Five years is a long time. Think about it: In 2008, the financial markets were in upheaval, still reeling from the failure of Lehman Brothers and the infamous bail-out of the too-big-to fail firms. Since that time the U.S. Congress wrote and passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, mandating that the various regulatory agencies put in place rules that would stem some of the bad behavior that happened during the financial crisis. A lot, it seems, can change in five years.
For the derivatives industry, the financial crisis volatility that many survived was hit with customer confidence issues caused by the failures of MF Global and Peregrine Financial Group. With the new customer protection rules released by the Commodity Futures Trading Commission (CFTC) in October, the mandated residual interest rule was put in place.
This rule basically forces brokers to shorten the current time they collect margin from customers to one day, and in five years, to the following morning. Although many firms are electronic, hence collect payments at T+0 and T+1 rates, some have a large group of clients that still write checks. To make this change would mean pre-payment of the account, something that could curb usage of the futures markets. But, as Mike Dawley, managing director of global futures and OTC clearing securities division of Goldman Sachs, noted on an FIA Expo panel, “who knows who will still be around in five years?” This highlights what many in the industry believe, that T+0 will never happen, although T+1 is a good bet. Don Roberts, managing director of futures & forex for ThinkorSwim, the derivatives arm of TD Ameritrade, summed it up that the regulator (like Congress) “kicked the can down the road.”
This is only one of the many issues on which we questioned a score of top futures commission merchants (FCMs) to discuss for our annual review. New regulations and compliance issues have become such the focus the last few years in the business, brokers seem to finally see the light of day and are getting back to real business. Matthew Simon, senior analyst and head of futures research at TABB Group, which just completed its annual FCM study, noted that after the past few years with the failure of MF Global and PFG, the shrinking volumes, low interest rates and continuous money flowing out to keep up with compliance, “this year we found more optimism,” he says. “Not so much that volumes will grow [rapidly], but that efforts put in terms of [futurization of swaps], and that rules that were talked about for years are now a reality and [FCMs] can get back to making money on executing trades.”
And he’s correct, except that there still is some anger about some of the regulations. Joe Guinan, chairman and CEO of Advantage Futures, believes despite being one- and five-years out, the residual interest rules border on “ridiculous.”
“The impact will be for FCMs to require customers to hold larger excess balances to avoid margin calls, causing a negative capital impact to the FCM — even from relatively minor market movements and position marks. This increase in margin required by FCMs effectively raises the client’s cost to trade. The need to resolve margin calls more quickly will tend to increase volatility at exactly the wrong time (during extreme market moves) as the FCM will be forced to liquidate more quickly (rather than take the appropriate time and do it in an orderly manner). The rule also will preclude people from initiating positions that may serve to temper a big market move (for fear of generating margin calls) — big moves in any market will be exacerbated by this rule. Intuitively, regulators should want to help foster liquidity that can dampen extreme market moves. This rule will force more intraday liquidation to avoid margin calls whenever a severe market movement occurs; some market segments may utilize alternative markets (cash or spot, forward, etc.) to hedge risk rather than deposit the extra funds, further reducing futures’ liquidity,” Guinan explains.
Gerry Corcoran, chairman and CEO of R.J. O’ Brien & Associates, says ” We believe the residual interest rule went too far,” adding, “This likely will have a profound impact on those in the agricultural community — even before the “at all times” phase-in after five years — which is very unfortunate.”
Scott Gordon, chairman and CEO of Rosenthal Collins Group, agrees. “As currently constructed with the phase-in provision, we have to be mindful of the prospective impact on clients whose livelihoods make it difficult to comply with the provisions. For example, smaller commercial hedgers, and also international clients, may have operational difficulty posting funds with their FCM to comply with the new deadlines being phased in.”
And despite the tightening of rules it might appear to be, says Tom Kadlec, president of ADMIS, it’s yet another cost for the customer. “Over time, the rule will increase the amount of capital required to be maintained by FCMs, which will decrease our returns. It also will increase the frequency of wire transactions and the amount of customer funds posted at FCMs, and increase the cost of hedging for mid-level accounts. This will possibly drive customers to other risk management products such as crop insurance or off-loading production to large processors earlier in the cycle to avoid increased hedging costs.”
The irony, muses TD’s Roberts, is if these rules were written due to the MF Global and PFG messes, “Peregrine would have asked you to prefund your account, [and] would have stolen more. Instead of $200 million, [PFG] would have walked out with $400 million. [Jon]Corzine’s positions would have been exponentially larger.” He’s glad the regulator has taken “iterative steps” with this rule to make sure it helps rather than hurts the business.
Granted, this is one rule of many, but when asked about how the Dodd-Frank rules impact their business overall, all FCMs were vocal. Keep in mind, according to the TABB Study, which interviewed 16 U.S.-based FCMs, of which represented almost 75% of the $157.7 billion in total seg funds, “addressing regulation remains the most time-consuming and energy-resource-heavy activity,” the report states, adding, “Yet, 43% of FCMs say they do not factor regulations into pricing, while 21% are still evaluating their decisions on how to charge for it.” For a business that has razor-thin margins, regulation always has raised blood pressures.
Guinan, always to-the-point, notes, “There are now mandatory and severely punitive fines for irrelevant, immaterial rule violations that in times past were handled more reasonably. Not long ago, exchanges and regulators employed a ‘reasonable man’ yardstick in evaluating mistakes made by an FCM. If an investigation revealed a minor human error had occurred and there was no pattern of negligence or deception, fines were usually set to a level acknowledging the error and economically encouraging FCM actions to minimize any recurrence. Now, in the aftermath of the great recession, the overarching regulatory goal seems to be to fine every firm and market participant as much as possible for any infraction that can be identified. Their need not be malice or mal-intent or negligence — a simple minor human error can now be met with a severe financial penalty. Over time, this will certainly result in higher commissions and costs for clients as FCMs will be forced to pass along this higher regulatory operating cost.”
Dan O’Neil, vice president of futures at optionsXpress, agrees. “The other big story is that the penalties for being non-compliant are now more severe than ever before. The steady drumbeat of new rules and regulations combined with the seriousness of being non-compliant means firms are focusing intently on this sort of thing.
“You might be familiar with a recent ruling that requires all futures industry participants to record and archive all communications that lead to the execution of a futures order, and that is presenting a number of problems for firms. There’s been very little interpretive guidance from the regulators as to what this means exactly, but we’re working hard on that right now.”
Kadlec agrees about the need for guidance: “The CFTC, NFA, and the exchanges could help immensely with this by putting out guidance letters and white papers that bridge the gap between theoretical rules and the practical implementation of the new rules.”
Enter the SWAP teams
A new rule that bodes well for the business is the move of the OTC swaps to be cleared via swaps execution facilities. And this, according to the TABB Group report, could be a boon for the industry. Of the FCMs that TABB interviewed, most saw this as a major growth opportunity for them; in fact, it could mean a 15% increase in revenues. The futurization of the swaps markets could be very good indeed for those firms who are approved, or are planning to be approved, swaps dealers. This includes typically the largest of the firms, such as Newedge, which was in the first 18 firms to be approved, to mid- to large-firms, such as FCStone Group. But for mid- to small-sized firms, the swaps business may be good for their larger brethren, but won’t be an area they have clientele. Even some mid-sized firms, such as TradeStation, cater mainly to retail business, so swaps aren’t an area for growth.
Says Newedge’s new CEO David Escoffier: “The futurization of swaps as well as OTC clearing are both major growth drivers for us. Clients have turned more and more to deliverable swap futures and we are actively engaged with the respective CCPs as well as new providers and new exchanges such as GMEX and Eris. Overall, the futurization of swaps is completely synergistic to our business and as the market leader in clearing of listed derivatives, we welcome this trend.”
Pete Nessler, CEO of FCStone Group, also believes this is a growth area for his firm, largely because they have a sizeable ag clientele that does swaps. He notes they already have seen “large increases in block trading.”
TABB found that 90% of their respondents believe swaps “hold the potential to bring new liquidity to the futures markets,” and in fact, the firm estimates swap futures will capture 3% of the swaps market, meaning huge growth, especially in the interest rate futures contracts. TABB reports some respondents already see a slowing down of the OTC desk business as the expenses of the OTC products increase.
So is there growth for non-swap firms? Apparently, yes. TD Ameritrade, which purchased ThinkorSwim in 2009, has seen huge growth in the appetite of its equity trader-clientele base for derivatives. Steve Quirk, executive vice president, notes that when they were first bought by TD Ameritrade, the group brought in about 9% of the revenues. Today they account for 40%, and the main growth has been by providing current equity clientele derivatives products. O’Neil echoes the sentiment with optionsXpress’ parent Charles Schwab’s clientele that is looking to hedge portfolios or trade derivatives.
Carl Gilmore, CEO of KCG (Knight Capital Getco), agrees with this growth potential. “Of course swaps are one thing, but the traditional futures space needs to do a better job as an industry telling our story to the world. The metric that always gets used is that futures activity is about 8%-9% of all activity in the capital markets in this country. So, if we were to expand the users of our markets by 5% and go to 13%, then the industry is now 50% bigger. I tend to see traditional market participants coming back in, including retail traders that had been on the sidelines.”
TABB’s Simon even sees this in the institutional space. “More traditional asset managers are seeing the benefit of using derivatives; many are starting up derivatives trading desks.”
But others see growth internationally, and as Simon notes, “when we ask where investors want to go, China is by far the number one request.”
Many of the mid-level firms on our panel agreed they were or already have ventured into other regional arenas. Some have a built-in business opportunity with sister or parent companies, such as ADMIS and FCStone. Other firms, such as RJO, Advantage and RCG, have looked east and west to expand. And on potential product growth, several saw options on futures as a major growth contract area, while others noted the Vix contract as the “rising star.”
And although TradeStation’s CEO Sal Sredni sees growth for the firm in Asia and the Middle East, this is largely due to licensing the firm’s technology and not its brokerage business, which is mainly retail and U.S.-based.
Interestingly, merging the CFTC and Securities and Exchange Commission (SEC) had few proponents on our panel. Nessler noted that “there would be more effective rule making” if the agencies merged, but Escoffier notes that “We do not believe a merger of the CFTC and SEC is critical with respect to the regulation of joint FCM/broker dealers in the U.S. Indeed, while the U.S. is one of the few jurisdictions in the world that bi-furcates the regulation of futures and securities, there are numerous examples of instances in which the same entity is governed by more than one regulator. Close cooperation — in regard to the issuance of rules, examinations, enforcement and other matters — between regulators that govern a particular entity is critical to optimize their efforts and minimize any unnecessary disruptions to the regulated entity. We also would like to see further harmonization of rule books to eliminate inconsistent, duplicative or overlapping regulations.”
Many shrugged at the potential merger. Sredni said “Be careful what you wish for,” while Guinan noted that “We can’t know in advance exactly how this would play out. It would likely be quite a mess. We want efficient and good regulators. We don’t necessarily need fewer regulators. A decade ago, New York State Attorney General Eliot Spitzer exposed the mutual fund timing scam that Wall Street firms were facilitating. The SEC completely missed this activity. The foxes have an ability to take over the chicken coops. Two regulators are better than one.”
On emerging trends, two reactions stand out. The first is many saw more consolidation of an industry that already is consolidating (see “Divergence in the numbers,” below). “With the combination of increased costs in meeting new regulatory requirements and higher technology costs, we expect to see continued consolidation among FCMs,” Gordon says.
Escoffier concurs: “I expect to see further consolidation in the market. Regulation is making it harder for smaller FCMs to do business, and clients will gravitate to scale and proven expertise, i.e., the current top five players.”
Corcoran believes the low-interest environment will continue, affecting FCMs in many ways. “In the low-interest-rate environment, in which there is slow growth in the industry and a high cost of compliance, we will see fewer firms able to survive, and therefore consolidation. We expect the low-interest-rate environment to continue for the next two to three years, and smart FCMs will have to address their pricing structures and models.”
Another focus would be continued regulation. Guinan says, “Greater regulatory costs will need to be passed on to clients in some manner.” However, he also notes, “As this rash of regulatory over-reach subsides, the FCM industry can focus on expansion and the exchanges can turn their attention to creating new products rather than jousting in Washington.”
TABB’s Simon agrees that consolidation is definitely going to continue, but he says “it’s harder for me these days to believe there will be a smaller number (of FCMs) as the number is starting to level off,” he says (see “Bigger firms getting bigger piece of pie,” below). What he sees more likely is a large firm could leave the business, allowing other firms to grab market share. However, he does see business migrating to the biggest players with the big balance sheets, and that capital is power in the business.
Escoffier agrees, stating: “Managing cash and collateral have become more important than ever with banks facing term liquidity shortages and pressure to diversify their sources of funding in the face of Basel III and CRD IV. Centrally cleared OTC markets also require higher initial margin and collateral capital. Hence, cash has become an asset class rather than a borrowing class pre-crisis.”
In the end, many FCMs are optimistic. Guinan notes “As the fixed income market descends, volume and return on investment of client funds should rise concomitantly — benefitting the entire FCM community.”
Gordon agrees, saying: “Despite all that the FCM community has been through in the past couple of years, there is tremendous potential in the FCM model, and no one should underestimate our ability to innovate and reinvent ourselves as new challenges come our way.”