Today’s futures commission merchants (FCMs) seem to be enjoying an almost permanent boom. March 2011 saw the highest volumes ever recorded across the world’s listed derivatives markets, excepting only the Flash Crash month of May 2010. So the longstanding growth trend is still in place, led by the recent surge in world commodity markets. And prime brokerage operations are proving particularly profitable for the leading firms in this field.
Things aren’t quite so easy
The volume increases are less exciting than they may first appear, as deal sizes are not growing, and responding to rapid changes in market conditions is not a cost-free exercise. Also the boom has led to a sharpening of competitive conditions, so all market participants have to fight to preserve market share, and there is of course resulting pressure on commission rates. Persistent low interest rates are yet another negative factor, restricting the returns on funds held in clients’ margin accounts.
There are also concerns on the part of derivatives market users about global market structure and costs. With the proposed Deutsche Börse-NYSE Euronext merger expected to be scrutinized closely by competition authorities, leading industry figures have been calling attention to some long-recognized issues: derivatives market concentration, restrictive intellectual property practices that preclude contract fungibility, and the prevalent vertical-silo model inhibiting competition at the clearing level.
Meanwhile trading clients and buy-side investors are not becoming any less demanding. Their strategies are more broad-based and complex, often ranging across multiple markets and asset classes. Direct market access (DMA) trading demand continues to grow steadily, and parallel growth in the use of execution algorithms has driven the requirement for brokers to distribute these algos also to their clients. And as the high frequency trading (HFT) phenomenon becomes established in derivatives markets, it brings another new set of requirements – ultra-low latency, sponsored access, exchange co-location and so on. There is no shortage of areas in which a derivatives brokerage is forced to invest, if it wishes to capture the best of the new revenue opportunities.
And alongside these market pressures, regulators are focusing hard on risk management standards, with high priority given to timely consolidation of overall positions and the associated risks and correlations.
How leading firms are responding
Capacity planning is a nightmare in the market conditions that FCMs face today. One way to respond is effectively to outsource the problem, at least for non-core process elements, by using managed services. Having market connectivity managed ‘in the cloud’, for example, places the burden of ensuring adequate performance on a trusted supplier, as well as dispensing with some complex technical management tasks. There has been a rapid trend towards usage of such services in recent years, and this continues.
Risk management is now central, and likely to remain so for the foreseeable future. We see two main areas of focus:
• Pre-trade risk management traps some major risks at the most appropriate time: before they hit the markets. SunGard has benchmarked the Valdi Selector product against these guidelines in order to determine next priorities (as described in our position paper Implementing effective electronic trading risk controls).
• Multi-platform risk management is important in cases where a firm needs to consolidate its view of activity for risk and margin management purposes. An increasing number of exchanges can provide real-time ‘drop copies’ of all completed trades to reflect all of a member firm’s market activity, and software vendors are responding with the necessary tools to handle them, such as SunGard’s Global Execution Server.
Increasing levels of technological sophistication among derivatives market users have fuelled the growth of DMA and algo trading in recent years. The main demands on brokers are then for extended capabilities in the trading workstations and other software tools that they provide to their clients. Increasingly, brokers differentiate themselves via the breadth and innovation offered in their algo suites. There is also demand for wider market access: despite the market concentration in certain segments discussed above, we count 60+ derivatives markets globally that attract significant levels of business, and a global broker needs connectivity to most or all of them.
Alongside the DMA growth, we have seen the large-scale application of high frequency trading techniques in the derivatives markets: often the HFT firms are themselves market-making exchange members, but in other cases they use brokerage services, and may then demand specific low-latency technology support.
The continuing growth of strategy trading is fed by wide availability of the necessary high-quality automated tools to support the trading of complex strategies. The leading software products that support strategy creation and execution today offer all the flexibility and market connectivity that most users require, so we can expect yet more imagination to be employed in exploiting the potential of these tools.
Exploiting market fragmentation
Derivatives markets have as yet seen almost none of the fragmentation that has revolutionized equity markets in North America and Europe: the one major exception is of course the US equity options market. There are signs of change: in Europe we see Turquoise Derivatives and BATS Chi-X making moves to compete directly against Eurex and Liffe. But the creation of a few non-fungible derivatives contracts is still a long way from what these firms have achieved in European equity markets. There is also much activity in the fast-growing Asian financial centres, with new exchanges in mainland China, Hong Kong and Singapore, but it is too early to tell how much impact they will have in competing against the established markets.
Where from here?
The continuing trends described above show that much is still in flux, and there is a lot to play for in the fast-changing competitive environment. There is potential for the central market structures to alter radically under the two major influences of globalization-driven mergers and new regulations, and this could in turn impact significantly on the priorities and strategies of brokerage firms. FCMs are likely to concentrate increasingly on their core business competences and to outsource large elements of technology management. Given the increasing range of possibilities, everyone involved in the listed derivatives markets will have to make hard choices about direction, but (at least for those with strong stomachs!) the ride will continue to be an exciting one.
