Non-bank FCMs yet to win over the buy-side

Non-bank firms have a huge potential to fill the void in clearing, but the realities of doing so could be easier said than done.

Non-banks are struggling to win over large buy-side clients despite the withdrawal of many banks from the derivatives clearing business, according to industry experts.

Following the onset of onerous compliance costs and capital requirements, the withdrawal of banks has opened the door for newer non-bank brokers to get into the clearing and market making business.

Certain non-bank organisations, such as Citadel Securities, have become more adept at providing liquidity to the market over the last five years. This is one area where the buy-side is in need of more participants, having seen banks withdraw a huge source of liquidity in the last few years. However, for smaller organisations, filling this void remains a massive challenge.

“It is a struggle to get into the liquidity provision business,” says Grant Oliver, director at Financial Market Engineering (FME). “We don’t have a salesforce to market to clients. It is something we have looked at but we are a technology-based trading company not a market making service provider. Stepping into the breach requires big investment.”

Oliver says the market needs to become more electronic before smaller technology-savvy shops like FME can enter the fray. But, for the buy-side, there is still a focus on doing things the old fashioned way.

“There are many considerations to meet in order to establish a relationship with a buy-side organisation,” says Oliver. “You need to establish block size, get on the approval list for a fund, adhere to particular conventions. But asset managers themselves have been slow to embrace electronic trading on exchange which would help us.”

Indeed the lack of electronification on the buy-side has stunted growth for non-banks as liquidity providers. In July, Citadel, with all its clout, went old school and opened up a voice broking service for European clients trading fixed income. And there are other considerations. For a buy-side client going into business with a new broker safety is more important than ever these days. The bankruptcy of MF Global in 2011 came as a wake-up call for the industry, highlighting the issue of counterparty risk in the broker business.

“MF Global put fear into the market,” says Matthew Rees, chief customer officer, RJ O’Brien. “Becoming an FCM from a regulatory perspective is easier than ever. The real challenge is to prove to clients that you are safe and secure. Even before banks exited there were many more clients looking more closely at who they wanted as an FCM.”

Furthermore, expanding into the bank business also requires a large balance sheet.

“The biggest challenge that non-banks face in this effort is their lack of leverage – this puts them in a rather difficult position in the eyes of the regulators and the industry at large,” says Virginie O’Shea, research director at Aite Group. “Without the capital reserves of a bank and the liquidity, non-banks could pose greater systemic risk.”

According to Russell Levens, CEO of GH Financials, he admits that having a smaller balance sheet means that attracting a top-tier fund manager by size is unlikely right now.

“We don’t offer bonds or equities so have pieces of their books,” says Levens. “Generally a lot of buy-siders keep their whole book with their prime brokers— where we win business is where the client can allocate it piecemeal.”

There are, however, other routes for non-banks to expand. In recent years some buy-side institutions have been looking to set up their own market access to exchanges, independent of their prime broker relationships. It should give them more commercial power, and a greater ability to access markets and the data that they need to execute their models.

For the future, the market is likely to continue with this state of flux. Rees believes there will be even fewer FCMs in the future but it is equally possible that banks may re-enter the fray at some point—as non-banks might exit.

“Banks get in and out of the business we will still see the ebb and flow of this,” he says. “Some will be back. Non-bank growth will also ebb and flow. The one big idea is that customers are not relying on the sanctity of segregated funds like before. It’s different– if you are strong you will grow.”

For the full article watch out for the latest issue of The Trade Derivatives.