of] the FCM model, the exchange model, the regulatory model, the customer model and the macroeconomic model. That is going to play out over a period of time.
JG: It became much harder to predict than it was before. Prior to ’08 you could get a good idea about the next year-and-a-half, but since the fall of ’08 I have found my own visibility of [what] the next [few] year are going to be like very cloudy in terms of volume and customer base growth.
SG: FCMs are adapting to the environment. I am bullish on the FCM sector. I can’t speak for exchanges, I can’t speak for regulators but I can speak for our FCM. We are making the right changes. Customers believe in our markets in terms of allowing them to manage their risk. I am bullish on the futures industry; it has secular growth that goes up and down based on cyclicality.
FM: Have ETFs taking business from futures?
GC: I don’t think we would be immediately aware of it. Somebody that might want to play in a commodity ETF or energy ETF or a metal ETF, that person would look at it as a way to get a little exposure to silver or gold or crude oil. They would be better off buying a commodity contract or CRB index.
SG: It is accretive. Whether you have stocks vs. futures, whether you have ETFs vs. futures, whether you have OTC vs. futures, that is what builds markets. We might not play on the OTC side [but] in general futures markets benefit from people in the OTC business coming over to manage their risk. I have no idea if we lost business to ETFs but I am not worried about it because in the end we end up getting business from them.
FM: Since the credit crisis hit, many of you assumed there would be a greater regulatory role but a bigger problem may have been the uncertainty surrounding rolling this out. This has dragged out. Is the uncertainty a bigger problem?
GC: Uncertainty is not good. It is challenging to run a business one year out and thinking two or three years out because of the uncertainty of the framework we are working with. Is it a dramatic impact on the business? Probably not, but uncertainty is one of the elements that cause business managers to think twice before making investments. If you make an investment in a line of business or a particular product and regulations aren’t out yet and they change course, it is a problem, so lots of folks are waiting. The whole Dodd-Frank rules and regulations, how they are unfolding, how they will be structured is holding back the industry so that uncertainty is not good.
SG: That is an important issue. Everyone out there [is affected by] that uncertainty.
JG: I had a client get a call in May from the CFTC. The CFTC never asked me, they never told me but they called one of my clients directly and told him that they wanted to visit. The guy called me almost in tears, ‘What am I doing wrong?’ And he was doing nothing wrong. He said ‘Maybe I should stop trading futures and go back to trading stocks’ because he felt intimidated, so there is some of that nonsense going on. The good news is that they assured him that he wasn’t doing anything wrong but it still rattled him because he feels he is on somebody’s radar and he doesn’t want to be on anyone’s radar.
GC: Along with that, the division of enforcement has been extraordinarily aggressive in the futures industry in the last couple of years. I mean prior to MF Global. Jamie Dimon said this about the banking industry, ‘When does a mistake become an enforcement action?’
In the course of executing day-to-day responsibilities, in FCMs and other businesses mistakes happen; early detection because of good internal controls mitigates these mistakes and 99.9% of the time there is no harm and no foul, but in today’s regulatory environment the division of enforcement may take an action against an FCM.
FM: Do you feel they are being overly sensitive?
JG: They are still trying to solve the financial crisis so [if] you did some little thing, they want to fine you like you are the bad guy who caused the great recession.
TK: I don’t think anyone is trying to maliciously avoid rules. We have a fiduciary duty and live it on a daily basis. Gerry said it very well, I work for a big company and perception is critically important. To manage the perception that they have for us, that we are rule followers and we have the ADM way that we practice and we are indoctrinated in, but that doesn’t mean anything to the CFTC and it is frustrating and it’s challenging. At times you feel like a scapegoat.
FM: How important is it for someone to be charged in the MF Global mess, to be kicked out of the industry?
JG: It helps to have a period at the end of the sentence.
GC: I am dismayed that there hasn’t been at least a statement, a disclosure by the regulators — what have they found, what have they not found. It has been a year; we have had the trustee’s report, which is pretty scathing, but we have not heard from the regulators at all as to where the investigation stands right now, whether it be the U.S. Attorney or the CFTC.
FM: What is the biggest issue for FCMs?
SG: Restoring customer confidence.
Other FCM voices…
FM: What has been the long-term impact of MF Global on business? Volumes are down this year — how much of that do you attribute to the MF Global and PFG failures?
Nicolas Breteau: There’s no doubt that the failures of MF Global and PFG have cast a cloud over the futures industry, but they also prompted customers to renew their vigilance and ask more questions of their brokers. That’s the type of side-effect that can only mean good things for the industry in the long-term.
While there certainly is work to be done to restore confidence, the exact extent to which we can blame the fall in volume on MF Global and PFG is minimal. Volumes are down industry-wide across a variety of markets and brokers are being forced to find new ways to profit. Newedge has remained competitive with our agency-broker model and we have even gained market share in several markets. For several of our commodities products, we’ve actually seen an increase in overall volume.
I think the more realistic issue affecting volumes is changing market conditions, and the broad range of national and international issues facing the industry today. Over the years, Newedge has proven itself more than capable of adapting to changing conditions and regulatory climates. So, we’ve weathered the storm better than some of our competitors.
FM: Grade the industry and regulatory reaction: FIA, NFA, CME Group and the CFTC. What did they do well and what did they do poorly?
NB: I believe the FIA and all these regulators have acted in a timely and affirmative manner in endeavoring to restore investor confidence in the futures industry, and we applaud these important efforts. That being said, I believe the most important measures instituted by the NFA and CME have been those requiring daily reporting of segregation calculations and greater accountability by FCMs to remove significant portions of their residual interest, or “top up,” from customer balances. We also supported all of the early recommendations by FIA regarding best practices around FCM handling of customer funds.
While we have not finished our internal review, we also find much to agree with in the recent CFTC proposals regarding customer protection, although we have a real issue with efforts to apply LSOC to futures through the backdoor – which we believe this proposal tries to do — let alone the LSOC proposal generally as applied to cleared swaps. Let’s be frank: Applying LSOC to futures would not have helped a single customer at MF Global or a single customer at PFG. What LSOC does do, however, is to unfairly transfer the burden of evaluating an FCM from its customers to fellow clearing members at a clearing house who are less able to conduct such evaluation, let alone to potentially penalize customers who have chosen a more responsible broker (perhaps even at a the cost of paying higher commissions for such responsibility) in the first place.
FM: Of the regulatory changes enacted and proposed, which will help prevent another MF Global-type failure? What don’t you like? Do you see potential unintended consequences of any rules? What additional measures would you like to see? What has been the response of your customers? Are they satisfied with the changes?
NB: Certainly, NFA and CME new rules requiring greater accountability prior to the removal of a large portion of an FCM’s residual interest potentially would have helped clients of MF Global, while new rules requiring certain depositories to provide “real time,” “read only” access to FCM’s statements to regulators is a step in the right direction to help protect against the type of fraud at PFG.
However, Newedge has publicly promoted — both through testimony at a CFTC Technology Advisory Committee during early 2012 and subsequently through a formal submission to the CFTC — adoption of an automated daily third-party reconciliation of FCMs’ stated segregation requirements with their depositories’ records of funds on deposits by such FCMs for their customers. This is a system Newedge has been subject to in China since the creation of its joint venture there — CITIC Newedge Futures — in 2008, under the auspices of the China Futures Margin Monitoring Center.
The NFA post-PFG announced plans to move to this type of program, and we applaud such development. We only wish this idea had been embraced and acted upon earlier.
FM: Ever since MF Global went bankrupt the idea of a SIPC-style insurance program has been floated. What is your opinion of this? It also has been suggested that customer funds could be placed in a third-party repository (Phil Johnson plan) or even completely held at the clearinghouse. What are your thoughts on these recommendations?
NB: We have already publicly endorsed a study of the possibility of offering some type of customer insurance. However, the issue with an insurance fund is who is going to pay for it? As discussed, it’s a challenging time for the industry and while regulators are doing the best they can, there is a significant increase in the cost of doing business as a result of Dodd-Frank as well as other recent regulatory initiatives. It is obvious that brokers have been underpricing their business and will have to deal with that moving forward. The system rests on our ability to make customers whole in the event of a default and we already don’t price for this situation adequately, if at all.
Although we believe there is merit to discuss permitting certain customers to maintain third party custodial arrangements to further protect their funds, we certainly are not in favor of mandatorily placing additional funds at clearinghouses. Dodd-Frank has already mandated a significant concentration of risk at clearinghouses, and we believe that any further mandatory concentration is not advisable.
As mentioned before, we think a more effective way to ensure the safety of customer funds is the third-party verification process to which our Chinese joint venture is already subject. And given the NFA’s endorsement and proposal of a similar model for the United States, it’s certainly a development we’ll be monitoring closely.
FM: What is your opinion regarding the changes in Rule 1.25 regarding how you can invest customer funds? Did changes go far enough? To far? Given the current zero interest rate world, which the Fed has extended out to 2015, is now a good time to end this practice?
NB: After proposals to amend 1.25 had been dormant for some time, they were rapidly instituted after the collapse of MF Global. Most of the restrictions adopted were sound, but some — such as the prohibition to invest in foreign sovereign debt — continue to make no sense to us. Ironically, one idea that would have made sense — reducing the permissible weighted average maturity of customer investments to something materially less than two years, as currently permitted — was not adopted.
Although it is not the responsibility of the CFTC to help FCMs make money, it appears to have been a common denominator of both the MF Global and PFG collapses that the firms were struggling prior to the events that led to their demise.
FCMs should invest customer funds in a conservative fashion no matter what (even applying today’s current approved investments under Rule 1.25). However, the CFTC probably should have been a bit less reactive to headlines in amending Rule 1.25 and been more conscious to restrict only those investments previously allowed that clearly were problematic.
FM: What has been the impact of Dodd-Frank on the industry? What is your opinion on the rule-writing process regarding cleared over-the-counter trading (OTC)? Do you expect to be more involved? Will MF Global make it harder for smaller non-bank FCMs to get involved in cleared OTC trading? Should it?
NB: We have argued for a long time, that the goals of Title VII of Dodd-Frank are the right goals, but the mechanism to get there is flawed. Keep in mind that the commodities industry had its own financial crisis in 2001 following the collapse of Enron. In response, NYMEX, ICE and SGX all adopted voluntary clearing mechanisms at first for certain energy swaps and then for other commodity products too, and these mechanisms worked well.
Rather than build upon the success of these mechanisms, Congress and now the CFTC and SEC, have decided to construct an elaborate new complex framework for regulation. It is bad enough in the United States to have separate regulatory systems for securities and futures, but now there is an additional regulatory system for cleared swaps! Moreover, we are very fearful that the current system will increase systemic risk by aggregating previously dispersed credit risk among many swap dealers into a few clearing houses. Although we plan to be a significant player with our two shareholders in the cleared swaps space, we are afraid Title VII ultimately will reduce the number of clearing brokers and competition, generally in the FCM space.
I believe we would have seen a greater percentage of all swaps cleared sooner and more efficiently had the approach simply been to build upon the status quo and add some important new provisions such as mandatory registration of and capital requirements for all swap dealers, mandatory reporting of all OTC swaps, and differential capital requirements for cleared and uncleared swaps. Through economic incentives, the OTC industry could have been encouraged to clear more swaps, while gaining responsibility and transparency, all with far less confusion and cost and on a timelier schedule.
FM: There has been a lot of talk of placing restrictions on high-frequency traders (HFT). Is this necessary? What portion of your business comes from HFT? Is HFT a danger to markets? Is this a concern for your customers? Are any additional rules or restriction necessary?
NB: I don’t think there is anything wrong per se with high-frequency trading, though we do not support “naked” sponsored access arrangements. In fact, my guess is that within 10 years, today’s high-frequency trading will be considered relatively slow and quaint.
A significant number of our clients are involved in HFT, who all [say] that it has helped to increase liquidity, narrow spreads and lower execution costs for many market participants, including smaller retail participants. Also, under most circumstances, HFT firms have helped to decrease market volatility.
That being said, no trading should be permitted to artificially distort markets. There should be reasonable rules — such as adopted recently by the SEC in Reg Mar and ESMA — that restrict direct market access without any control.