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FCM Crisis Becomes Opportunity as Positive Factors Emerge

| FinReg

By Radi Khasawneh, TABB Group

Originally published on TABB Forum

High-profile exits from some parts of Futures Commission Merchant’s clearing businesses have given the impression that the business model is fundamentally flawed. But policymakers and technology providers are combining to bring support to beleaguered FCMs as the focus shifts to capacity.

High-profile exits from some parts of Futures Commission Merchant’s (FCMs) clearing businesses have given the impression that the business model is fundamentally flawed. But comments at this year’s FIA IDX conference in London underline the fact that reductions in clearing capacity and balance sheets have led to an industry-wide push to support and effect change that could fundamentally alter the playing field over the coming year.

Most important, Timothy Massad, chairman of the US CFTC, hinted that the fraught process of agreeing to equivalence for US and European clearing entities is much closer to being completed than it was a year ago. At that time, TABB Group published a commentary (“Crunch Time for Clearinghouses as Regulators and Participants Shift Focus”) that referred to Massad’s ex-colleague Ananda Radhakrishnan’s comments about granting temporary relief to European entities (also referred to inMassad’s speech). Equivalence, alongside implementation of mandatory clearing in Europe, could do much to reinvigorate the flagging European side of the equation. This would bolster volumes and revenues for global businesses that can no longer support unprofitable operations, but much more needs to be done. Equivalence would do much to clear up the messy uncertainty that has left regional franchises in inefficient silos.

TABB Group’s recently published report, “The FCM Business 2015: Overcoming Industry Adversity,” highlighted the fact that nearly 90% of FCMs interviewed cited national regulatory leverage and capital rules (such as the enhanced Supplementary Leverage Ratio and Globally Systemically Important Bank rules in the US) as major concerns for the coming year. Forcing banks to account for derivatives and client funds as part of their obligations has made a difficult business impossible for some, and second-tier banks have restricted or exited balance sheet-intensive businesses such as clearing for over the counter (OTC) swaps.

As top-rank FCMs focus on their more profitable clients and preserving their margins to comply with internal return on investment/return on equity hurdles imposed by senior management, there is a competitive opportunity for challengers to capture market share and deploy their balance sheet capacity (exhibit 1, below).

Exhibit 1: Strategic Considerations for FCMs in 2015

6 10a resized 600

Source: TABB Group

Significant hurdles remain, particularly in the OTC market, where risk transfer and regulatory costs have meant a fresh round of conversations about re-pricing with existing clients. The focus on profitable and capital-efficient futures volumes means the barrier to entry remains high for new entrants, as clients seek full-service partners. Credit rating strength and balance sheet strength remain key differentiators for clients, meaning that so-called “non-bank” FCMs have a mountain to climb if they want to achieve the kind of scale necessary to achieve consistent profit and a stable client base. Outsourcing of technology management, and revenue and head count sharing at FCMs within prime services divisions at banks can both provide a partial solution to this problem.

Established dealer FCMs are consolidating and building out their offerings, and a recovery in the interest rate environment would aid profitability. But a gradual rebalancing of the clearing pie is far more likely than a revolutionary shift. The conciliatory attitude from national regulators and overwhelming support from large clients in a final push to get a more lenient interpretation of capital rules is welcome and, in TABB Group’s view, critical to creating a sustainable market infrastructure for the future.