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.”
New regime, new hope
In November the CFTC amended the rule interpretation so that FCMs will not eventually have to meet the higher requirements at the open the following day.
“This demonstrates a willingness to listen to industry participants,” Kadlec says. “A cost benefit study was not performed previously and based on indications, the CFTC will soon be asking for data from FCMs to better understand the effect the residual interest rule has had on us and our customers.”
Deputy Head, Global Markets, Societe Generale and Newedge CEO David Escoffier say. “The new CFTC leadership seems to be very much in tune with the various market participants, including FCM needs. This is a welcome stance in what remains a challenging environment.”
Blanc is a little more cautious. “It is too soon to say. The CFTC seems eager to work with the industry. You need to protect the customers but [also] make sure that customers can have access to the market,” he says. “That is the most important thing. Unfortunately, I’m not sure those changes are helping the customers have better access to the markets.”
Blanc believes in the end the rules can do the opposite of their aim [and push] people away from regulated markets.
The end of ZIRP!
Perhaps the most promising expectation for 2015 is the belief that central banks will move away from the global zero-interest-rate policy (ZIRP). In fact, the 2014 process of Federal Reserve tapering has led to an increase in volatility in the fixed income sector with hopefully more to come.
“Irrespective of timing, there has been significant volatility in interest rates, and we believe that will continue, regardless of what the Fed does,” says Gordon.
However, there is a lot of skepticism regarding how quickly the Fed will move. “The Fed will take a lot of time to raise rates. Living in QE for several years, I don’t think rates will go up quickly,” Blanc says. “The Fed could raise rates at the end of 2015. We could be at the very beginning where we could see U.S. rates go up. It could be very slow and very long.”
The fixed income world is in a strange place at the end of 2014 because as the U.S. Federal Reserve has completed QE, the European Central Bank is preparing for another round and Japan is in perpetual accommodation. “I don’t think we will see it go up in Europe or Japan,” Blanc says.
Yet the different modes that various central banks find themselves in can add to volatility, not just in interest rates but in forex as well. “Volatility is definitely coming back. It is always difficult for a central bank to raise rates. If there is one rule for 2015 it will be the return of volatility,” says Blanc.
Interest rates affect FCMs in two important ways: One is obviously volatility in the market and two is that interest earned on customer deposits—the float—had been a major driver of revenue pre-ZIRP.
Kadlec expects interest rates to rise, albeit slowly, in 2015 and notes, “100 basis points means approximately a 2.5% increase in our return on equity and I would expect increased volume to benefit the industry as a whole.”
While brokers would love a return to a world where they earn significant revenue on the float, many have moved on. “We accepted the reality several years ago that interest income would no longer be a major source of revenue,” Gordon says. “This need to adapt in the face of a changing landscape is a vital part of any firm’s success. We conducted a top-to-bottom review and found ways to reduce expenses and in some cases adjust service fees and commission rates to reflect the new environment.”
Lim agrees. “We are seeing interest rates creeping up slowly, so we are hopeful. However, our perspective is that we need to live with the times and survive in this low interest rate environment, and not rely on the interest rates going up to survive,” she says, adding, “It’s best to treat the low interest rate environment as the new normal.”
With ZIRP going on six years plus, one must use the word normal with caution. “Right off the bat, you have to ask ‘what is the norm?’ If the norm is having a positive carry, it is not a central piece of our business model and is not expected anytime soon,” Escoffier says.
Blanc is more direct. “Interest income is gone and I don’t think it will come back in a significant way, even when interest rates move up,” he says. “All the new rules are going to add more cost. Will FCMs benefit from higher interest rates? They will a little bit, but nothing to compare with what it was pre Dodd-Frank.”
Beware of what you want
Several years ago the concept of cleared OTC trading held out hope as a future source of revenue for futures brokers but as cleared OTC trading has become a reality, it is obvious that it will mainly remain in the purview of major banks who can profit from larger synergies in their business. “OTC clearing is not priced correctly,” Escoffier says. “At current levels, only banks that provide OTC dealing in addition to the clearing can benefit. OTC clearing in isolation is a loss maker.”
Blanc agrees. “I have been one of the first to say— even before Dodd-Frank—that it would be very doubtful for FCMs to make money with OTC clearing and I was right. No one is making money with OTC clearing. If you look at the cost of capital, if you look at all of the systems you need, no one is making money,” he says, adding, “You need to be a bank and have access to other products to make money with it. It is tough to be an independent FCM.”
Can the small guy survive?
Perhaps the most often voiced concern over the current state of the industry is that commission compression, ZIRP and higher compliance costs could eliminate the small- to mid-sized FCM. Futures decided to list the Top 40 Brokers because there were only 80 listed on the CFTC database (see disappearing FCMs,” right).
While it’s a real concern, the independent FCM provides a necessary service that will be hard to replace. The consensus seems to be that the small FCMs will survive but there will be fewer of them.
“Service and broker-added value are extremely important to the hedge community as they were to the many MF Global customers who were fooled into believing that a low clearing rate was all that mattered,” Kadlec says. “Consolidation will continue in the FCM community.”
“There is an important role for non-bank FCMs to play in servicing a vast array of commercial hedgers, professional traders, introducing brokers and retail clients,” Gordon adds. “The banks simply don’t service many of these clients. Not all FCMs can afford to stay in business under these circumstances, which is why we’ve seen consolidation on the middle and small end over the last couple of years.”
Lim also sees further consolidation but says pressure is on all futures brokers. “The bank FCMs also are facing pressure as well as the non-bank FCMs to get the expected [rate-of-return] for the amount of capital required. Some of the bank FCMs also might exit the business due to increased regulations and capital requirements.”
However, Lim notes that there are also new entrants. “[Chinese] owned FCMS are [seeing] exponential growth and want to expand abroad and to the [United States],” she says. “This is an interesting trend, because we anticipate more order flow coming from the East to the West and vice versa as China begins to open up its markets.”
Escoffier notes that it is difficult for smaller non-bank FCMs to compete. “Fixed costs are getting higher, clients are more and more global in their approach and needs and regulation and associated capital requirements are more onerous,” he says. “This challenging environment will not abate. Banks, however, can monetize the FCM service in the context of the overall client relationship. This is important, as it enables ongoing, necessary investment to enrich the FCM offer with additional services.”
Challenges and opportunities
What we are hearing a lot of from brokers is that the model is broken and it is incumbent on exchanges to reach out to brokers or they will not be able to bring customers to their markets.
“No one is making money. It is not good for the industry [or] for the exchanges to have the FCMs not making any money,” Blanc says. “I am a little bit surprised that the exchanges are not trying to see how they can help or do something for the FCMs. You are going to have some banks say, ‘why do we need this business…?’ It is becoming difficult for some customers to have access to futures markets.”
FCMs all cite rising regulatory and compliance costs in a competitive environment. They do note potential global expansion, particularly in Asia. “For FCMs, the biggest challenge is to provide an exceptional level of service at a fair price while managing a variety of increased costs, including those associated with technology, risk management and regulatory compliance,” Gordon says.
The business continues to be difficult as the financial industry still has not completely pulled itself out of the credit crisis tailspin. But there is hope that markets will return to some semblance of normal in 2015, which will provide opportunities to those that seek it.