By Gerry Turner, executive director, Object Trading
Decreased trading volumes, low interest rates, increased regulation and higher transaction costs have all but suffocated business models that have worked for years, even decades. Furthermore, higher operational costs and client pressure for new services at lower prices have intensified impending challenges. In 2014, we saw a number of banks either reduce their client list or quietly back away from the clearing business completely as they felt the squeeze of leverage ratio and capital requirements. Banks have to reevaluate their technology investment and determine ways to deliver unique value to their clients.
As 2015 rolls on, we will see the continued rise 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 increased flexibility to provide bespoke solutions to buy-side firms exploring new markets and asset classes.
Tighter Regulations Post-Crisis
The traditional FCMs continue to feel the impact of the 2008 financial crisis and resulting regulatory avalanche. In the past, bespoke derivatives contracts were traded in confidence and over the counter directly between banks and their clients, creating a challenge for regulators wanting to monitor trade activity and systemic risk. In 2009, the G20 countries agreed to stronger standardization of over the counter (OTC) derivatives, consequently moving these products to trade on exchange-like trading venues in order to clear through central clearing houses. The US and Japan have already begun implementing the new mandate with Europe just now setting new regulations in motion.
This issue, however, is that regulators are simultaneously creating capital rules for banks that do not take banks’ clearing businesses into account. There seems to be a disconnect between definitions of risk-reducing tasks depending on which side of the line firms fall. The mixed messages coupled with the ballooning costs of clearing practices have banks questioning their participation in swaps trading and OTC derivatives clearing all together.
Banks Back Away From Clearing
And who would blame them?
As banks attempt to meet new client demands at lower costs, capital to be spent on a regulatory runaround is in short supply. In addition, quantitative easing has meant interest revenue from portfolio balances is no longer enough to offset many of the higher costs associated with running the business.
As a result, many banks especially in North America, 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 UK clearing mandate goes through.
Regional FCMs are feeling equal pressure to step up to the plate and compete effectively. While the banks’ retreat may have opened up space for larger market share and consolidation, that retreat raises concerns as well. The health of central clearing relies on multiplicity to reduce concentration risk. Banks’ withdrawal from the space could have a serious impact on the life of OTC clearing overall as there are fewer players in the market bearing the bulk of the systemic risk.
New Players Emerge
Smaller and non-bank FCMs and technology firms recognize this as an opportunity, however. Non-bank FCMs are subject to lighter capital rules and are often more agile when it comes to meeting new customer demands. Technology companies are bringing in new and innovative solutions that take a utility approach to share the cost and operation.
Although non-bank FCMs could have limited capital and services capabilities, they are able to leverage technology partners to provide low latency direct market access and pre trade risk constraint capabilities. They are also more likely to have local market expertise and connectivity that meet the clients’ specific goals. In today’s environment, outsourcing technology to allow for focus on core competencies is inevitable for many market participants.
But banks may not be completely out of the picture, yet. A recent Tabb Group report on FCMs in 2015 suggests that market conditions are improving and that FCMs may have a revival if they can withstand the competition. As futures volumes see further growth, net interest income improves and UK regulations begin to take shape, it will be interesting to see who ends up on top.