As we close 2014 and look to 2015 futures commission merchants (FCMs) are making a sound not heard for quite some time. It is not clear what it is but there is a hint of actual hope.
It has been a long several years since the credit crisis hit in 2008, plunging interest rates to zero and promising greater regulatory hassles with fewer growth opportunities. But as we enter 2015, quantitative easing infinity (QE3) is over and the specter of interest rate movement, if not volatility, is alive. A less interventionist central bank will allow for more movement in multiple sectors and there is new leadership at the Commodity Futures Trading Commission (CFTC) that is sounding a more conciliatory tone to the concerns of futures brokers.
Still the challenges are real and serious. Rules are in place—even with perhaps a more understanding regime to interpret them—that are making life more difficult for the independent FCM.
What brought hope to FCMs this year was the hint of volatility and movement in interest rates along with an active ag sector.
“We saw complete volume boredom in August change to periods of real market volatility in October,” says Tom Kadlec, president of ADM Investor Services. “It was very good to see the interest rate complex get more active over the summer based on unemployment below 6% and ‘hopes’ of an increase in rates.”
Scott Gordon, Chairman and CEO of Rosenthal Collins Group, says every sector saw significant activity. “For our commercial hedger clients, the agricultural markets were particularly strong, along with energy and precious metals. For our professional trading clients, there was good volume in interest rates, equities and other sectors,” Gordon says. “Volatility in all markets, along with macro-economic factors, certainly contributed to the healthy activity, not just for professional and institutional traders but for retail as well.”
While market movement provided hope the ongoing theme is the cost of regulation. Kadlec notes that while all aspects of new regulation are challenging, the two that are most difficult are financial reporting and responding to CFTC inquiries.
“Inquiries have doubled or tripled since 2011,” he says. “To meet these obligations, [we have] expanded our accounting and compliance teams by 25% and invested heavily in technology to help drive efficiencies. The costs have been significant to us as a firm.”
Lynette Lim, CEO at Phillip Futures Inc., says the firm has had to invest heavily in people and processes. “It has cost us not only money but also opportunity because we have to devote resources to comply with the rules rather than develop or enhance our product offering.”
Lim is not opposed to many of the changes because she says it is important the industry gains back confidence, but adds, “The trend we see across all regulators is for more and more capital required to do this business, and this would be detrimental to firms with less resources.”
“It is not a lot of additional cost, it is more in terms of time,” says Patrice Blanc, CEO of Jefferies. “Regulatory changes over the last two years: Implementation of Dodd-Frank, the Volcker rule, rules for FCMs; [take time and are] more difficult to implement.”
And when you are working on compliance you are not focusing on your business. “It is a lot to learn, you have to present it to the salesman, to the customers. Customers who are trading less because of all those changes to the rules,” Blanc adds.
As the FCM world was digesting Dodd-Frank rules and the residual interest reinterpretation thanks to the MF Global and PFG debacles, they faced another additional cost when CME Group announced an increase in its data fees. The fees were not only expensive but extremely confusing. Kadlec notes that CME has amended the initial proposal but has more work to do.
“Internal estimates are an increased cost of approximately $400,000 a year which includes the fees we must pay in order for our employees to do their work and adding staff to track the MDLA (Market data license agreements) and pass the fees on to CME.”
He says that the fees apply to risk officers as well as sales people, which he calls absurd. But the biggest impact will be on introducing brokers. “Most of our introducing brokers are small businesses and the CME’s market data fees will be very burdensome to them,” Kadlec says. “They feel CME has lost sight of the fact that the brokers need access to the data in order to bring customers to the CME for trading. ICE fees are lower and calculated in a more rational manner.”
Blanc is more retrospective. “We are dealing with it [but] there are bigger issues than this one,” he says, while acknowledging that as an investment bank Jefferies does not have IBs to worry about.
FCMs lost the battle over the CFTC’s reinterpretation of the residual interest rule, which could require customers to post double margin. “It represents a sea change for all of us; it’s a complicated operational change and it increases the cost of doing business for everyone,” Gordon says. “Now that it’s a reality; we have continued that dialogue with brokers and customers and put processes into place to ensure that all of us will be ready on day one.”
Blanc says as an investment bank Jeffries can live with the rule but that it will have a negative impact on smaller firms and ultimately, volume. “At the end of the day it is an issue for the industry. It is an issue for the small- or medium-sized FCM, but the guys who are going to be impacted are the mid-market customers or the large corporates,” he says. “It is more an issue for the customers because it could prevent them from being more active in the market. When it is fully implemented it will hurt the customer. They will do less business and it will be more costly for them to hedge.”