The last decade has been marked by transition for Advantage Futures and the futures industry: the progression from pit to screen, the shift to 24-hour markets, the move by the individual trader into trading groups, the increase in international clientele and the consolidation of exchanges. In 2008-2009, Advantage endured the financial crisis, and with that the collapse of Bear Sterns and Lehman Brothers and subsequent actions to sharply reduce short-term interest rates. Later came the downfall of MF Global and Peregrine Financial with the result being an ever-changing and increasingly stringent regulatory environment which has affected Advantage and all FCMs. As Chief Risk Officer of the firm, Bill Steele has an unique perspective on the events that have shaped the last decade in the futures industry.
Advantage Futures recently celebrated its ten year anniversary, and Steele has been with Advantage since the firm’s inception. “Basically we were all employed at Fuji. Fuji merged with a couple of other Japanese banks to form Mizuho. In that merger, Mizuho decided there were certain business lines on the futures side with which they did not wish to be involved,” says Steele. Several employees from Mizuho went on to form Advantage Futures, those business lines were transferred in June 2003 and, according to Steele, “We’ve been going strong ever since.”
During 2003, electronic trading was taking hold in an ever-increasing number of markets. Advantage anticipated the opportunity of this eventual shift: “We foresaw the ultimate transition to the screen, and saw expanding the professional trader business as a means of establishing relationships which allowed us to assist these clients as they transitioned from floor trading to electronic access.”
Armed with a trader’s perspective, Steele is well versed in the psyche of the floor. “One big difference between the pit and the screen is that physical attributes are less important. A lot of successful traders in the pit were big, tall, loud guys,” explains Steele. “They had a position in the pit and a voice that could carry; they got the trades. Now, it’s more about relationships between markets and spreading, mathematical modeling, access to different markets and the speed of that access.”
Steele maintains a mostly positive viewpoint on the transition to the screen. “You have more oversight over trading on the screen because you can set specific limits and prevent clients from trading more than you want them to trade,” says Steele. “Additionally, access to trade information is generally faster and more reliable due to the straight-through processing of electronic activity.” He adds, “The move to electronic trading allows smaller clients to access many markets while controlling risk by limiting trading to the available funding. The same holds for clients located outside the U.S. or trading overseas markets—supervision is enhanced now that they are no longer phoning in orders. Instead, limits can be placed on their electronic systems.”
While the conversion allowed risk managers more monitoring ability, the actual transition period presented complications. “There was a lot of pit-screen arbitrage early on. You were required to give bigger limits than you might otherwise to avoid locking someone out while executing these arbs. In theory, however, one could execute just on the screen and not do the other side in the pit so you had that kind of exposure. Fortunately, we knew our clients well, so that was never a problem for us,” explained Steele.
Whether on the screen or in the pit, some of Steele’s methods have not changed. “If somebody is active, I always like to contact them before I take any action. If you are trying to shut someone off in a rapidly moving market, you have to make sure there are no working orders and, if there are, cancel those orders and confirm what the position really is because systems might lag if the market is really moving,” says Steele. “Yes, it is easier than trying to pull a guy out of the pit, but it comes with its own set of difficulties. It is still not cut and dried. We still have to take certain steps to prevent errors in the liquidation process.”
Steele sums up the transition to the screen in that “The advent of electronic trading means you are no longer trading in your little quadrant of the floor. You are able to trade any market in any place.” With an open and more accessible trading environment, one might assume that market fluctuations could result in rapid increases in volatility. However, according to Steele, the transition to the screen did not necessarily increase volatility: “I do not sense that the markets on a day-to-day basis are any more or less volatile now as opposed to ten years ago. I do think our world now carries an increased probability of event risk, but that has nothing to do with the advent of electronic trading.”
Around-the-clock markets were not the norm a decade ago; the markets were moving in that direction at the time Advantage started, with some markets closer than others. For the Chief Risk Officer, it is a mixed blessing. “You do not have the same type of overnight risk with 24-hour trading as you did prior to that development. If you miss something at the close, you can get out shortly thereafter. However, it also means you have overnight movements that are sometimes not ‘real’ as markets are thinner and get pushed around, but you have to treat them as real just in case,” says Steele. “With 24-hour markets, there are a lot of issues that you have to address overnight that you did not have to address with pit- only trading; on the other hand, you have the opportunity to address them as they occur.”
With the advent of electronic trading and the move to 24-hour markets, one may assume that trading now, as opposed to a decade ago, has become increasingly complicated. “There is a lot more trading that is relationally-oriented now. It is much more about speed; everything is in microseconds. As far as the barriers to entry for your average trader, it is no big deal. In some respects, if speed is not an issue for you, it is a lot cheaper to trade now. Commissions are a fraction of what it would have cost years ago. For your average trader, costs have come down,” says Steele. On the other hand, for the professional trader interested in speed, Steele believes access to different markets and ability to take advantage of aberrations in those different markets is partially offset; costs have come down to an extent as well, but now a certain level of technology has to be maintained.
Similarly, these changes have created firm-wide transitions in the types of business being cleared at Advantage. “It is not just futures, day trading and the go-home-flat type of trader anymore. We are doing much more business with clients who are carrying both futures and options positions,” says Steele. “By definition, we have increased overnight risk because we are carrying positions of a longer term nature.” For Advantage, the increase in exposure to different types of event risk is a direct result of the change in the nature of their clientele.
Steele elaborates on the transformation of the clientele: “Here at Advantage, there has been a little bit more of a consolidation of clients. There are fewer individual guys and a move toward prop shop type groups. It has been kind of a transition even for the successful individuals; they had to learn how to put groups together and back other traders.”
Steele considers the move to professional trader groups as a function of the 24-hour markets. “It is like you have a taxi cab and you want to keep it running 24-hours a day b
ecause you are paying for it 24-hours a day. You have this set infrastructure cost for your computers, your servers, your quote-feeds and everything else. You have the potential for market opportunities around the clock, and you want to keep them running for 24-hours. If you have groups, there is staff available to monitor and participate in the markets around the clock and around the world.”
In addition to the consolidation of clients, Advantage has seen a surge of international clientele emerge in the last decade. While it is still not a significant portion of our business, it has broadened the scope of revenues coming into the firm. From Steele’s perspective, an ever-growing international client base comes with its challenges: “As a risk unit, we need to be more proactive about disabling people or requesting money at odd hours. It is not the same as a client down the street in Chicago.” Steele added, “There are also nuances with respect to sending us money. If we request funds from them during our hours because of an extreme market move for example, they cannot send it because their banks are closed.”
“With that said, there is obviously an opportunity out there [overseas]. Overall, I think our move into international clients has been positive to the firm in that it broadens the scope of revenues coming in. I had experience with overseas clients at other firms; it is not new to me to have these clients. In general, it has been positive. It opens up our client base, you just have to be aware of the special issues.”
Just as traders have consolidated in the last ten years, so have the exchanges. The total harmonization of rules, however, has not been completed. “It is somewhat more centralized now, in that you are dealing with some of the same people. There are still many of these exchanges that are treated as separate units. Some rules have been harmonized; some rules remain as they were before the consolidation,” explains Steele. “I would not be surprised to see more consolidation; although, there are not a lot of exchanges left to be bought.”
Consolidation has its benefits; when CME, CBOT and NYMEX were separate clearing houses, one did not have the ability to cross margin like products. According to Steele, “It is a more accurate reflection of risk and reduces the capital burden for the client. We, as a firm, have not really felt any negative effects from the consolidation.”
Leading up to the financial crisis, event risk was of a short- term nature. The financial crisis presented uncertainty and the resulting credit-driven contraction generated its own set of risk issues.
“Being that we were a very interest-rate-centric firm at that time, there was probably a six or seven month period that created a pretty steep learning curve for everyone. The volatility in both the outright interest rate markets as well as the spreads was something a lot of people had not seen for a long time,” says Steele. “There was a learning curve in terms of knowing how best to trade and realizing that you could trade smaller and still have the same bang for your buck. You could not trade your normal size because the liquidity kind of dried up.”
Nearing the end of 2008, the clientele at Advantage—the professional trader type—had a handle on how to trade the markets. “The type of risk stresses we faced throughout ‘08 lessened a bit. Now we are back to those shock type of events like the Flash Crash. We have seen repeated issues; the credit-driven financial crisis in the U.S. and a similar situation in Europe. By the time Europe came around, it increased volatility but the markets had a better idea of how to deal with it and central banks were a little quicker to respond with
liquidity. It was more easily managed from a risk perspective than the initial push down in the U.S.,” explains Steele.
The biggest transition for Advantage was carrying an increased inventory of overnight positions, exposing the firm to overnight moves which were not an issue when the client base primarily went home flat. “From a business perspective, that made it much more capital intensive because we had to maintain the capital sufficient to support those overnight positions based on our industry rules,” says Steele.
“In 2003, our bread and butter business was in interest rates, particularly Eurodollars and to a slightly lesser extent the treasury curve. As we got into the 2008-09 period with the
financial crisis and the push by the Fed to drive short-term rates down to virtually zero, opportunities in those markets kind of diminished,” says Steele.
Steele continues, “We do a lot more in the metals, energies and equities now than we did at our start. Some of the New York markets (metals and energies) were locals that came aboard much like the Chicago markets did, but there were also a lot more corporate entities and commercial type entities that are using those markets now.” As a firm, Advantage has broadened its scope of the markets that contribute significantly to its volume in order to maintain revenue generation beyond the interest rate sector.
“If and when the interest rate trade picks up—and we are seeing some evidence of that now—we will be that much better off because, in addition to that interest rate generated revenue, we will have these other markets trading too.”
THE REGULATORY ENVIRONMENT
“From my perspective, the regulatory environment has changed such that it has increased the risk to the FCM with no real benefit to clients. It is a function of the financial crisis and the perception that all financial firms were at fault. The financial crisis had nothing to do with the futures industry,” explains Steele. In fact, the futures industry came through the crisis quite successfully.
For Advantage, the subsequent issues with MF Global and Peregrine certainly accelerated what has been done on the futures side from a regulatory perspective. Leading up to the financial crisis, the regulatory environment had more of a monitoring nature. “If there was some problem caused by human error, you fixed it and you moved on. It was not viewed cynically and with punitive punishment,” says Steele.
“Post Dodd Frank, MF Global and Peregrine, the regulatory mentality seems to have changed in that there was no longer such a thing as human error, nor is there any consideration of materiality. Everything is viewed as an intentional act. Fixing a problem is no longer a solution. You fix it, and then you get fined.” For Steele, the harsh regulatory environment is not affording any extra client protections. “In the past, an exchange or regulator may have been willing to work with a firm or its clients. Now because procedures are expected to be followed without question, they have to follow through with a fine. It is more black and white.”
According to Steele, the extra supervisory requirements raise the costs to the FCMs, which later get passed on to their clients. Because FCMs are already operating in a thin margin environment, there should be greater attention paid to the costs of expanded supervision which does not afford any discernible benefit to the client. “I do not know who benefits from many of these enhanced regulatory requirements; it is not the FCMs, and it is not the clients,” confirms Steele.
Current regulations require an FCM to have 8% of its client’s overnight margin in capital. Prior to 2004, an FCM was required to have 6% of segregated funds in capital. “If you had a lot of segregated funds on deposit, you had this big capital burden, but there might not be any risk involved if those segregated funds were not actually being traded. In August 2004, that went to 8% of overnight margin. The change in capital requirement was a benefit to us as a firm starting out because it allowed us to grow the type of business we were doing without having to incur this enormous charge,” explains Steele. Given the current regulatory environment, Steele believes it would not be surprising to see a move toward increased capital requirements. In fact, there are proposals pending which would require additional capital on the part of the FCM and, ultimately, the client. Despite objections from firms and clients alike, these proposals seem likely to be enacted in some form. It remains to be seen whether the benefits of these rules will outweigh the presumed costs.
Advantage has operated effectively in the current environment, despite the increased stringency and fluidity of rule changes.“We always aim to operate within the rules,” says Steele. “At our core, we are a big firm operating as a smaller firm in terms of service. It is hard to keep up with it, but the people who run Treasury, Operations, Compliance and Risk, as well as the CEO of this firm, do not tolerate rule violations—even minor ones.”
“There have been firms out there over the years that play what we internally referred to as ‘compliance arbitrage’ or ‘regulatory roulette.’ If they were going to get fined $2 million but make $10 million on whatever it was they were doing, then it was a win. We have never looked at things that way, so it is frustrating when you feel constantly under attack over very minor oversights or ‘human error’ types of things. There is no criminal mentality, but that is how you
feel like you are being treated these days; it seems as though the regulatory attitude reflects a belief that everything we do must be because we are trying to rip off the client. Nothing could be further from the truth here!”
According to Steele, an event like MF Global or Peregrine would not occur at Advantage. “Peregrine was fraud based. My perception of MF Global is that it seemed to be an issue of internal controls failing to ensure the appropriate handling of client monies as far as where they were deposited and how they were being invested,” says Steele. “Advantage’s Risk, Treasury and Compliance Departments, in conjunction with the Credit Committee, have worked diligently to ensure appropriate and effective procedures are in place to prevent that sort of thing from happening here. There is also no conflict of interest in that we do not have any proprietary trading or other affiliate activity competing with the FCM. That is different, of course, from market blow-up risk which is not what happened to Peregrine or MF Global.”
“I am all for enhanced protection and improved oversight and supervision, if in fact it leads to real improvement as far as protecting clients. There have definitely been positive changes made, but I see many things now that are time consuming and provide no material improvement in protecting clients. We spend an enormous amount of time answering regulator questions about things that are really insignificant,” stated Steele.
THE NEXT TEN YEARS
“Going forward, we are entering a very interesting time in this business,” says Steele. Interest earned on client deposits was a prime source of income for FCMs. Following the financial crisis, the industry has operated in a low interest rate environment, forcing FCMs to operate more leanly. According to Steele, “FCMs that have managed to remain profitable are in pretty good shape. Thankfully, Advantage is in that camp. I think we have ourselves very well positioned for what is likely to take place going forward, in terms of our mix of clients and breadth of business. Ultimately, when interest rates rise, we will earn some extra revenue. On the flip
side, the regulatory environment has become very onerous. Like most things market-oriented, it will swing to an extreme and then come back to a level that makes a little more sense for everybody.”
Steele believes there is a gross misunderstanding of what constitutes risk to client funds.“The emphasis is being put on areas that in the long run will hurt the clients. FCMs will not have a choice but to require clients to deposit more money. The very thing you are trying to protect against, which is risk to client monies on deposit, is going to be affected by the fact that they will be required to have more money on deposit,” he says.
“I think there is some regulatory overreach; the objective is admirable and appropriate, but I do not think it is being approached in the right way. The fact that nearly all market participants are opposed to some of these changes speaks volumes. I think there needs to be a return to some sense of materiality as to what constitutes reckless disregard or intentional violations of rules and what are relatively minor oversights—occasional human errors—that do not harm the marketplace or clients,” says Steele.
“If you look back through history, any big crisis, whether financial or otherwise, invites overreach by the government. To the extent that certain abuses and problems are corrected, I am all for it. It is embarrassing to have what happened at MF and Peregrine occur in our industry. To legislate solely for the sake of legislation; to do something regardless of whether it is right or not—that needs to be addressed,” explains Steele. “If we can find a happy medium on that, I think Advantage is well positioned for the next ten years.”
Written by Amanda Dunkel and Shery Johnson