The growing opportunity in derivatives clearing

Ali Curi: Markets conversation is a new ION podcast where we discuss topics of importance to capital market participants with product owners, subject matter experts, and industry leaders. Since the financial crisis of 2008, the FCM market has undergone remarkable transformations, adapting to new regulations, market volatility, and advancements in technology. Our guests today, will shed light on how these changes have shaped the FCM industry’s resilience and have provided a foundation for growth.

Bruce Roberts: Reflecting back to the 2008-2010 period, the financial crisis was driven by cheap credit and lax lending standards for mortgage lending that fueled a housing bubble. As interest rates started to rise, it led mortgage holders to default on their payments. And this led to significant lack of confidence in the quality of the products that have been used to securitize these mortgages. Some of these firms were allowed to fail, such as Lehman’s and others were taken over by larger firms such as Bear Stearns being acquired by JP Morgan.

The response by governments and central banks was to drop interest rates to near zero or negative in some cases, to prop up their economies and use quantitative easing to stimulate economic activity. So the crisis also led to a host of new regulatory reforms that were known as Dodd-Frank in the US or Amir in Europe, along with a number of changes by the Bank for International Settlements on capital requirements. So the impact to FCMs post the crisis was driven by the ultra low interest rate environment and increased capital and regulatory requirements. So quantifying, this impact FCMs can be seen with the total number of FCMs globally falling from somewhere around 170 before the financial crisis to approximately 70 today.

And with smaller FCMs in particular pulling out of the market. It’s expected for the bank to increase by another one quarter of a percent tomorrow, which will bring the rate to five and quarter percent. So the increase in interest rates not only here, but globally, by central banks is leading to significant increases in revenue and profitability for FCMs. There’s also the view that interest rates are not going to return to the ultra low rates we’ve seen in the last decade.

I’m not seeing traditional banks in that, but interest is growing in a diverse range of companies, including crypto retail brokers and also institutional brokers looking at specific areas of the market such as commodities or markets such as China, Brazil, to name a few. The additional competitions, it’s healthy for the market and it also helps provide additional alternatives to market participants and a potential reduction in the concentration risk that’s been highlighted. Insofar as they were able to make medium term decisions on business growth in the expectation that rates would remain high.

So we wanted to really understand the impact that rising rates and indeed rising volumes, which we’ve also seen since 2020 was having on both FCMs expansion plans, but also for firms that may have looked at the market previously, some brokers that maybe wanted to look at non-bank FCMs, some regional banks or tier two and three banks, that didn’t have any or significant clearing operations currently. The understanding from them how the changing economics is changing how they view the market. So the audience of the survey was very much the sell-side community, but the audience for distribution was really the whole market.

Will Mitting: I think as Bruce discussed earlier, the rapid change in the economics of clearing following over a decade of near zero interest rates, I think caught a lot of people unawares. Outside interest rates also featuring highly, actually featuring higher than the interest rate environment. Trading is becoming increasingly global. And clients are looking for multiple opportunities, whether that’s arbitrage or whether it’s new markets to, execute their strategies or trade against an increasingly diverse portfolio of counterparties.

So you’ve seen the consolidation, which has obviously reduced the number of FCMs, and you’ve also seen some small FCMs drop out the market. But that is quite overstated, we think, in terms of how many significant, how many FCMs are actually providing end user service have pulled back is far smaller than the 160 to 60, the implications of a drop of a hundred firms. The others would go through either those FCMs or through local clearing firms. I think what you’re gonna see is a greater coverage of memberships from tier two firms, and indeed increasingly tier three firms.

So you’re gonna have the same firms offering more markets, which is gonna create, I think, price pressure in terms of access to regional markets, which obviously will increase competition and probably increase flow to those regional markets.

Ali Curi: Will, as high interest rates are a key component of FCM profits, right, known as interest income. What does your research tell us about the confidence level that increased interest rates may now lead to the creation of new FCMs? So that was almost unique trend in the US that led to that, the economic conditions where that was worth investing in. But now you see a diversity of firms.

You have non-bank FCMs, or brokers looking to become non-bank FCMs for specific markets such as, commodity markets where they maybe want to reduce costs and own more of the trade workflow by gaining one or two memberships. You still have the retail firms and retail brokers looking to replicate the trend that I alluded to earlier in terms of gaining memberships to offer a clearing to their retail clients. And you also have the crypto element, which while in something of a draw down at the moment, we expect to come back and that is exchanges becoming FCMs or exchange, that blurring of the boundaries between an exchange and the FCM, which clearly, has a regulatory uncertainty to it, to say the least, in the US currently.

But you’ve already seen MYX Holdings by an FCM. You’ve seen CME without an application to run an FCM in response to the FGX proposal. So I would expect to see that trend as well continue, perhaps not in the US because of the regulatory push back against that, but certainly elsewhere that blurring of the boundaries with exchanges also playing a role in FCM membership because for them it makes clear sense that they can bring products to market quicker and then they can prove the success of some products without relying on their FCM clients, their clearing clients to wait for client demand and to invest in the post-trade works which required often to onboard a new product.

I think if you are looking to set, if you are a tier two bank looking to set up a new FCM. You can either grow it organically or you can do it via acquisition. Because, in part because of the reduction in FCMs over the last 15 years, there were very few clear acquisition targets that a tier two or three bank could look to, to get a kind of ready-made FCM and get, accelerate their growth into the market. And, because of that, drilling into that technology requirement that many firms are gonna need to tackle, and it’s a challenging obstacle at times for various different reasons.

Some of those are the internal decisions of build versus buy. It’s also the expertise in clearing and risk to operate the systems as well as the capacity to manage the implementation for, clearing, accounting and reporting systems. So for FCMs, wanting to act rapidly and to get set up, there’s several product companies to work with in the market to accelerate that journey into clearing. I would suggest, a strong partnership with an external party needs to really be based on your clearing objectives and the product firm, their understanding of your business requirements.

Ali Curi: What would you say about regulatory factors to consider? Do you have any concerns over any new rules that may discourage firms from gaining clearing membership. What advice would you give new entrants to navigate the complex regulatory environment and manage the risk effectively? But this would raise the bar for capital requirements of banks with assets over a hundred billion dollars.

So this is still to be iron out to what the final rules will be, but I would suggest underlying economics in the clearing business as markedly changed and this is gonna drive competition and firms will look to selectively enter the market even with the regulatory requirements.

Bruce Roberts: So the move to greener technologies in crypto, they’ve been influencing and shaping investment decisions over the last decade. The future’s markets are essential to companies in managing risk, improving transparency, and also providing liquidity, which aligns with many of the ESG principles that are there. But ultimately, FCMs are currently, the traditional FCMs, are currently predominantly unable to access much of the crypto market. Firms like Deribit, it’s very difficult for them to offer access and obviously the clearing model in the native crypto market is very different to the clearing model in traditional markets.

Will Mitting: Since 2020 and the volatility around the outbreak of Covid, technology has, post-trade, has become a C-suite issue for many banks because we saw a lot of infrastructures were overwhelmed by volumes. And I think that is a fundamental shift that’s occurred in the market over the past 10 years. Very few firms these days are going to be building everything in-house. I think the ease of development via third party, the mutualization of costs, the ability to get best-in-breed from a third party and crucially the lack of reliance on key staff who may have had an important role in building the technology is all driving firms to look to third parties.

And at the same time the quality of third party offerings on the market has really improved dramatically over the last five years. Despite the fact that the relative competition and post-trade for derivatives for technology is limited compared to, say the front office.

Bruce Roberts: So it is great question. Clearly entering any new business line, being technology driven as clearing is, there’s a big investment that has to be made. The other, factors that I would consider really, if you’re gonna work with a product firm externally, what are the front to back solutions that they provide in the ability to automate workflows for you to do, reduce your dependency on costly personnel and then the others, really, real-time risk management. With the volatility we’ve seen since 2020, it’s becoming an ongoing market dynamic and the ability to manage the credit risk and your capital requirements is key.

And then the final component I would’ve said is really the flexibility to scale your business as you grow. And I believe the days of kind of one size fits all is not really appropriate for firms who have so many different requirements, as Will described, in terms of, looking at more regional or specific markets.

Ali Curi: And Will, same question. Before you move forward again. So I’d encourage being patient over that promotion or compensation adjustment for your longer term career growth. And I’m not saying, not to take risks, but if you’re learning and growing, I think you can take a lot out of that and take the long-term view would be what I think’s benefited me.

Ali Curi: And that’s our episode for today. You can follow ION Markets on Twitter and LinkedIn. Thank you for joining us. I’m Ali Curi.

Until next time.