Some futures commission merchants (FCM) will be forced out of the business by proposed rules on client money released by the Commodity Futures Trading Commission (CFTC) but industry insiders are divided on whether this means less choice for the buy-side.
The latest round of CFTC rules to be open to public comment focus on holding customer funds, meaning FCMs can make even less money on the funds they hold. Combined with weak equity markets and low interest rates, many FCMs will exit the sphere, leaving the buy-side with less providers to chose from.
The tighter rules increase the likelihood of futures traders going out of business, as occurred with FCMs Peregrine this year and MF Global last year. FCM’s will not be able to net positions and will have to manage accounts at the customer level. Exchange fees will no longer be different from what the broker charges clients, so FCM will not be able to profit from netting as a revenue stream,”
The new CFTC rules require FCMs to hold sufficient funds in secured accounts to meet their total obligations to both US and foreign-based clients trading on designated contract markets, according to Matt Simon, senior analyst at consultants TABB Group, who published a report on the state of the US futures market last week.
The TABB report, authored by Simon, sees competition amongst broker-dealers and FCMs becoming increasingly top-heavy, as larger players soak up more business, which will boost offerings for the buy-side.
“As futures become a more demanded asset class from the buy-side, we’re seeing many of the top FCMs ramp up efforts to offer new products and services, so despite fewer numbers, there will not be less competition,” says Simon.
According to Simon, the listed futures business is slowing after several years of healthy growth, but next year will again pick up as further clarity on impending Dodd-Frank rules impacting futures markets emerges.
TABB predict the total available revenue of FCMs for listed futures will be US$4 billion in 2013, a decrease of over 40% in the past five years, and Simon believes the listed futures market is braced for several changes.
“Similar trends that have occurred in equities markets will occur in the futures industry, such as increased use of algos and measuring their performance through transaction cost analysis data,” says Simon, adding that high-frequency trading strategies accounted for 63% of volume in 2011, a figure set to remain unchanged in 2012.
Rules on over-the-counter (OTC) derivatives trading through Dodd-Frank will mandate that all trades will be cleared through a central counterparty (CCP), forcing trading costs up. The new rules, expected to come into force in the first half of next year, have already seen a migration of flow from swaps to futures through a suite of new exchange-traded products created by venues to offer the benefits of swaps in futures contracts.
Leading US futures venues run by the CME Group and IntercontinentalExchange both announced new products in October to capitalise on the increased futures trading, as firms reduced swaps trading ahead of the restrictive Dodd-Frank rules.
Nowhere to hide
For firms that fall outside of the reporting requirements for swaps, there will be a flow-on effect caused by the shift to futures, as participants will be forced to follow liquidity, some of which appears to be shifting to futures venues. There has already been a move from firms that trade in energy swaps products to similar futures products, such as airlines hedging against changes to the price of oil.
Wholesale Markets Brokers Association Americas (WMBAA) chair Christopher Giancarlo believes the move from swaps to futures will reduce buy-side choice in US energy markets, as the structure of the instrument makes the venue, mode of execution and clearing all set by the venue. Giancarlo is particularly concerned about the effect of rules governing venues created by the Dodd-Frank Act, the swaps execution facility (SEF).
"We haven’t seen the CFTC’s latest proposed SEF rules, but bad SEF regulations that are not based upon a simple reading of the plain language of the Dodd-Frank law or proper cost-benefit analysis are the biggest thing to fear for US capital markets," says Giancarlo.
However, some industry participants believe the swing away from off-exchange derivatives is temporary, including Michelle Neal, global head of electronic markets, futures and OTC derivative clearing at investment bank Nomura.
“It remains to be seen whether people will trade highly standardised futures contracts in place of more bespoke OTC contracts that more closely meet their requirements to manage specific risks. It is not a foregone conclusion that we will see a wholesale migration of liquidity from OTC contracts to futures,” says Neal.
Nomura has adopted a listed derivatives trading platform from technology provider Fidessa, as part of the firms strategy of freeing up internal resources to concentrate on its core business, which Neal foresees as remaining in both on- and off-exchange derivatives.
“Everyone’s anticipating a large collateral requirement in the market as a result of the increased emphasis on central clearing and that will be a factor in trading OTC derivatives, but ultimately we view regulatory change as an opportunity in terms of leveling the playing field,” says Neal.