What is the future for Futures?

I was lunching with some friends recently andwe had agreed beforehand that work was definitely not going to be on theagenda. We were successful until about half way through when suddenly, one personbroke ranks and quietly, but mournfully announced ‘There is not much of futurefor our industry, is there?’ This almost whispered statement was initially metwith silence, and then one by one, each had their say.

By the end of the discussion it was clearthat the majority felt a ‘perfect storm’ had descended on the futures and clearing industry, and it wasn’t going to pass anytime soon. This ‘storm’ hada number of fronts to it. It was raining new regulations, some of which weredifficult to understand in terms of what they were meant to achieve, and theywere costly. The dark clouds of implementation expense and the cost of capitalwas now a serious impediment to profitability, and for some, survival. Tradingconditions were poor when compared to say 2008, 2009, with low interest ratesand volumes to match.

Some felt that politicians and regulators whodemanded that OTC must be centrally cleared had thrown the CCP clearing model,which was once the exclusive domain of listed derivatives, into chaos. 

And finally, to finish off on a high note, thefun had disappeared. Banker bashing was still periodically catching theheadlines. Fat Cat’s was still an often used phrase. Certainly no one aroundthe table fell into that category. Anyone ever receive a Million pound bonus?No, not a sniff, not even close.

I decided to carry on this debate in my ownhead to determine if the pessimism was a fair reflection, or imagined as aresult of a couple of glasses of red. I thought it wise to look at our debatein the cold light of day, and review some of the events, key and otherwise,that have led us to this point, and this is what I have concluded, my ownpersonal take of the future of the cleared derivatives market,

While few in our industry would dispute theneed for stronger regulation following the crisis, Futures had come through it relativelyunscathed reputationally, and by and large financially. The need for new, futures-specificregulations was less obvious, particularly when it seemed to most of the futures fraternity that the crisis was nurtured elsewhere in the financial markets.

Shortly after being appointed chairman ofthe CFTC, Gary Gensler stated that he was leading the effort to ‘start policingthe Wild West of finance: the murky market for over-the-counter derivatives’. InOctober 2011 MF Global failed. Soon after in July 2012 Peregrine Financial wentthe same way, but for different reasons. As a result of these two failures, the futures industry was now viewed as being no more responsible or trustworthythan the OTC Market. 

When Dodd-Frank was passed in to law in January2010, it gave the CFTC scope for significant rule making and mandated Gensler’searlier commitment to centrally clear OTC trades. With legislative clout behindhim, and a thought process refined since May the previous year, Gensler put onhis Sheriff’s badge.

On the other hand, over here in Europe, onJanuary 3 2011, a full year after Dodd-Frank first saw the lightof day, Esma issued its first Q&A, ‘A Guide to Understanding Esma’. At thispoint, it was clear that the industry was about to observe a two-speed,uncoordinated regulatory battle. The US and the EU held very different viewsabout how to prevent the next crisis, while bringing the banks to heel at thesame time.

It is well documented that Banks and TradeAssociations met frequently with US and EU Regulators, in public and inprivate, in an effort to fashion sensible, workable regulation to meet theneeds of both parties. However, there is little doubt in my mind that regulatorsdistrusted those who sat opposite. Public and political opinion regarding the financial industry and banks in particular was still the hottest game in town.No regulator wanted to be seen in the eyes of their political masters as goingsoft, or agreeing with the perpetrators and architects of the crisis, as aresult some proposed regulation was just plain daft.

Consultation papers and draft rules often (andstill do) contained little, or no specific useful guidance, no understanding ofthe subject or the size and complex technical nature of the industry. 

Two words to emphasis the point here; transaction reporting, a dogs dinner if ever I saw one! My current hobby-horse isthe Mifid II 60 second pre-trade check proposal; one sure way to eliminate high-frequency trading! Surely the penny must have dropped bynow that futures contracts have certainty of clearing at a central counterparty. If this is ignored,then the EU may as well put out the ‘welcome mat’. Neither the US nor Asia haveindicated that they are looking at any similar 60 second proposal, and no onethat I have spoken to expects them to do so.

One argument bandied about by regulators inthe years immediately post the crisis, was that their rule making would attractnew entrants. True, swap execution facilities in particular were sprouting out of the ground likeweeds, but consolidation in this segment is as inevitable as it was with electronic crossing networks and more latterly multi-lateral trading facilities.

But it was clearing where the regulators reallyhoped that competition would increase. To run a profitable (can we still use thatword?) futures business offering clients access to 40, 50 Global Exchanges andassociated CCPs takes decades to build and maintain. It’s a process ofcarefully orchestrated investments, an evolutionary process that doesn’t happenovernight.

No disrespect intended here to some of the custody banks who have tried courageously to break into clearing and havesubsequently withdrawn, but without the history of prolonged investmentmentioned above, becoming a dominant global clearer is not going to materialiseusing general clearing members and futures commission merchants carrying brokers.  

So who is waiting in the wings to challengethe major clearers? It would take massive corporate cahoonas to submit abusiness plan on the basis of ‘give me a $100 million, I will build you aclearing business and they will come’.  Whowould sanction such a proposal? In the current economic environment! No one isthe answer, not even little Green Men from Mars!

In reality the truth is quite the opposite.The pressures placed on clearing firms (capital charges, balance sheet repair, investment to meet regulations diverted from income generation –not an exhaustive list), clearers are now actively debating ‘is this a businesswe should still be in’? A major, global clearer announcing a withdrawal from clientclearing is not impossible, with all the concentration risk ramifications itwould bring. 

So what is my conclusion? Far from being arant about regulators, which it is most definitely not, it's more of a mildreflection on opportunities that were missed or dismissed, and as a result, haslead us to a less than satisfactory place. 

While I am now seeing someindications that regulators are beginning to realise the pressure clearingbusinesses are under, which is welcome news and testament to the on-going effortsof the trade associations to engage and educate, there is little that I believe regulators can do in the short term. Elections need to come and go, political mastersneed to change in order for there to be any hope, or understanding that some regulationis punitive, and beginning to have unintended consequences.

Banks that decided to continue in theclearing business are slimming the client base in order to reduce balance sheetutilisation. This will deny some clients access. While we all talk about costsgoing up, few have dared to up rates and the debate about who pays continueswith the buy-side. If proof were needed that the clearing business model ischanging in effort to cut costs still further, look no further than theBarclays/ Sungard announcement last week. 

In my view, the number of GCM’s, FCM’s willonly continue to decline, but I expect to see an increase and conversions to direct clearing member status, certainly for those who make the strategic decision of exitingclient clearing.

But there is some hope. If history hastaught us anything, futures is a very resilient business. It wasn’t that longago that the closure of the floors and the advance of electronic trading wasfollowed shortly by cries that futures was a dead industry. Up until the crisisat least, volumes showed no sign of decline and they will, at some point, startto creep back up. But when? Are we talking 2-3, or 3-5 years? For volumes, 2-3.For new clearing participants, and I am not talking about one or two, my viewis 3-5 years, but it will be more regional, certainly not global.

So, for the younger generation, don’tlisten to those stories about what the futures markets used to be like; fun,profitable, well paid with job security. Those benefits disappeared before thecrisis.  The industry model that I grewup with no longer exists. A new one is taking shape and there will beopportunities that emerge. It’s now time to start shaping the new landscape.

But that my friends, is progress, and longmay it continue.