July 2, 2015 / 1:12 AM / 4 years ago

Ranks of commodities brokers dwindle as U.S. futures industry evolves

NEW YORK (Reuters) - U.S. commodities brokerages - a key focus of reforms designed to make the financial system safer - are increasingly struggling to eke out a profit, spurring many firms to think about leaving the business, or trying to boost commissions.

Traders work in the silver and gold options pit on the floor of the New York Mercantile Exchange in New York in New York July 18, 2011. REUTERS/Shannon Stapleton

The brokers, known as “futures commission merchants” or FCMs, are paying increasingly large sums to comply with new regulations, bolster their cyber security systems, and do business with exchanges, among other areas.

The vanishing FCMs are one way the futures trading business is changing in the United States. Another example is the imminent closure of the grains futures “open-outcry” pits at CME Group Inc, although the two cases are not necessarily related.

There were 74 FCMs in the United States at the beginning of 2015, down from 93 a year earlier, and 154 prior to the financial crisis, according to the Commodity Futures Trading Commission.

“Sadly, it appears that the markets where ‘derivatives’ were born are quickly losing their core service providers, possibly forever,” CFTC Commissioner Christopher Giancarlo said in a statement in June.

The decline is significant because it means more risk is concentrated among fewer firms and some customers of FCMs may find it more difficult to gain access to the market because they do not generate enough profit for the brokers to justify taking them on.

The dwindling number of FCMs has also made it more expensive for some customers to use derivatives. Regulators and lawmakers are trying to push customers like hedge funds and farmers toward using more standardized derivatives contracts, which can be traded on an exchange, or at least “cleared” through a third party after the trade. Central clearing allows regulators and others to ensure that parties are keeping enough collateral on hand to guarantee their contracts if one party to the trade goes bust. Brokers help clear trades for clients.

Steve Sanders, executive senior vice president at Interactive Brokers, said rising fees and regulatory costs have kept Timber Hill, the company’s FCM, from growing as fast as the rest of Interactive Brokers’ other business units.

   “The decision might be at some point if the cost gets to be too much, it may not be worth it for us to be in this business,” he said.

Other firms have made their decisions. Bank of New York Mellon, Royal Bank of Scotland, State Street, and Nomura have all pulled back from or quit the FCM business.

The number of FCMs has also shrunk due to mergers, with Wedbush Securities buying KCG Holdings’ futures execution and clearing business, and Societe Generale taking over Jefferies Group’s Bache unit.

“They are more concerned about whether they can get the return on equity that they need from a shareholder perspective in those businesses, and that seems to be getting harder and harder,” said Kevin McPartland, head of market-structure research at consulting firm Greenwich Associates. The top 10 FCMs are mostly run by large, global banks, which hold around 75 percent of all customer funds.

    

PROFIT-CUTTING RULES

FCMs make money through commissions and interest income. Their profit is falling due to a number of market and rule changes. The brokers hold client money in what are known as “segregated accounts,” and they are entitled to invest that money in low-risk securities. With the Federal Reserve having kept interest rates at near zero levels for six years, the profit from those investments has dwindled. In 2014 interest income made up less than 10 percent of the $4 billion in revenue made by futures brokers, down from nearly 50 percent of $7.1 billion in 2008, according to TABB Group.

New capital rules require banks to set aside more capital to cover client exposures in their FCMs - by JPMorgan Chase & Co’s estimate for its own business, four to six times more equity.

JPMorgan, one of the largest providers of over-the-counter derivatives services, said in February that the new capital rules hampered its profitability.

The bank recently raised clearing prices following a similar move by Goldman Sachs Group Inc, according to a person with direct knowledge of the matter who did not have permission to be quoted in the media. It is also hopeful that talks with regulators may prompt a pullback on some rules that are costly to FCMs but do not necessarily make the financial system safer, the person said.

    YOU’RE FIRED

    Some firms feel that increasing prices is not an option. Timber Hill said it has resisted raising the fees it charges on top of exchange and clearing fees even as its own expenses have risen.

    “The cost is already so high that if we were to raise it any higher, there would be a lot less business,” said Sanders.

    Some FCMs have resorted to abandoning their least profitable clients, said Matt Simon, an analyst at TABB Group. 

    “There may be certain customers where we say, ‘Unless you’re willing to provide us a higher return by having a higher rate, we’re going to deploy that capital to a different customer segment,’” said Gerry Corcoran, CEO of RJ O’Brien, in an interview in March. No such plan had yet been made, he added.

    To be sure, FCMs are not going to go away entirely, because new regulations require OTC derivatives to be cleared.

    But as more firms decide to leave the FCM business, more risk is concentrated among fewer players. Examples of FCMs that have collapsed include MF Global and Peregrine Financial.   

    “If something was to go tragically wrong then it’s going to be a much bigger problem if there’s one entity handling 40 percent of derivatives flow,” said Greenwich’s McPartland. 

Editing by Daniel Wilchins and Matthew Lewis

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