Charting a Difficult Course: FCMs Find Ways to Thrive in a Difficult Business Environment
by Mary Ann Burns
If volume is your yardstick, then 2001 was a great year for the futures industry. More than 629 million futures contracts changed hands in the United States last year, breaking a record set back in 1998, and if you add in the rest of the world, total volume surpassed 1.8 billion contracts, also a record and up 25 percent from the previous year.
Certainly the exchanges were happy to see such a large increase in trading activity. But futures commission merchants, who channel a large part of that activity to the exchanges, aren’t nearly as upbeat. Sure, volumes are rising, but so are costs. Regulatory hassles seem to be getting worse, not better, fees are being slashed to the bone, and the level of service that customers are demanding keeps rising.
More a global business than ever before, futures customers want easy access to all markets all the time. This is not about putting a French customer base into a French market. This is all about giving a French customer base access to an international market and vice versa.
Not only do customers want an international passport, they increasingly want one-stop shopping for cash and derivative instruments. “Delivering multiple exchange access is interesting, but it’s becoming old news,” says Lewis, who heads a growing futures business at Deutsche Bank. Customers now want access to cash securities, bonds and foreign exchange all on one screen.
These challenges are leading to a marked divergence in FCM business strategies, according to senior industry officials interviewed for this article. Some firms are busy ramping up their personnel and technology investments to handle more customers and a wider range of contracts. Other firms are focused more on integrating futures into a larger universe of financial products offered by their parent companies. And some are cutting back on their commitment to the futures business, sending the message that the required investment isn’t worth the potential return.
What are Futures?
For a limited number of FCM-only firms, the answer is simple. Futures are their core product. But most FCMs today are part of large global intermediaries and investment banks, and at these institutions, futures are being integrated into product areas such as fixed income, equities and commodities.
“It is no longer considered to be a core product by the major investment banks and their institutional customers,” says Ron Hersch, senior managing director in charge of futures at Bear Stearns. Instead, futures are being “mainstreamed” into the rest of the business, with the ultimate goal of putting them alongside other products on a single platform.
“You can see by the way that the futures business has been consolidating, and by the fact that commission rates continue to go lower, that it’s very difficult for futures to be considered a core business in the major firms,” says Hersch.
“I go back to the theme that I’ve been discussing for years now, which is: How do you make futures mainstream? The answer is to have them included with the other products so when customers need to trade equities or cash bonds, or certain common derivatives, they have access to futures markets from the same platform that those other products are traded on.”
That hasn’t happened yet, Hersch says, mainly because futures continue to be regulated and traded in a way that requires FCMs to maintain separate systems, and that requires a very large investment.
Not only is the technology changing extremely rapidly, but the FCMs also must deal with the fact that in the U.S., open outcry trading is not fading out as fast as some people expected. That’s good news again for the exchanges, but difficult indeed for the FCMs, who have to shoulder the burden of maintaining two separate platforms, with all the attendant personnel and technology costs.
“We have to be able to execute trades through open outcry and electronic,” says Bob Felker, president of Banc One Capital Markets. “That’s very expensive. Basically, we have doubled the fixed cost of execution over the past five years.” Several other industry officials echoed this sentiment, and added that this is a particular problem for firms that want to offer a “global electronic solution” to their customers.
On the other hand, the costs of technology investments are relatively fixed, at least for electronic trading, says Marc Breillout, chairman of FIMAT Group. “In terms of the IT infrastructure and the operational infrastructure, it is true that you can absorb additional volumes at very small actual costs.” In other words, there is real potential for economies of scale.
Given all these pressures, it’s no wonder that fewer and fewer FCMs are viewing futures as a stand-alone product. The danger, warn some industry officials, is that the integration trend could lead to the marginalization of the futures business, especially at the larger firms that are finding it hard to justify the revenue to support the infrastructure necessary to maintain a full-service FCM.
Joe Murphy, the head of one of the biggest stand-alone FCMs, says these pressures will lead to continued consolidation among the smaller firms and smaller investments in growth among the larger firms.
“If you don’t have scale, it is impossible to maintain the infrastructure, and if you don’t maintain the infrastructure, customers are not going to be happy,” Murphy said. “And don’t forget that there is still enough competition out there that you have to be top notch in all those areas to really maintain the business.”
Among the larger firms, he sees a trend towards treating futures as little more than what he calls a “utility.” These firms may continue to offer futures to their customers in core product areas, but only because they fear losing those customers if they stop offering that service. Such firms won’t make the investments necessary for growth, and in his view that could lead to a self-reinforcing cycle of cutbacks.
Another change that he sees is the conversion of futures departments into little more than a vehicle for lowering internal trading costs. “For some large Wall Street proprietary trading groups, it’s worth their while to own memberships [on exchanges] because they pay lower brokerage. So they’re keeping a moderate clearing presence that pays for itself and some, de-emphasizing futures as a business, and treating it more as a utility to get cheaper clearing rates.”
Deutsche Bank’s Lewis agrees in part with Murphy’s views, saying futures are at risk of becoming a marginal, utility-type business unless managers deliver enough revenue to justify stand-alone status within the firm. On the other hand, he believes the futures business needs customer alignment with every major product line in which the firm is involved. You do not only want to develop a customer base that is single product focused.
“Revenue for the product line should be viewed as secondary to the profitability of the division as a whole,” Lewis says. “Working with accounts that may not necessarily be a large user of the futures product, but are key to the overall franchise of the firm, will ensure longevity of the product and keep it in the critical path.”
Lewis added that services related to futures are sometimes used as a currency or reward for services performed in other areas. “That basically means that people are willing to move their execution around [from firm to firm] based on services in other areas,” he says. “You tend to find that futures execution can bounce around a little bit depending on who is the flavor of the month, so there is less stickiness in the execution element.”
At Morgan Stanley, another institution where futures are marketed in conjunction with a wide range of other products, futures are viewed neither as a utility nor as a stand-alone product, but rather as a tool for managing risk.
“I am not convinced that futures are a product in the traditional sense of how people think of them as a product,” says John Davidson, managing director at Morgan Stanley. “They are a tool that investors use to manage risk, and they are part of a portfolio of products that intermediaries offer to customers to help them manage risk.”
Davidson agrees that one could view the processing of futures as a utility, in the sense of being done on a centralized basis in a stand-alone unit. But other aspects of the futures business—namely the marketing and order handling and proprietary trading—are increasingly being done with the rest of the business.
“Obviously that varies from firm to firm. Certainly I think customers are demanding more and more cross-product approaches to investment opportunities,” he says.
Even among those firms which historically concentrated on futures, customers are pushing to have access to more products on their futures platform. James Davison, president of Cargill Investor Services, is expanding and developing his firm’s capabilities for the cash and over-the-counter environment. “No longer are we dealing with just plain vanilla futures. Our customers demand that we are able to support different needs,” he says.
The Holy Grail
The more the futures business becomes commoditized, the more difficult it is for FCMs to distinguish themselves from their competitors. In the world of open outcry, FCMs were in contact with their customers throughout the trading day. Relationships were key. Advice was given. Markets were read. Service was distinctive. Now that most of the world has gone electronic, customer satisfaction revolves around the trading platform.
“If I were to look at execution in the major six firms, I don’t think there is too much difference between them,” says Deutsche Bank’s Lewis. “If you’re going to differentiate yourself, you’re going to do things outside of that arena. Now we’re in a position where the customer is demanding more. If you can deliver multiple exchange access from one location using straight-through-processing and deliver that on a Web-based statement, you have the holy grail. The industry is very close to that now.”
One of the principal obstacles to this vision lies in Washington, D.C. Unlike most other parts of the world, the futures business in the U.S. continues to be regulated separately from the rest of the financial sector.
“This really creates problems for intermediaries because customers don’t really consider the regulatory environment when they choose a trading venue,” says Bear Stearns’ Hersch. “Customers like to see the results of their trading in one place on one statement that’s easy to understand and that allows them to control their business in a very effective, cost-efficient way. It’s difficult for intermediaries to provide that now because of the inconsistencies in the regulation not only domestically, but internationally.”
In the U.S., rules involving treatment of customer funds prevents futures and securities from being handled in one account. Not so in Europe. “When we are with clients, we don’t even think about what the product is. It makes no difference,” says Richard Berliand who directs J.P. Morgan Futures from London. “The whole lot sits in one account. From the reporting point of view, the client is a massive beneficiary.”
While harmonization of regulation between the SEC and CFTC in the U.S. seems a long way off, Cargill’s Davison is more optimistic about cooperation at the international level. As a result of the war on terrorism, regulators are working together in the hunt for the financial assets of terrorists. Davison hopes this will translate through to other aspects of their work. “The key point for us from a global perspective is we need to participate in the evolution of regulation,” he says. “We need to be part of that debate. We can all benefit from good regulation.”
Security Futures
The barriers to product integration are being lowered slightly in the U.S. with the introduction of security futures. Not strictly a futures product, but not a security product either, this hybrid will take significant system changes to enable trading.
Many firms are struggling with whether to do this business out of the FCM or the broker-dealer. “Ultimately, I think as the industries do come together, you’re going to have to be a full broker-dealer and be prepared to handle stocks and stock options,” says Refco’s Murphy. “Are our customers ultimately going to want one-stop shopping? If you’re going to go part-way, you might as well go all of the way. What this in-between product does is make you wonder whether you need to be a full broker-dealer to do it properly.”
Morgan Stanley’s Davidson believes that if one or two firms are able to successfully build a bridge between the two products and gain market share because of their ability to integrate the two sides of the business, it won’t be too long before other firms follow suit.
FIMAT’s Breillout sees both regulatory and practical impediments to their success. “We have competition between exchanges when what you need is to concentrate the liquidity somewhere. In the short-term, it will be relatively slow.”
Security futures may be recognized for its impact on market structure more than its popularity as a product. Prognostications regarding the success of the product vary widely. Some think it will be a retail-only product. Others believe institutions will be the primary participants. Some are gearing up for high volume, others are adopting a wait-and-see attitude. Whatever the outcome, firms have put an enormous amount of resources toward getting the regulatory environment right. Davidson estimates that firms have spent as much as the new exchanges on educating regulators, studying alternatives and commenting on proposed regulation.
The Bottom Line
As indicated before, some FCM representatives are concerned that the price tag for futures is too high. Maintaining an open outcry and electronic infrastructure in the U.S. was the most frequent complaint expressed by firm representatives. But as long as the open outcry pits retain their liquidity pools, firms have little choice.
“There has been still some confusion about the direction the exchanges are going in Chicago,” says Deutsche Bank’s Lewis. “It’s becoming increasingly difficult for us to support both platforms. I do have a fear that one exchange would move quicker than the other, leaving one standing and then the whole infrastructure we have in Chicago is not going to be cost effective. We are concerned that they stay hand-in-hand to a degree.”
Refco’s Murphy agrees that the challenge is to continue to maintain the infrastructure to do the business well. “It’s a scale game and you need quite a bit of business to make money based on the infrastructure you need to support the business.”
On the revenue side, new pricing strategies are emerging. In some cases, the traditional model of execution and clearing fees is being blended into one full-service price. “We are now in a position where there are quite a lot of competitors out there who are not looking to even price the execution component which is scary,” says Lewis.
Despite the efficiencies gained from electronic trading and record volume last year, the cost pressure on broker-dealer FCMs is enormous, perhaps greater than at any time in a generation, says Davidson. “Every imaginable expense element is being scrutinized, from transaction fees to conference attendance to technology budgets to customer demands for manually intensive service.”
Exchanges: Competitors or Partners?
The angst a couple of years ago over disintermediation died down only to resurface recently as for-profit exchanges went to work to build their own client-base. That has raised concerns in the FCM world about potential conflicts of interest.
“Basically, the exchanges, despite the fact that in the main we own them, are increasingly seeing as part of their job to go behind our backs to our client base and offer their products direct,” says Kevin Davis, managing director, Man Financial Inc.
In general, however, firm representatives are in favor of exchanges moving to a for-profit structure, which they say leads to faster decisions, more effective management and more efficient organizations. “There’s a lot more clarity and transparency. I applaud them for doing it,” says Deutsche Bank’s Lewis.
Demutualization has not necessarily given firms more influence in the decision-making process, but corporate organizations are something they understand and know how to deal with. Ultimately, these for-profit organizations are going to have to satisfy the customer and at least for now, they are getting most of their business from the brokerage community.
“In general, I think most exchanges have realized they need to work with FCMs and not against them,” says FIMAT’s Breillout.
Exchanges and dealers as competitors give rise to certain dilemmas. As Morgan Stanley’s Davidson points out, one of those participants gets to inspect the books and records of the other type of participant, but it is not mutual. “I’m not questioning anybody’s ethics or good faith efforts to do Chinese walls, but are Chinese walls as fundamentally strong a protection as separation of function is?”
Davidson also believes that structural changes in the industry are making it more difficult for exchanges to oversee firms who trade products in which they have little expertise. How does a self-regulatory organization without particular interest or expertise in a product perform its regulatory responsibilities?
For example, is the New York Stock Exchange the best entity to review member firms on their activity in security futures and options when they have made a business decision not to offer those markets? “You certainly wouldn’t find any fault with the way the NYSE has handled the margin regulations over time and the examination of its member firms with respect to compliance of those margin regulations, but at some point, what does the NYSE staff care about securities options? What does the NYSE staff care about security futures? So there’s a tension in terms of focus and expertise and the products are more and more complicated and I think there’s a conflict there,” he says.
Conflict of interest combined with the need to focus on many different products suggests the regulatory structure needs to be changed. Davidson offers two solutions. The first solution would be to let product-specific exchanges collectively oversee their members. The options exchanges conduct options related self-regulation. The stock exchanges become the regulator of stock-related trading and so on with futures and security futures.
The second approach, and one that Davidson favors, would have the NFA and NASDR perform these functions. “Those two organizations are clearly disinterested regulators. They don’t have to worry about Chinese walls because they are not in the business of being a marketplace. If they were the two primary self-regulators and you took the very talented staffs of the various exchanges that are in the self-regulatory business today, and combined them together in one or two distinct places, that would seem to be a pretty good outcome.”
Another source of tension between exchanges and firms is clearing. A voice in the governance of clearing organizations where their capital is at risk has been a source of frustration for many years. Attempts at consolidation of clearing organizations and cross-margining have been marginally successful.
J.P. Morgan’s Berliand says he would like to see two sets of clearing organizations in each region, with each one supporting multiple asset classes across cash equities, equity derivatives, bonds, repos, swaps, fixed income listed derivatives and commodities. Several others made similar points, and emphasized the advantages of choice.
“An FCM needs to have the option to clear all of its trades at a single venue,” believes Banc One’s Felker. “From the 1960s through last year, there have been attempts to merge futures clearing operations and most of these efforts have failed. In the United States, single clearinghouses exist for almost all securities products. That makes it easier for securities firms to monitor firm and client risk. I think FCMs should enjoy the same ability to view risk that the securities firms have. Giving the FCM the option to select the clearinghouse where they clear all products might be an option.”
Future
If it’s any consolation to futures professionals, commoditization is impacting other financial markets—swaps, repos and forex. “Everyone is going down that same path as futures went down five or 10 years ago,” says Lewis. “With narrowing margins, you have to get out there and increase distribution. It’s best to use electronics…period.” |
