Last year, client clearing of OTC derivatives was largely seen as a business in retreat. The Basel III leverage ratio, also known as the US supplementary leverage ratio (SLR), has pilled huge pressure on the traditional business models of clearing brokers, or futures commission merchants (FCMs) as they are more commonly referred to in the US.
Facing the pressures of the leverage ratio, it resulted in a swathe of radical changes in the business models of FCMs, including raising costs, cutting customers, and even pulling out of the business altogether.
“The result of continued consolidation in this industry is fewer FCMs catering to an expanding universe of cleared derivatives. This issue poses significant challenges,” explains Jerome Kemp, global head of futures and OTC clearing, Citi.
As of the end of 2015, the number of FCMs clearing for the buy-side dropped to just 54, according to data from the US Commodity Futures Trading Commission (CFTC). This number could drop even further when margin rules for uncleared derivatives come into force in September this year.
“Unable to reconcile the expanding clearing mandate with a dynamically evolving regulatory landscape, the FCM industry may indeed face further contraction, an outcome that seems to be counterintuitive to the original intent of regulators and lawmakers in the post-crisis world,” says Kemp.
In times of radical changes in the industry, Kemp argues FCMs will have to apply radical thought if they wish to survive.
“FCMs active in this space these spaces have had to make changes to their model, and these changes have covered a wide range of alternatives from repricing the service offering to reducing both the balance sheet and RWA (risk weighted asset) footprint,” says Kemp.
Citi has not been immune to these pressures, but it has adopted a bold strategy to optimise its clearing business.
It has sought minimise the use of its balance sheet by removing client-posted cash initial margin for cleared OTC derivatives in the US. The move allows Citi to free up its balance sheet capacity to take on more clients, and improve on profitability without raising client fees or impacting collateral flexibility.
To date, Citi has removed almost $4 billion of client cash margin posted with its US OTC clearing business from its balance sheet.
It is this kind of innovation that other FCMs have to open up to if they are to remain profitable in an increasingly constrained environment.
“FCMs are going to have to admit that the world has changed: bottom-line returns are taking on primary importance so the need for radical thought is very much on the order of the day,” Kemp adds.
Watch out for the latest issue of The TRADE Derivatives for the full article with Citi’s Jerome Kemp.