FCMs Face Fragmented Markets

Terry Flanagan

The fragmentation of the derivatives markets is putting intense pressure on futures commission merchants to rationalize their cost structure. This means finding newer, less expensive ways to connect to exchanges and other trading venues.

“Exchange proliferation is significant,” said Steve Woodyatt, CEO of Object Trading, during a webcast on Tuesday. “FCMs are being forced to reevaluate their franchise, and either become a specialist or a one-stop shop. The demand by the buy side from FCMs is for nimbleness and cross-asset class coverage. Market hyper-fragmentation increases underlying costs required to access the markets.”

Although competition in clearing futures may have once centered on cost efficiency, some clearers believe this is changing due to the unintended consequences on capital efficiency stemming from new OTC market regulations, said Woodyatt. If buyside firms are unable to allocate their capital effectively and have to fragment their margin in efforts to comply with regulations, the resulting increased transaction costs and necessary reduction in overall trading volumes may inadvertently stifle liquidity.

As a result, FCMs will need to innovate or suffer contraction, whether they’re global or regional clearers.

One executive at a regional FCM recently concluded that there’s too many trading venues to connect to everything, so the firm decided to join markets central to their core customers, and use a carry broker structure to gain access to other markets. This solves one problem but creates challenges in execution and clearing.

This FCM clears under its own name on seven or eight markets, and clears the remainder through carry brokers. “What that gives us is the ability to gain access to markets quickly. The challenge is have you picked the right third party?” he said. “A single third party doesn’t have access to every market.”

Another issue is whether to run technology internally. “We run the majority of our services in as ASP structure,” said the executive. “If we want to join a new exchange, it’s relatively quick in a vendor-controlled environment. The ASP model gives us the ability to build change in a relatively short time period. If you’re a client, you need seamless execution across multiple markets. We are spending time making sure we build an execution solution to allow every client to connect to markets globally.”

Market consolidation is inevitable in 2014, particularly in the U.S. SEF market system. Market participants say the current level of fragmentation is not sustainable, as there’s not enough order flow to go around.

“It’s important to see tangible client demand before connecting,” one market participant said. “When we decide there’s sufficient client demand, we can deliver connectivity in 90 days using a modular development model.”

Featured image via Dollar Photo Club

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