By Ginger Szala
Reprinted with permission of CTA Intelligence
Like the rattling chains of Jacob Marley haunting Scrooge, the ghosts of MF Global and PFG still wander the halls at futures commission merchants today and remain alive and well in the manifested actions of CTAs who diversify their funds among brokers. But realities exist: there are fewer FCMs in which to diversify, and many bank FCMs won’t take anything smaller than an account that can guarantee them $1m in fees annually, which they can get because big clients want sizeable balance sheets and credit worthiness.
Assets tell a true story of two businesses that, despite current issues and past challenges, are growing. CTA assets under management since 2011 have grown just over 7% to a record $337.5bn at the end of 2016, according to BarclayHedge statistics. Dovetailing with that is the growth of FCM customer segregated funds, margin monies held at brokerage houses, which today are $170bn, a small increase over last year, and a 9% increase since 2011.
And despite Basel III and Dodd-Frank restrictions, big bank FCMs continue to get the lion’s share of business. Today the top 10 firms (nine bank FCMs and non-bank ADMIS) account for 73% of segregated funds, while in 2011 they accounted for roughly 77% of segregated funds. According to CFTC reports, in 2011 there were 110 FCMs, while today there are 66 (and only 58 of those carry segregated funds).
Tom Lehrkinder, senior analyst with Tabb Group, wrote in his November 2016 report, The Tide is Rising for US FCMs, that “[FCMs], at least for the most part, have weathered the post-financial crisis environment. Wave after wave of new capital rules, increased regulation, stagnant interest rates, and growing technology costs have pounded profitability and driven industry consolidation.”
While the consolidation continued in 2016, the drastic drop in the number of FCMs has eased while segregated assets remain consistent. While some detractors may be concerned about the consolidation in terms of adding concentration risk to the equation, Tabb research shows concentration has in fact remained range bound (+/- 5%) for the last 13 years.
Regulation is still a key headache, FCMs state, but most have adapted and take a wait and see attitude to any rollbacks promised by the new administration. Basel III has caused a lot of consternation throughout the business with its valuation of some balance sheets, forcing brokers to offload unprofitable or inactive customers.
“Capital charge is a huge piece,” says John Vassallo, president and co-founder of Coquest, one of the largest US independent brokers. He says one of their accounts carried $50m in excess capital at the FCM, which he adds “used to be a home run”, but this bank FCM told Coquest they needed to send the excess back because the client wasn’t an active trader and so they couldn’t keep the amount on the balance sheet.
This story is echoed by several CTAs, and is compounded by today’s regulatory hurdles, which makes opening new accounts even more slow. Vassallo says it takes maybe a month to open an account at a non-bank FCM, but can take up to a year at a bank-owned FCM, and then paperwork may need to be updated. Barry Sims, director of operations for Abraham Trading, says they use several FCMs, including JP Morgan at one point, where they kept millions in collateral just to have an open account, but were forced to close it because it wasn’t active. “Five years ago you could open a bank FCM account in a month, but now it takes at least four months,” he says. Vassallo adds that the process sometimes is so “arduous” that the client will forgo the hedge and just accept the risk to avoid the paper nightmare.
There are also new fees. Matt Peluse, head of Esulep Management, which uses five FCMs, notes that they get charged now for capital carry and even for posting T-bills. “They are ticky-tack charges in the scheme of things, it’s not a lot of money but we’re a large client for them.”
Another complaint from the CTA side is excessive margin requirements by FCMs. “Requiring multiples of exchange minimum margins is up there on our [issue] list. Perhaps we’re more sensitive to that than others as we were forced to hold 2x exchange minimums at MF Global before they went under, and that just made it more difficult for us to stay in business until we recovered our money,” one CEO of a long-time CTA says.
“I also view it as a sign of desperation if an FCM is demanding that from a CTA that trades in 100+ markets like we do. Perhaps with a trader who has all its margin on one market, [it makes sense] but for us, it is unnecessary to require any more than exchange minimums,” he adds.
Brokers Besieged Too
Brokers understand these complaints but also see their business squeezed from new regulations and exchanges.
“The cost of running the business is high due to the increased regulatory burdens related to leverage and capital (RWA), as well as from IHC requirements,” says Alain Courbebaisse, head of US prime brokerage, Société Générale.
“Plus, a larger proportion of client fees are going to the exchanges rather than to the FCMs, which is crimping profitability at FCMs. We are still in an environment where margins for FCMs are being squeezed and profitability is low.”
Joe Guinan, chairman and CEO of Advantage Futures concurs. “Because exchanges are charging clients so much money for quote fees, they have shrunk the industry and forced out a lot of traders,” he says. He adds that a pretax trading profit five years ago of $50,000 might net $20,000 today because of higher exchange and quote fees. “Yes, it’s a pass along to the client, but a rising cost to the end user has shrunk the number of traders, which in turn has hurt the FCMs.”
Scott Gordon, CEO of RGC, agrees. As intermediaries between exchanges and clients, they “face the pressures of increased charges from the exchanges without the ability to absorb them all, and new regulatory demands and other factors that have raised the cost of serving as an exchange clearing member,” he says.
Lehrkinder’s report states “that the revenue available for the US FCMs will be an estimated $4.5bn in 2016, up 5% over 2015. The growth is largely attributed to a strong first half of the year and expected volatility before and after the election in November. There are also indications that FCMs may be entering a stronger operating environment in terms of commission revenue, with 73% of the FCMs interviewed indicating they have been able to raise their commission rates over the last two years. Total interest earnings by the FCMs as a whole was actually seeing an increase this year, only to be dragged back when two of the top 10 FCMs decided to ‘de-recognise’ customer balance from their FCM balance sheet.”
It’s a puzzle that, despite the balance sheet constraint, many top bank FCMs have continued to grow segregated funds. Courbebaisse says “for bank FCMs in general, new balance sheet constraints added a substantial additional cost to a business that already needed to be repriced.”
Some FCMs have done much better than others in terms of customer segregated assets growth. Morgan Stanley had roughly $5.3bn in customer segregated assets in 2011, while it shot up to $15.4 billion in 2016. Wells Fargo has a similar meteoric rise, just building its FCM in 2011 to having $3.8 billion at the end of 2016.
Tabb found that clients first want credit worthiness and a commitment to the business, then look to client servicing and pricing. Technology is the answer to how many FCMs are better servicing their clients as well as helping their bottom line. In truth, technology is still a saint and devil for FCMs, who love its efficiencies but rue its costs.
“The cost of technology remains a key issue for us,” Gordon says. “At RCG, we have long invested heavily in technology to ensure we are offering best-in-class tools and service. We always want to stay a step ahead of the curve as technology continues to evolve at an increasingly rapid pace.”
Courbebaisse says straight-through-processing has been “key in enhancing profitability”. In addition, technology has been integral in that ability to manage large volumes and is core to them “handling the significantly increased reporting requirements.”
Tom Kadlec, president of ADMIS, says his top 2017 goal is optimising their core. He says it’s been an ongoing process over several years, but they are automating every process so they can “subjectively analyse the business and add value to customers and brokers”. This includes everything from processing and allocating trades, balancing back-office functions, using tools like DUKO to balance and match trades consistently, reconcile fees with tools and fully integrate this into that daily process analytics.
They’ve also been able to develop risk tools that provide real-time analysis of market swings, which have reduced counterparty risk, he says. They’ve also worked closely with the CME Group risk team to refine credit controls. These controls also help them with their new CTA business. “CTAs are an excellent business and professional client. But they have their own registration challenges and process,” he says. After taking over Vision, now High Ridge, ADMIS had to understand them as customers because it was different than their historical hedging clientele.
“We are risk-averse and conservative by nature,” he says. “We believe in an interactive discussion with any customer in terms of margin. A vast majority of our accounts are at exchange minimum. For concentrated portfolios, we will put on a lever because it is concentrated, but we do [ask] where other assets may be or if the money on our books is the only asset.” He says that he expects conversations to be transparent and “non-emotional”. “Everyone knows we’re risk-averse and don’t prop trade. We have one shareholder who has a strong financial standing in the world and we don’t make any apologies for it.”
Gerry Corcoran, chairman and CEO at RJ O’Brien & Associates, says: “I can’t emphasise enough how important technology is to our business and growth. It touches everything we do, from how we interact with our clients and how they participate in the markets to how we find ever more efficient ways of doing business, to critical middle- and back-office operations.”
With an eye toward growing the CTA business, RJO developed its Oasis platform, providing clients “access to a variety of alternative investment strategies through managed accounts and fund structures”, Corcoran says. There are other platforms available on the brokerage side, such as DB Select and Luxor, as well as independents, such as Gemini and Kettera, but Oasis was a way for RJO to use its technology and brokerage reach to service clients and CTAs. Sometimes, though, technology comes at a cost. CTAs that are forced out of larger FCMs and end up going to firms that are not set up to handle their businesses.
“It seems most FCMs these days are run by compliance people and have no interest in doing what’s best for their customer,” says Mike Dever of Brandywine Asset Management. “Their first response, which they often adhere to, is ‘no’. My guess is that their parent companies don’t want to be in the business so are trying to kill it softly.”
Vassallo says they’ve seen a lot of FCMs stay lean from an expense side, but because they’ve computerized so many systems, they hire a less experienced person and give them a single task. “It used to be that you could call one person who was in charge of onboarding accounts and they could handle the entire process, but now you get passed along once that one task is done,” he says, adding Coquest has taken on the duty to upload paperwork for clients at the FCM portal as well as act as a CTA’s liaison. Abraham’s Sims vouches for this, stating they use Coquest as an IB to handle a lot of the correspondence with the FCM to reduce their headaches.
Other CTAs have gravitated to Coquest and other IBs to handle not only the daily issues of working with an FCM, but to help them raise money, which has often been a key grievance against FCMs.
Esulep’s Peluse chuckled when asked about it, saying “unfortunately it’s a short conversation. They won’t do anything. They feel they have increased scrutiny and liability on them if they did”, he says. Peluse says in a true reversal, one of their brokers actually asked him to buy some of the FCM’s debt to help out the balance sheet. He said no.
Sims, having been with Abraham for 22 years, says he just “scoffs” at FCM cap intro pitches as “so little has come from it.”
Tim Pickering, founder and CEO of Auspice Capital Advisors in Calgary, concurs. “We will never rely, nor ever had any benefit from, an FCM in our business or cap intro efforts”. He adds that unless a CTA is in the $1bn AuM zone and generating a certain level of fees, they should expect poor service from their FCM.
Granted, not all FCMs can be painted with the same brush. Sims praises SocGen, stating they use them almost universally for execution because they are efficient and reliable. He says that’s not true across the board of bank FCMs, adding they will be moving business to ADM because their providers have not been able to execute on it.
Jerry Parker of Chesapeake Capital said they were in the process of moving from a bank FCM to Interactive Brokers for many reasons, including automated technology and cross-margining abilities.
FCMs state they definitely want the CTA business but are largely caught between the exchanges and regulations. Exchanges have ‘pricing power’ advantages over firms regarding market data and other fees, FCMs say.
“The challenge with CME and ICE is they have pricing power,” Kadlec says. “The CME calls us a strategic partner, and they need to demonstrate it.”
That said, he says they’ve helped in developing new tools to curtail market risk and aid in some automating processes. Corcoran concurs, stating the exchanges “play a critical role in providing our clients with a great set of products for risk management and trading.” Acknowledging exchanges’ pricing power, he says they pass along fees to the customer, “but this has a cost for the industry. More competition ultimately would serve market participants better.”
Gordon notes that the significant consolidation at the exchange level globally has changed the dynamic between exchanges and FCMs. “We have seen some larger exchanges attempt to disintermediate firms by offering a direct clearing model to certain large customers. As these types of firms represent an important source of revenue to many FCMs who have to bear significant fixed costs, this challenge to the intermediary role introduces another competitor.”
Guinan adds that disintermediation is “something to worry about,” but Tabb Group’s research shows there hasn’t been “a big move toward it yet” Lehrkinder says.
SocGen’s Courbebaisse says disintermediation is a new concern, but he is not convinced it will happen as exchange members have mounted a strong challenge.”
With the interminable squeeze between exchanges and clients and regulatory assault despite the possibility of some rollback, is being an FCM still a good business? Advantage’s Guinan says one of his investors asked him that very question a year and a half ago.
“As long as we stay at 0% interest rates, I don’t think the FCM business is necessarily good. But thank goodness 0% appears to be coming to an end with the second rate increase last December.”
With today’s financial industry stock rising as well as volatility increasing on account of the Trump presidency, he sees a better future for FCMs, traders and exchanges. This might alleviate the love/hate relationship CTAs have with some of their brokers.
Freelance journalist, business writer, media consultant
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