The second half of the year, however, focused mostly on regulation. The US marched ahead with Dodd-Frank, the EU is following, but the outcome for the industry is still unclear. Mareen Goebel looks back over a busy 2010 and asks leading industry professionals what they expect from the year to come.
Regardless of the day-to-day news, product launches and technology upgrades, ask anyone in the derivatives market what the biggest issues are, and the answer is likely to be regulation.
When the US Congress passed the Dodd-Frank Act in July, the ripples could be felt globally, and while the US industry feared that this might drive business to Europe, the European Commission soon followed with its own regulatory crackdown.
While reform in the US took the shape of one weighty tome, which will be fleshed out further in the coming months, the European Union is endeavouring to finalise several pieces of legislation for the financial markets, from the Mifid review to the Alternative Investment Fund Managers and Market Abusive Directives, and has created a whole new regulatory superstructure.
In September the European Parliament adopted a law creating four new EU-wide regulators: the European Securities and Markets Authority, European Banking Authority, European Insurance and Occupational Pensions Authority and a macro-prudential overseer, the European Systemic Risk Board.
“For us the key development was the passing of the Dodd-Frank Act and the provisions it makes for Swap Execution Facilities,” says Richard Giles, head of commodities and energy brokerage North America at GFI Group in New York. “The future will show how the legislation is going to be turned into regulation, but it’s clear that it’s a huge sweeping change.”
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Market change shakes up the brokers
The economic turbulence and regulatory reforms of 2010 could not leave the leading investment banks and brokers untouched – even if, unlike some recent years, no substantial firms went bust.
Striking and far-reaching changes took place at several leading firms – notably MF Global, where Jon Corzine, former CEO of Goldman Sachs and governor of New Jersey, took over as CEO in March.
That brought to an end the brief reign of Bernie Dan, which was marked by painful losses.
Corzine has wasted no time, but set about cutting some 12% of the workforce in his first three months, to get the compensation ratio down from 63% in the second quarter of 2009 to 54% a year later. The broker turned a narrow profit of $9m in that quarter.
No sooner was that phase over than MF Global embarked on a new hiring spree, to carry out Corzine’s plan of turning it into a broader-based investment bank.
The arrival of Jon Bass as head of institutional sales in December was just one example.
JP Morgan has been going through change too, though much more quietly. Its head of prime brokerage and a leading futures industry figure, Richard Berliand, retired in the summer after 23 years at the bank.
That is believed to have been a factor in the subsequent departure of Jerome Kemp, global co-head of futures and options and head of OTC clearing in London, who moved to Citigroup to take the new role of global head of exchange-traded derivatives sales and clearing.
JP Morgan also closed its commodities proprietary trading desk, in what was billed as an early response to the Dodd-Frank Act.
Deutsche Bank and State Street are among other banks, like Citi, that want to raise their rankings in futures and options.
State Street followed the example of custodian banks BNY Mellon and BNP Paribas Securities Services with a concerted move to break into the futures and OTC derivatives clearing business. In October it hired Steve Martin, head of SEB Futures, to be head of futures EMEA.
SEB responded with a reshuffle and the hiring of Barclays Capital’s Lawrence Peirson as head of futures sales and marketing.
Fortis fallout
For Chris Lee, global head of market access and electronic brokerage at ABN Amro Clearing, the year has brought a move to Hong Kong and coping with the reshaping of the Fortis group.
"In 2010, we completed the process of building up our infrastructure after the split of Fortis into Dutch and Belgian operations in late 2008," Lee says. "Much of our infrastructure in specific locations was supported by the bank, and in many countries we had to build up our own IT, compliance, legal and HR departments so we could go it alone. So in the last 18 months, we were busy putting us in the best position to relaunch ourselves into the new world, post-crisis."
Upheavals like these will no doubt continue in 2011, and some believe they could intensify. "We think one of the changes will be that the new regulation will put many smaller brokers in North America out of business, resulting in a move towards consolidation," says Richard Giles, head of commodities and energy brokerage North America at GFI Group. "The smaller firms will struggle to comply with the Swap Execution Facility rules, as there are a lot of costs involved. As an example, the SEF rules require a disaster recovery plan. We as a firm have established one, involving around 600 people in the States and a similar number in London, but a small broker will struggle to comply. Another rule is that you need external non-executive directors, and an independent compliance department, which becomes a problem for the small brokers with maybe half a dozen people that work with external lawyers and other external firms." |
The time lag between the US and Europe might even lead to a better regime, some hope.
“The most important issue on the agenda for 2010 was the agenda for regulatory change in both the EU and its member states – both good and bad,” says Anthony Belchambers, chief executive of the Futures and Options Association in London. “While the EU is a year behind the US in implementation, this could turn out to be an advantage if it results in a more thoughtful and business-sensitive approach.”
However, Belchambers believes that whatever the outcome, costs will increase and the changes will curb the financial activities of firms and their customers. This will affect traditional business models, revenue streams and the underlying economics of trading and risk management. The question, Belchambers asks, is by how much?
One turning point is imminent – the establishment of the European Securities and Markets Authority (Esma), which begins work on January 1, even if the actual impact of the rules and regulations might take a while to be felt in the market.
Regulatory angst
While some derivatives specialists in Europe hope that things will soon revert to business as usual, others resent “bureaucrats” who, they believe, serve a political rather than economical agenda, or worry that the devils in the detail could play havoc with the way firms run their business.
Giles says GFI Group is working hard with the Commodity Futures Trading Commission and the Wholesale Market Brokers’ Association, trying to gauge exactly what the landscape is going to look like.
Everybody expects the over the counter markets to lose some of their volume to exchanges and more and more contracts to be centrally cleared. “Clearly, there will be a significant migration of ‘eligible’ OTC transactions into central clearing – a process that had actually started before the crisis – but it is vital that the regulators exercise care and restraint to ensure that CCPs are not compelled to clear contracts which are either beyond their capabilities or uneconomic for end-users,” says Belchambers.
Some fear that regulators might go too far and threaten the business models of some market participants, or limit the hedging and investing choices available to customers.
“When it comes to the central execution of OTC contracts, the criteria for eligibility will be different, in some respects, to those for clearing,” Belchambers believes. “Even more to the point, bilaterally executed transactions will be subject to new requirements to improve transparency, trade reporting and post-trade efficiency. It is unclear therefore what level of risk is left that would justify the authorities depriving firms of their execution business models and end-users of execution choice.”
In particular, this line of thought goes, the authorities should restrain themselves from incentivising the market to use standardised contracts when they are not useful or sufficient. “The fact is that exchanges do offer central regulation, efficient execution, liquidity, price transparency and integrated clearing; they will look to offer a wider spread of services to the OTC markets; and end users will wish to take advantage of those services where they can,” argues Belchambers.
But he believes users should not be leaned on to use standardised contracts to tackle complex risks. In mitigating counterparty credit risk, regulators could end up increasing basis risk or the market risk of unhedged positions.
Change will continue
With the new EU supervisory bodies not yet established, and US rulemaking under Dodd-Frank still at an early stage, it is very difficult to predict the actual impact of legislation on costs, the scope of what is allowed, and what Belchambers calls “the cost/reward ratios of trading and risk management”.
But as Scott Gordon, chairman and CEO of US futures broker Rosenthal Collins Group, is keen to emphasise, regulation is not going to derail the derivatives industry. “At the moment I see none of these [industry] drivers change materially, so 2011 will be ruled by the same factors that dominated 2010,” he says. “In the first half of 2011, regulation will sort itself out, as regulation emanating from Dodd-Frank will become clearer, but whatever comes out of it, we’ll live with it.”
| From hands-off to hands-on regulators
Industry leaders agree that in 2010, the derivatives market crossed a watershed in the way it is regulated. The financial sector has been under closer public scrutiny than ever, and there is a fair amount of outrage in the population over bank profits, pay in the financial sector, and the way private risktakers were bailed out by the taxpayer.
Perceptions are that the banks have learnt nothing, and there is pressure on governments and state agencies to regulate and control much more strictly.
This has led to regulators from the US Commodity Futures Trading Commission to Germany’s BaFin increasing their headcount to fulfill all these expanded duties, but also, arguably, to them adopting a more robust approach.
Some caution that much more hands-on regulation might hold back growth. “It is difficult to anticipate how the more business-intrusive approach of the FSA will work out in terms of elevating tensions between risk-averse regulation and pro-competitive business models – which is precisely why it is so important that recognition of the need for firms to be competitive is retained as a factor in the principles of good regulation,” warns Anthony Belchambers, CEO of the Futures and Options Association. “It is entirely right that the FSA concentrates on various elements of ‘people risk’, including governance and senior management responsibility, but, at the same time, there should be no undue compression of risk, entrepreneurialism, innovation, choice and diversity.”
Other sources of conflict are expected as the four new EU regulators get settled and find their rhythm.
Although industry leaders like Belchambers recognise the need to harmonise the implementation of EU laws and regulatory objectives across countries, which therefore requires a new pan-European layer of supervision, they predict that tensions will emerge, as Belchambers puts it: “upstream with the Commission over the setting of regulatory policy, and downstream with national supervisors over supervisory turf." |
For some, there will undoubtedly be business opportunities as the landscape changes.
“In the next year, we expect to grow the business and add people and activities where opportunities arise, especially once there is more visibility,” says Giles at GFI. “We continue to invest in technology, namely our own hybrid system Energymatch, and also focus on pre- and post-trade offerings. We see an opportunity for our Energymatch systems to capture the extra business that will be pushed towards us.”
Yet far-sighted market participants have realised that the present wave of change is unlikely to be the last. Regulatory reforms themselves, by changing the market, are likely to create new facts that alter the financial system, and generate new issues to fix. The interplay between OTC and listed markets is one such theme.
“Clearing houses have moved centre stage and the risk posed by CCPs to the financial system will be increased,” mentions Belchambers as an example. “That will call for significantly closer regulation. Some clearing members will be concerned at the exacerbation in contingent risk on their balance sheets; others will bring pressure to bear on clearing houses to silo the higher tiers of risk into separate default funds; whereas others yet may be concerned that the drive to increase protection for customers in the event of a default could lead to possible shifts in the sequencing of default waterfalls.”
From low to record volumes
Futures and options, like other derivatives, had their fortunes reversed in 2010. After many years of steady growth, 2009 halted the growth trend. Then 2010 started off with subdued activity, continuing the insecurity of 2009.
“There were a lot of uncertainties throughout 2010, which affected people’s vision. If there’s a lack of visibility and clarity, there’s a corresponding lack of risk appetite and risk capital,” says Giles.
However, in the second half of the year, growth recovered. Gordon at Rosenthal Collins sums up: “The futures industry did very well coming out of the financial crisis of 2008. There was low volume in 2009, and 2010 started off with subdued volume. But volume has picked up this year, and at RCG, we’re easily on track for a record year.”
The mainstream media are sometimes alarmed by the growth of derivatives, and regulators are wary of the influence of high frequency trading which has been boosting volumes, but Gordon is convinced it is not speculators driving the renewed vigour in futures.
“We believe this growth was fuelled by market factors, especially price movement and volatility in commodities and record volumes in grain and other agricultural commodities,” he says.
There is guarded optimism in the market that this favourable trend will continue into 2011. “Markets will remain volatile, but it’s conceivable that volumes can continue to increase in 2011,” Gordon believes.
Low interest rates bite into profits
Like the previous year, 2010 was a time of cheap money and quantitative easing. To prop up the housing sector with cheap mortgages and the business sector with low financing costs, interest rates remain low and in much of the Western world way below inflation.
Investors have been looking for things to spend the money on before it evaporates. While this means the central banks have been doing their level best to stimulate financial markets – as Wall Street and the City demanded – it has not been without awkward consequences.
“One challenge for all FCMs at the moment,” says Gordon, “is how to operate in a low interest rate environment. Interest income was one of the revenue generators for FCMs, and in times of prolonged low interest rates, FCMs have to look at ways to make up for diminished income from that side.”
Oppressive technology costs
With the industry so heavily focused on technology – it’s been said that a quarter of global spending on IT comes from the financial sector – some sound a note of caution about the cost involved.
“The two key drivers for the futures market are regulation and technology,” says Gordon. “As we have no power over regulation, which has been seeing a tremendous amount of movement, we’re focusing on the driver that we can control, namely technology, and on building technology that differentiates us from our competitors.”
As Gordon points out, one of the main challenges in managing IT is rising costs. “Regulation contributes to overall cost, but this pales compared to the spend on technology, as bandwidth increases and platforms are increasingly colocated at the point of execution, namely the exchanges,” he says. “We have made significant investments in technology at the front, middle and back office levels. We have made a conscious effort and followed a multi-year technology plan and now have a very substantial programme to offer our clients the best possible technology.”
%20webbed.gif) EXPERT FORECAST - Clive Furness, managing director, Contango Markets
Concentration risk in CCPs – and will tech firms be regulated?
2011 will be a year in which the status quo is challenged. This will mean significant investment in time and money to accommodate and implement change – a process that has already begun.
A key issue for market participants will be increased concentration risk in clearing. With more products being forced into clearing, the risk that the central counterparties represent to their members will increase. Generally, the rise in risk will result in higher costs to all market participants in the form of increased cost of capital and collateral requirements and associated fees.
Technology will remain high on the agenda for 2011. Of course the regulatory debate on high frequency trading will continue, but other issues are likely to arise.
The role of technology companies in the market and the issue of how much they charge for providing access to new products and markets will become a significant debate. Ultimately, the importance of technology to modern markets may lead to increasing calls for technology companies to be regulated directly.
For exchange-traded derivative markets, the monopoly of middle and back office providers is likely to be challenged. Historically, the three incumbent providers have been largely unchallenged due to widely held fears of ‘migration risk’.
However, the need to amalgamate OTC trade flows into mostly ageing post-trade technology used by the market majors is exposing the inadequacies of those systems. We will begin to see credible alternatives emerge as the limitations of current post-trade technology are recognised. Newcomers will likely include current providers in OTC derivatives processing and major IT firms already in the financial technology space.
In product development, there will be significant exchange and clearing house activity in trying to capture volumes from OTC markets, notably interest rate swaps in financials and freight markets in the commodity space.
Indeed, commodities are sure to feature heavily, with a number of regional contracts being launched – particularly in European agriculture. The increasing competition to become the Asian hub for commodities is certain to add competitive spice, although it is doubtful if the current trend towards ‘me too’ products in the region is really adding value for market participants. |
Freaks of nature – and man
There was barely been a week in 2010 when commodities were out of the headlines, and there is renewed talk of regulators imposing tougher position limits.
UK hedge fund Armajaro’s affaire Chocfinger didn’t help, but Anthony Ward’s remarkable trade in which he took delivery of 7% of world cocoa production in July was only one of the big commodity stories of 2010.
“2010 has been an unusual year,” says Brenda Sullivan, head of research at derivatives broker Sucden Financial in London. “We’ve seen the governments get involved in commodities, and commodities are constantly in the headlines and in the public’s perception. A shortage in cotton might lead to higher clothing prices, which in turn might mean that shoppers will buy less clothes or defer spending, with obvious effect on retail stocks.”
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 EXPERT FORECAST - Chris Lee, global head of market access and electronic brokerage, ABN Amro Clearing
Colocation requires better cost control
In my personal view, colocation and proximity services have been the big trend in 2010. All the exchanges that do not so far offer these services are talking about doing so. There’s certainly the demand for them, and the exchanges see them as a revenue-generator.
I am also a strong believer in companies outsourcing their market access. At the moment, all companies are trying to do the same thing, whether they are vendors, exchanges, network providers or brokers – they are all looking to build global access services and colocation services.
But some of those strategies and business models are flawed in my view, not enough emphasis is being put on the cost issue, and the costs are phenomenal. And it will only get more expensive.
So it would make good sense to access the markets through a neutral global provider. The role of the broker would become more focussed on servicing the needs of clients, while the market access and exchange memberships are serviced by a discrete third party.
They don’t have to provide all that infrastructure themselves, thereby cutting costs and helping their clients access the markets more quickly and cost-effectively. It’s perfectly reasonable to outsource market access if you outsource to the right partner.
Asia remains the second big trend, as it is on a massive growth path. More and more firms are getting involved in the region with local representations, bringing more trades and activity. In terms of locations within the region, there’s healthy competition between Hong Kong, which is more and more seen as a gateway to China, and Singapore, which seems privileged with its links to India.
We are getting trades from India into European and US markets, as there are prop traders and brokers set up there. Trading into India is more of a challenge, due to regulatory issues, but where there’s a will, there’s a way. |
Next year, Sullivan expects the main trend to be a general tightness in commodities, further fuelled by investors seeing them as an asset class. “Pension funds and other large investors sometimes invest in commodities as a hedge against higher government bond yields,” says Sullivan. In general, she believes, most commodities will move in the same direction, though some will be tighter than others.
Supply in agricultural commodities has been keenly affected by bad weather in 2010. “Sugar, for example, has had two years of bad harvests, with further troubles in loading capacity and infrastructure in Brazil tightening the supply,” says Sullivan. “Markets still await whether India may move to ease some of the tightness in sugar supplies. Wheat was troubled by weather conditions in Russia, which then had a knock-on effect on corn as a feed grain.”
Not all price drivers are natural – some are man-made. “Other reasons were purely statistical,” Sullivan adds. “The US had large crops and decent weather, so that some of this year’s crop was counted as last year’s harvest. And metals have encountered other tightening factors, such as mining capacities and under-investment making their impact felt.”
However, nature has asserted her influence on prices, even reversing some seasonal price patterns, which makes it hard to predict price movements based on historical experience.
“Normally, October, November and December contracts would show lower prices in grain, down to a ‘harvest low’, but due to those weather patterns, prices haven’t placed a harvest low when it would have been normally expected,” Sullivan adds.
Driving interest in commodities is also the expectation of inflation in some markets and the potential for stagnation or recession in others, she argues.
But there are other changes in the commodities market as well. “Crude oil, which used to look at the dollar’s strength or weakness, is now looking at the euro and dollar as separate entities, rather than their exchange rate,” says Sullivan. “The euro has come into its own as an indicator of European demand in some commodities markets.”
2011: year of the bull
Industry participants expect similar trends to rule the commodity sector in 2011. “The big theme for us in 2011 is agricultural and soft commodities such as corn, wheat, orange juice, sugar, cocoa and coffee,” says Giles at GFI. “We expect global food prices to be volatile – as opposed to increase – in 2011, driven by the basics of supply and demand.”
Sullivan agrees: “Key market drivers are the potential for inflation and the unsolved question of the integrity of the euro, which contributes to overall volatility, especially in metals and oil, which then influence other commodities.”
In addition, she says, the tight commodity markets are especially vulnerable to further weather disruptions. Growth in commodities will come from China, India, Latin America and Vietnam, she says.
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%20webbed.gif) EXPERT FORECAST - Lee Griggs, president, Orc Software EMEA
Vendors will step up to tackle tech risks as volumes rise
As we move into 2011 it is evident firms in the major European markets are focussing on consolidation and cost-cutting measures to set them in better stead for 2011 and 2012.
In 2010 the markets slowed down significantly as regulatory uncertainty and a lack of volume impacted profitability for some market participants.
The general trend throughout 2010 has been one of caution. A necessity for reliable solutions from longstanding and proven providers has become increasingly important in a climate where it is costly to risk moves into the unknown. New technology, be it internal or external, carries significant risk, one the markets this year have not been sympathetic to.
In 2011 I expect to see volumes increase and the markets slowly become more stable. Firms may start to move from cautious uncertainty to a more positive approach.
I therefore expect to see more new business start-ups, and that these and established firms will look to vendors to provide market-leading technology which is available deployed or as a service.
The evolution of technology is vital in this competitive industry, and the ability to provide out of the box, functionally rich products but also customisable components which give firms full flexibility to enhance and expand is crucial.
Coupled with this, it is evident that exchanges are placing greater focus on managing and protecting against technology risks and the cost to keep up is significant. Accordingly, longstanding vendors will continue to use their experience, existing depths of resources and market expertise to ensure they are able to meet these requirements. |
Sucden also expects that exchange-traded commodities and exchange-traded funds will attract more interest, as more funds are expected to open. “But at the same time,” Sullivan says, “this growth may be more democratised, as a lot more retail investors are getting involved. Information on financial markets is becoming more available – in theory, retail investors can be more informed than ever.”
Commodity boom reaches headhunters
With most banks and brokers agreeing that commodities are going to be an even bigger part of derivatives markets next year, experts in this field rank high on the recruiting wish list.
“Over the last 12 months a key trend in oil has been the banks and trading houses seeking to develop their refined products businesses,” says Douglas Ferguson, a director specialising in commodities at financial recruiting agency Webber Chase in London. “We have seen a strong demand for both physical and derivatives traders across fuel oil, distillates and light ends.”
Agricultural traders are just as hot a commodity as the resources they trade. “Due to the huge surge in wheat prices this year, there has been a frenzy of hiring across agricultural trading desks globally,” says Ferguson. “In Asia, many firms have been developing trading capabilities in oilseeds, palmoil and rubber.”
Metals specialists are just as much in demand, especially those who trade copper and aluminium. “Several investment banks and trading firms have bought warehousing businesses in order to take delivery of metals which has resulted in a significant increase in demand for physical metals traders.”
New products like iron ore derivatives are already being felt in the job market. “Many of the more innovative firms have poached teams of physical iron ore traders with the intention of developing global paper trading platforms,” Ferguson says.
Looking ahead, lead, nickel and tin may be the in-demand specialisms in 2012, Ferguson reckons, as firms try to capitalise on opportunities in less saturated markets.
Hiring trends are also shifting towards sales, and away from headhunting star traders. “Anyone [in sales] with a large portfolio of clients that is easily transferable is particularly valuable, due to the perception of guaranteed revenue,” Ferguson believes. “Unlike traders, which have been limited due to the Volcker rule [curbing banks’ proprietary trading], salespeople are viewed as low risk and are therefore highly attractive hires in such an uncertain financial climate.”
Another hot area identified by Webber Chase is eastern and southern European power, where energy trading firms have made a spate of hires, in expectation of deregulation in Turkey and the Balkans.