Is the reduction in Futures Commission Merchants (FCMs) about to reverse?
In the decade leading up to March 2020, the dual headwinds of low interest rates and subdued volatility had a significantly detrimental impact on revenues for sell-side clearing providers.
During the last 12 months, rapidly rising rates have combined with sustained volatility and associated higher volumes in derivatives markets to create an abrupt reversal in the economics of clearing. For the first time in years, FCMs are pulling in substantial net interest income revenue from their clients’ margin, without having to adjust their business models significantly.
This leads us to question the impact that this shift will have on the number of sell-side firms, and therefore new competition, in the market.
The clearing market over the past decade
The conditions of the previous decade have not just been detrimental for firms, but for the wider market too. According to the CFTC register of Futures Commission Merchants (FCMs), the number of US entities registered has dropped from 151 in 2008 to 62 today. These numbers are distorted by firms with multiple entities consolidating registrations and effectively dormant FCMs canceling their registrations. However, there has been a clear and significant drop in the total number of firms offering services to the market. Globally, the total number of FCMs has dropped from 170 before the financial crisis to 70 today.
This is having a disproportionate impact on competition in some areas of the market. Smaller hedge funds and high-frequency proprietary trading firms, in particular, are facing limited choices for clearing providers.
A recent study by Acuiti, in partnership with ION, suggests that the tide is about to turn on the decline in clearing firms in the market.
In the wake of increased volumes and interest rates, incumbent clearing firms are expanding their offerings. Almost two-thirds of clearing firms are planning to increase the number of memberships they hold in the next five years—a move driven by client demand and rising volumes, organic growth, and interest rates.
Only 7 percent of survey respondents did not think that interest rates would remain high long enough for them to expand their business with confidence.
And while existing firms are expanding memberships, boosting competition in more markets, new firms are also eyeing launches in clearing. These firms are drawn from a disparate range of company types, from institutional brokers eyeing one or two memberships in specific asset classes to retail brokers looking for broader access in a specific region. Acuiti understands that discussions are underway at several tier 2 and 3 banks about developing clearing offerings.
Minimizing industry growing pains
Starting out in clearing is no small undertaking. Capital costs can be punitive and the time to apply for and gain memberships is extensive. However, with few clearing firms on the market that could be considered acquisition targets, many firms will have to develop their offerings organically.
In this respect, firms will have to buy or build the technology required to offer clearing services. The survey found that firms experience significantly more difficulty in building in-house than in partnering with a third party.
For firms trying to accelerate entry into the market, some key companies like ION offer entry-level technology. This approach gives firms a rapid and cost-effective means of starting out in clearing, without the levels of investment and lead times associated with traditional full-scale builds.
Such technologies will be crucial to firms that want to enter the clearing business and scale up as quickly as possible to latch onto the surging growth in interest income. This will hopefully build a virtuous cycle of investment and increased competitiveness.
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