Deep fears behind a frosty exchange
By Jeremy Grant
Published: February 8 2005 23:22 | Last updated: February 8 2005 23:22
Man Financial's outburst in December against Eurex may have involved insults and apologies, but behind the emotions lie fundamental shifts fracturing the futures industry.
For the most visible manifestation of what has been happening in relations between exchanges, brokers and customers in the futures industry in the last 12 months, look no further that the trading floors of Chicago’s big futures exchanges.
The once-teeming pits are slowly emptying as the broker is being edged out by electronic trading, cutting out the middleman. Many in this category are heading to “trading arcades” to trade on their own account rather than on behalf of someone else.
Computers screens and cheap electronic trading have lowered the barriers to entry for derivatives traders of all kinds. One impetus for this process in the US has been the arrival on US soil of Eurex, the all-electronic Frankfurt-based exchange.
While its US venture has been a failure in prising market share in US Treasury futures products from the Chicago Board of Trade, it has prompted a dramatic lowering of the industry’s basic cost structure, by offering low fees that have been copied by its US rivals.
Against a backdrop of volatility in oil and commodity prices and fevered interest-rate speculation, new players such as hedge funds are now pumping vast sums into futures trading as they use complex algorithms to execute trading strategies – cheaply, and often without a middleman.
The arrival of online brokers has already had a similar effect on brokers in the equities trading business.
Exchanges, as a result, are battling as never before to get direct access to these users. That has led to traditional US exchanges abandoning their insistence that users are members of an exchange and allowing direct access to trading and clearing.
The Chicago Mercantile Exchange last year offered a new category of membership – costing less than a standard CME membership - to hedge funds and proprietary traders that would allow them to trade and have those trades cleared at the CME.
Proprietary traders are traders who trade on their own account and account for a substantial proportion of trading in futures.
Previously, users had to find a broker who was a so-called “clearing member” of the exchange to guide trades through the clearing process, which involves matching buyers with sellers.
This process of cutting out the broker is what the industry refers to broadly as “disintermediation”. And it is worrying brokers - commonly referred to in the industry as “futures commission merchants” (FCMs).
“The FCMs are fighting to see where they fit in,” says the head of one large proprietary trading firm in the US.
One Chicago-based broker says: “Exchanges are offering special clearing memberships for hedge funds and having a much greater reach beyond their brokerage members to the end customers – and that worries brokers.”
Such fears have been brought into sharp focus by the establishment of Eurex’s Chicago-based futures exchange.
A key part of the project has been an arrangement that for the first time allows trades in euro-denominated futures products - normally cleared through a clearing broker at Eurex’s Frankfurt-based clearing house - to be cleared instead at Eurex’s US-based clearer, The Clearing Corporation (TCC).
The arrangement - known as the global clearing link - means US-based hedge funds, proprietary traders and others that formerly relied on a broker in Europe to clear trades in, say, German government bond futures, can now have this done at TCC in the US.
Many brokers, who for years earned clearing fees from the old arrangement, stand to lose out as their clients consider turning to TCC instead.
It is this situation that appears to have enraged Man Financial chief executive Kevin Davis. While he must have been aware that his client, Marquette Partners, now has a choice as to where its euro-denominated Eurex trades are cleared, he still suspected that Eurex was behind moves to disintermediate him from Marquette.
Marquette is understood to have engaged in discussions with TCC after an approach from the clearer. There is no evidence of any involvement by Eurex, although it has close ties with TCC through its 14 per cent stake, which has doubtless fuelled Man’s suspicions.
Some say disintermediation is likely to continue, raising questions over whether there is any future role for a broker at all.
That is partly because futures and options exchanges in the US are in a process of demutualising or, as in the case of the CME, have already become publicly listed companies. That means there is now shareholder pressure to maximise returns – and so continue to disintermediate brokers.
Thomas Peterffy, chairman of Interactive Brokers, an early pioneer of electronic trading and online access to multiple exchanges across the equities, options and futures markets, says: “Eventually exchanges could even enter the brokerage business. Brokers will have to come up with new products and services. It’s a constant battle, a continuous competition - survival of the fittest.”
David Prosperi, CME spokesman, says of his exchange’s move to attract hedge funds by offering special memberships: “We recognise that in an era of competition the need for efficient markets is upon all of us, and it is incumbent on the CME to do whatever it takes to increase its product access and add value.”
Others say there are limits to how far disintermediation can go and that brokers are already re-aligning their services to the changing landscape.
A senior executive at one broker, owned by a European bank, says: “The exchanges are becoming more aggressive. It’s a natural result of competition. I do think however that for the largest customers – particularly hedge funds – there are services we can provide that are difficult for exchanges to replicate.”
Such services include trading strategy advice, back office processing and offering a consolidated account statement that explains an end-user’s trading positions across multiple exchanges, globally, in a variety of products at one time.
John Damgard is president of the Washington, DC-based Futures Industry Association, which represents the interests of the broking community. He says disintermediation comes up at board meetings “from time to time”.
But he adds: “The big FCMs [brokers] are global players that believe their relationship with the customer is stronger than the relationship that the customer may have with the exchange.”
He acknowledges that disintermediation is eroding the broker’s role “to the extent that new exchanges like Eurex don’t have to kowtow to a bunch of floor traders [in Chicago]”.
In addition, brokers offer end-users access to margin collateral – funds posted at a clearing house to guarantee against defaults – where exchanges or their clearing houses can not. Mr Peterffy says: “The Clearing Corporation does not offer hedge funds the same sort of leverage in terms of lending margin money as a brokerage does.”
Indeed, Mr Damgard says the role that brokers play in assisting with the provision of margin collateral will limit how far brokers are disintermediated from the industry.
He argues that if brokers are disintermediated to the extent that they, as clearing members of an exchange, leave the provision or margin collateral to an exchange, this would create structural risks to the industry.
“What worries me is that the financial integrity [of the industry] it dependent on the clearing model - that is, on the collective capital of all the clearing members. If a clearing member isn’t going to get paid a fair price for his client’s business he’s not going to stay in that business.
“You would then have the exchange’s clearing house taking on the function of creditworthiness. Someone has to make sure that the customer has the wherewithal to make good on his obligations. Does an exchange have the ability to do this on a global basis? I think the [broking] firms offer much more to the customer on a global basis than one exchange in one city can offer,” he says. |
