Insights & Analysis

Are we set for the rise of the non-bank FCMs?

14th May, 2015|External Author

Derivatives

Non-bank futures brokers could hoover up some business coming out of banks

By Gerry Turner, executive director, Object Trading

Decreased trading volumes, low interest rates,increased regulation and higher transaction costs have all but suffocatedbusiness models that have worked for years, even decades. Furthermore, higheroperational costs and client pressure for new services at lower prices haveintensified impending challenges. In 2014, we saw a number of banks eitherreduce their client list or quietly back away from the clearing businesscompletely as they felt the squeeze of leverage ratio and capital requirements.Banks have to reevaluate their technology investment and determine ways todeliver unique value to their clients.

As 2015 rolls on, we will see the continuedrise of non-bank futures commission merchants (FCMs) that don’t have banking licenses to protect.  Historically,these firms have specialized in access to regional markets.  Now, their non-bank status gives them increasedflexibility to provide bespoke solutions to buy-side firms exploring newmarkets and asset classes.

TighterRegulations Post-Crisis

The traditional FCMs continue to feel the impact of the 2008 financial crisis and resultingregulatory avalanche. In the past, bespoke derivatives contracts were traded inconfidence and over the counter directly between banks and their clients,creating a challenge for regulators wanting to monitor trade activity andsystemic risk. In 2009, the G20 countries agreed to stronger standardization ofover the counter (OTC) derivatives, consequently moving these products to tradeon exchange-like trading venues in order to clear through central clearinghouses. The US and Japan have already begun implementing the new mandate withEurope just now setting new regulations in motion.

This issue, however, is that regulators aresimultaneously creating capital rules for banks that do not take banks’clearing businesses into account. There seems to be a disconnect betweendefinitions of risk-reducing tasks depending on which side of the line firmsfall. The mixed messages coupled with the ballooning costs of clearing practiceshave banks questioning their participation in swaps trading and OTC derivativesclearing all together.

BanksBack Away From Clearing

And who would blame them?

As banks attempt to meet new client demandsat lower costs, capital to be spent on a regulatory runaround is in shortsupply. In addition, quantitative easing has meant interest revenue fromportfolio balances is no longer enough to offset many of the higher costsassociated with running the business.

As a result, many banks especially in NorthAmerica, including BNY Mellon and State Street, have pulled back from OTC clearing while continuing to offer futures execution and clearing. 

Similarly, many European banks have simply stepped away until the UKclearing mandate goes through.

Regional FCMs are feeling equal pressure tostep up to the plate and compete effectively. While the banks’ retreat may haveopened up space for larger market share and consolidation, that retreat raisesconcerns as well.  The health of centralclearing relies on multiplicity to reduce concentration risk. Banks’ withdrawalfrom the space could have a serious impact on the life of OTC clearing overallas there are fewer players in the market bearing the bulk of the systemic risk.

NewPlayers Emerge

Smaller and non-bank FCMs and technologyfirms recognize this as an opportunity, however. Non-bank FCMs are subject tolighter capital rules and are often more agile when it comes to meeting newcustomer demands. Technology companies are bringing in new and innovativesolutions that take a utility approach to share the cost and operation.

Although non-bank FCMs could have limitedcapital and services capabilities, they are able to leverage technologypartners to provide low latency direct market access and pre trade risk constraintcapabilities.  They are also more likelyto have local market expertise and connectivity that meet the clients’ specificgoals. In today’s environment, outsourcing technology to allow for focus oncore competencies is inevitable for many market participants.

But banks may not be completely out of thepicture, yet. A recent Tabb Group report on FCMs in 2015 suggests that marketconditions are improving and that FCMs may have a revival if they can withstandthe competition. As futures volumes see further growth, net interest incomeimproves and UK regulations begin to take shape, it will be interesting to seewho ends up on top.