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.