A Love/Hate Relationship
The relationship between FCMs and exchanges has been strained ever since the exchanges demutualized, consolidated and became for-profit entities. While they are partners in some sense, many FCMs believe that CME Group and Intercontinental Exchange (ICE) have exploited their pricing power.
“The marketplace has helped define who has the pricing power. That marketplace, who we all are students of, shows they can drive price,” Kadlec says.
“Exchange fees are a large part of the trading cost. Anything we can do to make the cost for retail traders come down and make them simple and easy to understand is a step in the right direction,” says Lamaina, who adds that CME is helping the retail FCM. “They have made some progress with their retail program and even advertising on television trying to promote retail futures trading,” Lamaina says. “They also have some programs for the retail-focused FCMs like ourselves that help us restructure some of our costs.”
“The exchanges could do more to aid FCMs,” Guinan says. “Certainly everyone benefits if the number of participants increases. Perhaps joint marketing efforts with FCMs will evolve into a team effort.”
“We have some strategic initiatives with the CME Group to help education and drive additional business into the futures market,” Kadlec adds. “We appreciate their support around that, we appreciate their transparency effort but at the end of the day, I do have a question on how directly they compete with us.”
And therein lies the rub. While FCMs appreciate some of the work the exchanges do in promoting products, they are also reaching out directly to some customers, which threatens to disintermediate FCMs.
“Their trading platform CME Direct does compete with many of the platforms that have supported this business for many years,” Kadlec says. There are good things about it. The CME is doing a lot of good things that are supportive of FCMs but they are also doing a lot of things that allows them to have direct access to customers.”
Of particular concern for Kadlec is a CME remote clearing initiative that would allow non-FCMs from outside the United States to access its markets. “They would like non-U.S. FCMs to trade directly with the CME. To me that is a direct competitor of the U.S. FCM. If they are going to lower the standards of an FCM at the CME level or at ICE and not require U.S. boots on the ground that is a concern,” Kadlec says.
“It is a big problem for the existing FCM community, we need to preempt this,” Corcoran adds. “There is, however, a logical reason for part of this rule, that would provide capital relief for firms that have CME clearing members in Europe. But, it also opens the door in Asia, where firms can become a CME clearing member without the same types of controls and oversight as U.S. FCMs have.”
While Corcoran acknowledges that there are legitimate problems the remote clearing rule is addressing, he says it is undercutting existing FCMs who have invested in those markets. “Solve the problem with your current members but don’t open the door to others that don’t have the same requirements we do. Adding FCMs in Asia doesn’t create new business. All you’re doing is splitting the pie further and diluting the existing brokerage community.”
“FCMs are quasi franchisees of these exchanges; we are out there as their sales unit,” Corcoran says. “This proposed rule allows access to the CME for FCMs that don’t have the same oversight that we have and that is not good from a regulatory standpoint. We have spent a ton of money being regulatory compliant and investing in technology and they flip a switch on the rule book that allows potentially eight or nine FCMs in with different types of oversight than we have. It is not necessary, and it doesn’t make sense”
Corcoran says that the FCMs and exchanges have a symbiotic relationship “We are their frontline salespeople for every product, and we provide a layer of capital protection. The FCMs’ capital constitutes 99% – close to $5 billion – of the guaranteed funds the exchanges have put in place for protection. To be fair, the exchanges have helped with co-op advertising dollars. I would urge them to understand the FCM better because the FCM is an important element of their success.”
In terms of what they would like to see from the exchanges, Kadlec put it this way, “Lower market data fees, lower custodial fees, lower transactional fees, be a rational regulator, promote market transparency and be good educators to undeveloped marketplaces.”
Gordon adds, “FCMs provide an extremely valuable benefit to exchanges as a conduit or intermediary for their business. It is in the exchanges’ best interest to ensure that FCMs remain a vital part of their ecosystem. We would welcome any initiatives that bring us greater cost efficiencies and new revenue-producing opportunities.”
The bottom line for brokers is that exchanges have thrived over the last decade, while FCMs have struggled with consolidation, added regulatory costs and a low-interest environment. They would like the exchanges to recognize this value and not press their pricing advantage (see “A good decade, for exchanges,” below).
While FCMs work out their complicated relationship with the exchange community, they appear satisfied that the era of over-regulation is coming to an end.
“We are a proponent of good and reasonable regulation, but we hope to see a pattern going forward of more thoughtful cost/benefit analysis in the introduction of new rules,” Gordon says. “This is consistent with the CFTC’s recent Project KISS initiative, which we hope will bring a decrease in requirements that are burdensome without serving a broader purpose.”
“We see light now,” Corcoran adds. “With the reconstituted CFTC we are seeing a common sense approach to regulation and also some relief on how past rules or proposed rules are being thought through. [We are] feeling a lot better about regulation and optimistic that the CFTC is taking a more reasonable approach.”
An example of this new approach is the CFTC’s decision to pull a provision of Reg AT that would have allowed the regulator to access the proprietary algorithms of high-frequency traders. This rule drew the ire of traders who feared sharing their proprietary algorithms with a third party.
“What are they going to do with the data?” Kadlec asks. “If you have data you should define what you are going to do with it. I know what we do with our data.”
Most brokers have little desire to roll back rules; they simply want a break from additional rules and a more rational approach to enforcement. “We dedicate material resources to ensure our adherence with regulatory requirements, and any reduction in those requirements would allow for those resources to be redeployed on other client-facing initiatives,” says Craig Robertson, head of listed derivatives, Americas, Prime Services, Societe Generale.
“There is room for smarter regulation,” Guinan says. “Disruptive trade practices, in particular, seems to me an area where some top-down reform can aid the entire industry. Two simple rules could eliminate 90% of the disruptive trade issues, while also boosting trading volumes and providing more clarity and less of a gray zone for traders.”
Guinan would like every order to be exposed to the market for a minimum period of time, a fraction of a second. The other rule would delay, by a similar time period, an order lifting a bid or offer from a trader who has a resting order on that bid or offer. The original order must be canceled and then a mini-delay will come in. This way a trader couldn’t bait others to join a bid or offer that he intends to cancel.
Kadlec has one simple request, “How about no new rules.”
One area these existing FCMs do not have a problem with is broker consolidation. They see it as a natural evolution. “Capital intensive industries offer significant economies of scale and are ripe for consolidation,” Guinan says. “The post-crisis regulatory efforts have raised the capital requirements increasing the trend toward consolidation. There are still plenty of FCMs and lots of competition.”
Kadlec views consolidation as a positive sign of a maturing business. “In any maturing business, with added regulation [and] technology requirements, scale matters. Any [firm] must be larger to deal with the infrastructure costs. It is a natural progression of a changing business that has gone from a manual process with much wider commissions to a more efficient marketplace where scale is key. I don’t believe it will reverse.”
While there is some debate over whether consolidation will continue or taper, there is a consensus among FCM leaders that we won’t go back to a world with 100+ FCMs. “It is not reversing. I don’t see a need for more FCMs,” Corcoran says. “You would have to start from scratch. It is a very high cost to entry. The survivors have a very specific strategy on what market segment they are going to serve.”
Robertson says, “Despite the reduction of FCMs in previous years, our clients still have a great range of options when it comes to finding a service provider and the marketplace remains competitive.”