Regulators around the world are pursuing a relentless agenda aimed at reducing risk and increasing transparency. The derivatives industry, with its 24-hour global and highly interconnected business model, is therefore providing an interesting challenge for them. The macro-economic position, as abnormally low interest rates have become the new normal, is not helping either. This suggests that a futures commission merchant (FCM) model dependent solely on intermediating between clients and liquidity may not be viable going forward.
The changes can be summed up in two words: convergence and aggregation. Distinct over-the-counter (OTC) and exchange-traded workflows that used to run along separate but parallel streams have now become permanently intertwined. The FCM of the future will need to refine its strategy and streamline its operations accordingly.
The dust is yet to settle, but the signs are that the traditional on- or off-exchange paradigm will evolve towards a broader spectrum of standard and custom contracts. The standard contracts will take many forms and be traded across both designated contract markets (DCMs) and swaps execution facilities (SEFs). Flexibility will be critical, and may include the potential evolution of an agency model that aggregates liquidity on behalf of the buy-side and combines relevant liquidity onto one screen regardless of where it is traded. One of the key tools for FCMs in all this will be benchmarking algos, such as daily volume-weighted average price (VWAP). As algos working across multiple pools of liquidity proliferate, transaction cost analysis will also play an increasingly vital role. Buy-sides will apply it to decide which brokers to use, and so it will become critical in demonstrating an FCM’s worth.
Aggregation will also extend to risk and margin, which will enable FCMs to provide the greatest possible clearing efficiencies to their clients. The middle office and its interoperation with clearing houses, credit hubs and clients will be where this particular battle is fought.
In this light, maintaining multiple desks that run different trading applications looks increasingly old-fashioned. It hinders efforts to manage compliance and risk but, above all, it is simply too expensive. The same is true of deploying multiple third party screens to clients just to meet specific trading quirks or habits. Anachronism and sentimentality have no place in today’s FCM playbook.
What is needed is a more centralised approach to business workflow so that information can persist more fluidly through the entire firm. This needs to be done in such a way that different desks and clients feel empowered rather than constrained by centralised bureaucracy.
Rising to these challenges poses a tough set of questions, especially with regards to technology. The goal is simple: a resilient, high-performance backbone that centralises as many functions as possible but is flexible enough to accommodate different desk and client needs. But how can that best be achieved?
The first question is whether to build or buy. When so much remains unclear, buy becomes the strategic option; not only is it cheaper, but it's more effective too. This is especially true when the entire platform is outsourced as the provider can generate economies of scale unavailable to individual firms. It also allows FCMs to replace fixed cost with variable cost, and so scale how they address the market and new opportunities.