On October 30th, the day before MF Global declared bankruptcy, I (John Lothian) wrote an email to some industry leaders expressing my strongly-held belief that there would be no deal to buy MF Global. The biggest reason was that there “has not been any player in recent years that has come into the futures brokerage business and acquired companies with MFG’s model and proven successful,” I wrote.
The futures commission merchant (FCM) business model is broken, with no better example than by the struggles of MF Global. It is hard to earn profits when a major revenue input to your business model includes interest income and short-term rates that are, practically speaking, zero.
In order to earn a return on capital in the form of interest income, you must take more risk. The problem of course is that the more risk you take, the less liquid the investments and the more variance the price will be when you need to get your funds back quickly.
Short-term U.S. Treasury securities are a deep, liquid market that makes it easy for FCM executives to sleep at night knowing they can turn those instruments into cash quickly and easily. Other instruments cause increasing amounts of insomnia.
Of the three major revenue inputs for FCMs – commissions, interest and principal risk – the sure thing has always been the interest income. Commissions have been in a downward spiral since the deregulation of commissions led to the rise of discount brokers. However, since the rise of electronic trading commissions, prices have cratered.
Electronic trading led to a disintermediation that eliminated costs, including personnel (floor brokers, phone clerks, floor messengers and off the floor brokers) and transcription errors. With customers entering their own orders online, a smaller support staff is required to support the customer when they have problems or questions. This trend is no better represented than by the firm that was the last reported to be interested in buying MF Global, Interactive Brokers.
One cost that did go up was technology. With the cost of systems and telecommunication lines to access electronic markets so high, firms found refuge in merging with rivals to cut costs and improve profitability. This is true in the brokerage space as well as the proprietary or principal trading space.
Locals and Clearing
And clearing has also had its challenges. MF Global did not even want to be in the business of clearing local traders. They acquired some of that business through various deals when they were Man Financial, but would always seem to spit those customers out later. It was only with the acquisition of the FCM assets of Refco after its 2005 meltdown that they got back into the local clearing business to stay. That local customer base proved helpful when Man Group decided to spin off Man Financial in 2007, as it allowed the broker to boast huge volume numbers as part of its IPO.
With the CME’s stock soaring at the time, anything that looked and smelled like an exchange was bound to get a premium value attached. Man Financial even bought an interest in US Futures Exchange in 2006, nee Eurex US, so they could get more of this aroma for their IPO.
Today, with the MF Global bankruptcy, the CME Group could not find any takers for the local trading business.
Retail and Institutional Business
ABN AMRO was awarded the institutional business from MF Global by the CME, and R.J. O’Brien stepped up (reportedly adding $100 million in capital to the firm) to take the retail business. Other firms took on some business as those deals were privately negotiated, including my firm (The Price Group) moving to ADM Investor Services.
ABN AMRO though is owned by the Dutch government as a result of the implosion in the banking sector following the financial crisis and some very bad mergers preceding it. So who wants into the the institutional side of the futures business? The Dutch government? (Hey, at least its not Bawag, the former – and now most famous – fourth largest bank in Austria.)
R.J. O’Brien was sold to a couple of private equity firms back in 2007 for an unreported sum. The O’Briens maintained a minor interest in the firm, though in December 2010 they bought back controlling interest for what was whispered as pennies on the dollar from the 2007 sale price.
So you have the Dutch government and the O’Brien family, one a reluctant forced buyer and the other a recent seller (and later buyer back), who want in to the futures brokerage business.
One thing to me is clear, and that is if interest rates continue to stay near zero for an extended period of time, it could kill the futures commission merchant business as we know it.
Commissions will need to rise to compensate for the non-existent interest income. Some local traders, unable to find a new clearing broker home, will likely end up as customers of Interactive Brokers or some similar deep discount online broker. The higher commission rates they will be charged as a result will impact their style of trading, even potentially leading them to drop their exchange trading rights as they don’t need the volume discounts. Or, they may need the money from the trading rights if some of their capital is stuck in the MF Global bankruptcy proceedings for an extended time.
Some of the firms coming into the futures brokerage space are coming out of the equities world, firms like TD Ameritrade, Charles Schwab and E*Trade. They offer a different model than MF Global’s. They run a house business, not a broker-driven customer business like MF Global. Maybe the future looks more like them, offering multi-asset class products from a single relationship, than the standalone futures brokers of today.
So who wants in to the futures clearing brokerage business? Step right up.