The growing opportunity in derivatives clearing
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Ali Curi: [00:00:00] Markets conversation is a new ION podcast where we discuss topics of importance to capital market participants with product owners, subject matter experts, and industry leaders. 

Will Mitting: One of my first bosses once said that I was like a dog that no matter how much he knocked me back and said no, I always kept coming back, which at the time I was pretty offended. 

Having run a startup now for four years, I think, "acting like a dog," is actually a pretty good, pretty good philosophy when it comes to building and growing a business. 

Ali Curi: Hi everyone and welcome to Markets Conversation. I'm Ali Curi. On today's episode, Bruce Roberts from ION Markets and Will Mitting from Acuiti will discuss how firms can best take advantage of emerging opportunities in derivatives clearing.

Since the financial crisis of 2008, the FCM market has undergone remarkable transformations, adapting to new regulations, market volatility, and advancements in technology. Our guests today, will shed [00:01:00] light on how these changes have shaped the FCM industry's resilience and have provided a foundation for growth.

Bruce Roberts is part of the global management team in clear derivatives and global business development at ION. Will Mitting is the founder and CEO of Acuiti, a research platform that provides insights and operational trends on clear derivatives. 

Let's get started.

Bruce Roberts, welcome back to the podcast.

Bruce Roberts: Hi, Ali, great to be back.

Ali Curi: And also no stranger to the podcast; Will Mitting, welcome back. 

Will Mitting: Great to be here. 

Ali Curi: Bruce, let's start with you. The 2008 financial crisis was devastating to every industry, but particularly to the financial industry. Can you share some background on what happened and what were the major challenges faced by FCMs during the crisis?

Bruce Roberts: Reflecting back to the 2008-2010 period, the financial crisis was driven by cheap credit and [00:02:00] lax lending standards for mortgage lending that fueled a housing bubble. As interest rates started to rise, it led mortgage holders to default on their payments. And this led to significant lack of confidence in the quality of the products that have been used to securitize these mortgages.

Such as through mortgage-backed securities, asset-backed securities, collateral debt obligations to name a few. As holders of these products started to realize the poor quality of the underlying mortgage assets, it drove many institutions to the wall and default as they had to write off billions in losses.

Some of these firms were allowed to fail, such as Lehman's and others were taken over by larger firms such as Bear Stearns being acquired by JP Morgan. The response by governments and central banks was to drop interest rates to near zero or negative in some cases, to prop up their economies and use quantitative easing to stimulate economic activity. So the crisis also led to a host of new regulatory reforms that were [00:03:00] known as Dodd-Frank in the US or Amir in Europe, along with a number of changes by the Bank for International Settlements on capital requirements. So the impact to FCMs post the crisis was driven by the ultra low interest rate environment and increased capital and regulatory requirements.

So all of these meant the cost of the business increased while revenues were shrunk with one of the key revenue streams of FCMs being driven to near zero. And some estimates suggest that, one quarter to half of an FCM's revenues are driven by net interest income earned on client margins. So the resulting outcome was for a number of FCMs to exit the industry or look to merge as it was no longer profitable for the capital allocated to the business.

So quantifying, this impact FCMs can be seen with the total number of FCMs globally falling from somewhere around 170 before the financial crisis to approximately 70 today. And with smaller [00:04:00] FCMs in particular pulling out of the market. 

Ali Curi: And now, after a decade of struggling, the economics of the clearing business have rapidly improved. How has derivatives clearing become a growing opportunity? And what are the potential benefits for market participants? So simply put, why do we need more FCMs? 


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Bruce Roberts: It's been highlighted with the decline in the number of FCMs in the market post the financial crisis that concentration risk exists. So the existing firms have become larger with the amount of clearing volume that is undertaken by these firms.

Overlay this with central banks' recent actions such as, the Bank of England, who are using aggressive interest rate policy to tame inflation with a succession of interest rate increases over the last year. It's changing the dynamics of the market and the base rate for the Bank of England is now 5% as of last month.

It's expected for the bank to increase by another one quarter of a percent [00:05:00] tomorrow, which will bring the rate to five and quarter percent. So the increase in interest rates not only here, but globally, by central banks is leading to significant increases in revenue and profitability for FCMs. There's also the view that interest rates are not going to return to the ultra low rates we've seen in the last decade.

So this provides firms with some certainty to revenue opportunities, and if they looked to enter the market, there's some confidence in the opportunities now being created within clearing. It's still early days, but it feels the pendulum is starting to swing back to more firms looking to reenter the market as FCMs.

I'm not seeing traditional banks in that, but interest is growing in a diverse range of companies, including crypto retail brokers and also institutional brokers looking at specific areas of the market such as commodities or markets such as China, Brazil, to name a few. The additional competitions, it's healthy for the market [00:06:00] and it also helps provide additional alternatives to market participants and a potential reduction in the concentration risk that's been highlighted.

Ali Curi: Thank you, Bruce. Now let's have a quick chat with Mr. Mitting. Hi Will.

Will Mitting: Hi Ali. How are you doing? 

Ali Curi: Great. Tell us about the report that Acuiti published. Who's your intended audience and what was the objective of your research? 

Will Mitting: So Acuiti provides insights into the global derivatives market. Bruce and I chatted out of the year really about doing a report, looking at the trends that Bruce just outlined, really trying to drill down into understanding how FCMs were responding to it, both in terms of their appetite for growth and expansion, their optimism and their, faith in the longevity of higher rates.

Insofar as they were able to make medium term decisions on business growth in the expectation that rates would remain high. So we wanted to really understand the impact that rising rates and indeed rising volumes, which we've also seen since 2020 was having on [00:07:00] both FCMs expansion plans, but also for firms that may have looked at the market previously, some brokers that maybe wanted to look at non-bank FCMs, some regional banks or tier two and three banks, that didn't have any or significant clearing operations currently. The understanding from them how the changing economics is changing how they view the market. So the audience of the survey was very much the sell-side community, but the audience for distribution was really the whole market.

I think also as Bruce alluded to and your question alluded to earlier to Bruce highlighting the need for greater number of FCMs to come in to reduce concentration risk, which is particularly evident in, certain markets such as proprietary trading and some of the smaller hedge funds.

Ali Curi: Okay. So now a two-part question. What does your research tell us about the possibility of growth or expansion in the FCM market domestically and internationally, and what are some of the key drivers of this growth? 

Will Mitting: I think as Bruce discussed earlier, the rapid change in the economics of clearing following over a [00:08:00] decade of near zero interest rates, I think caught a lot of people unawares.

And so firms have had to very quickly reevaluate their plans and see the opportunity for growth. So we see very strong appetite for growth, both among non-bank FCMs and banks alike. Of the incumbent FCMs that growth is predominantly adding new markets or expanding offerings in existing markets, maybe connecting to more exchanges in some of the markets they already cover. As I mentioned earlier, for firms that aren't currently clearing, it's about taking those early steps into clearing, and we'll come on a bit later to some of the challenges involved in that. But I think what interests me about the findings of the report is that the rising interest rates and volumes was only one part of the drive to expansion among FCMs with client demand and organic growth of companies.

Outside interest rates also featuring highly, actually featuring higher than the interest rate environment. Trading is becoming increasingly global. And clients are looking for multiple opportunities, whether that's arbitrage or whether it's new markets to, execute their [00:09:00] strategies or trade against an increasingly diverse portfolio of counterparties.

And so FCMs are responding, I think, predominantly to that in their expansion plans and seeking to, ensure that they're not missing opportunities as clients look for greater international exposures. 

Ali Curi: You mentioned there's significant room for more competition. What does more regional competition mean for the market?

Will Mitting: Bruce mentioned that quite rightly, that the number of FCMs had fallen. The headline numbers that are often quoted and indeed were quoted by Bruce, I think paint some of the picture, but not the whole picture. So what we've done some analysis on the concentration of FCMs over the years have found that once you strip out, if you go back, sorry, go back to 2007 with I think the 160 FCMs registered at the CFTC, actually a lot of those didn't have any significant client balance. A lot of them didn't have any client assets held. Some of them were multiple entities of the same organization who may have had an FCM license for the house business and FCM license for the client business.

So you've seen the consolidation, which [00:10:00] has obviously reduced the number of FCMs, and you've also seen some small FCMs drop out the market. But that is quite overstated, we think, in terms of how many significant, how many FCMs are actually providing end user service have pulled back is far smaller than the 160 to 60, the implications of a drop of a hundred firms.

However, there has been a drop, and I think that the point we've reached now is the number of FCMs as the trends that we've been discussing come to the fore. But what we see is there are certainly, and we'll come onto it, new FCMs coming into the market, but one of the trends that surprised me is the level of expansion from FCMs into regions.

So you see European banks looking to gain new memberships in places like, in new markets like Saudi Arabia, but also to expand their offerings in Asia. So, I think you're gonna see a lot more regional competition from existing FCMs. So historically, if you looked at some esoteric markets in Asia, you probably only had two or three major FCMs that provided access to those markets.

The others would go through either those FCMs or through local clearing [00:11:00] firms. I think what you're gonna see is a greater coverage of memberships from tier two firms, and indeed increasingly tier three firms. So you're gonna have the same firms offering more markets, which is gonna create, I think, price pressure in terms of access to regional markets, which obviously will increase competition and probably increase flow to those regional markets.

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Ali Curi: Will, as high interest rates are a key component of FCM profits, right, known as interest income. What does your research tell us about the confidence level [00:12:00] that increased interest rates may now lead to the creation of new FCMs? 

Will Mitting: We've found certainly in the survey, that the majority of people thought rates would remain high enough for to make medium to long-term decisions on expansion.

And so far we've talked a lot about the expansion of existing FCMs, but one of the interesting things we picked up was the nascent at this stage, but growing demand from new firms to come in and become FCMs. And if you look historically, that has happened. You have seen that since 2008, despite the poor economic conditions.

In the US for example, there's been four or five new FCMs that have registered in the real nadir of interest rates 2013 to and onwards. But they tended to be from a very distinct market. They were retail, brokers that were gaining FCM membership to offer clearing to retail clients in listed derivatives markets.

So that was almost unique trend in the US that led to that, the economic conditions where that was worth investing in. But now you see a diversity of firms. You have non-bank FCMs, or brokers looking to [00:13:00] become non-bank FCMs for specific markets such as, commodity markets where they maybe want to reduce costs and own more of the trade workflow by gaining one or two memberships. You still have the retail firms and retail brokers looking to replicate the trend that I alluded to earlier in terms of gaining memberships to offer a clearing to their retail clients. And you also have the crypto element, which while in something of a draw down at the moment, we expect to come back and that is exchanges becoming FCMs or exchange, that blurring of the boundaries between an exchange and the FCM, which clearly, has a regulatory uncertainty to it, to say the least, in the US currently. But you've already seen MYX Holdings by an FCM. You've seen CME without an application to run an FCM in response to the FGX proposal.

So I would expect to see that trend as well continue, perhaps not in the US because of the regulatory push back against that, but certainly elsewhere that blurring of the boundaries with exchanges also playing a role in FCM membership because for them it makes clear sense [00:14:00] that they can bring products to market quicker and then they can prove the success of some products without relying on their FCM clients, their clearing clients to wait for client demand and to invest in the post-trade works which required often to onboard a new product.

Ali Curi: So currently in the US we have high interest rates. We also have central banks signaling that higher interest rates may come in the near future. According to what you said earlier, it also means the possibility of the creation of new FCMs. If this is the case, what might be some barriers to entry for them?

Will Mitting: So I think there's three, three major barriers. The capital requirements clearly is the big one. The operational costs and the cost of capital of running an FCM are enormous and unlikely to go away anytime soon. So capital's one major barrier to entry. Then you also have the difficulties in the acquisition strategy.

I think if you are looking to set, if you are a tier two bank looking to set up a new FCM. You can either grow it organically or you can do it via acquisition. Because, in part because of the [00:15:00] reduction in FCMs over the last 15 years, there were very few clear acquisition targets that a tier two or three bank could look to, to get a kind of ready-made FCM and get, accelerate their growth into the market.

So that leaves organic growth and the incremental build. Which comes onto the technology question, which I'll hand over to Bruce, but I think one of the key barriers we picked up on was the investment or the technology requirements remain high. And firms are looking for a lower cost, lighter touch option in order to get into the market.

Ali Curi: Bruce, let's tackle the same question. What are your thoughts on any barriers to entry for FCMs? 

Bruce Roberts: So Will's perspective on acquisition versus organic growth is similar to mine. I think that the challenge to, acquire, another FCM is very challenging, so most firms are gonna go down the organic growth path from what I can see.

And, because of that, drilling into that technology [00:16:00] requirement that many firms are gonna need to tackle, and it's a challenging obstacle at times for various different reasons. Some of those are the internal decisions of build versus buy. It's also the expertise in clearing and risk to operate the systems as well as the capacity to manage the implementation for, clearing, accounting and reporting systems. So for FCMs, wanting to act rapidly and to get set up, there's several product companies to work with in the market to accelerate that journey into clearing. I would suggest, a strong partnership with an external party needs to really be based on your clearing objectives and the product firm, their understanding of your business requirements.

So in support of this, I'd always, recommend more analysis upfront to your requirements, which will cascade throughout the project implementation and achieve better results for any new FCMs moving into clearing. 

Ali Curi: What would you [00:17:00] say about regulatory factors to consider? Do you have any concerns over any new rules that may discourage firms from gaining clearing membership. What advice would you give new entrants to navigate the complex regulatory environment and manage the risk effectively? 

Bruce Roberts: Challenges on the regulatory side are always important factors to consider. The cost of capital that Will alluded to earlier, required by an FCM places pressure on existing firms and creates a hurdle for any new firms looking to enter the market.

And I commented a little bit about those earlier, but the regulation and capital adequacy rules are largely in place by clearing houses with Dodd-Frank, Amir, and Basel over the past decade. So we may see regulators tweak these rules such as highlighted by the regulators, looking at the proposed Basel III Endgame capital rules.

But this would raise the bar for capital requirements of banks with assets over a hundred billion dollars. So [00:18:00] this is still to be iron out to what the final rules will be, but I would suggest underlying economics in the clearing business as markedly changed and this is gonna drive competition and firms will look to selectively enter the market even with the regulatory requirements.

Ali Curi: So share with us your thoughts on considerations that perhaps didn't come into play, say 15 years ago. For example, ESG considerations are gaining momentum in the financial industry, and cryptocurrencies are becoming a legit asset class. How do you see ESG crypto or even geopolitical unrest as factors influencing the FCM market in the coming years?

Bruce, let's start with you and Will, I would love to hear your take on this as well. 

Bruce Roberts: So the move to greener technologies in crypto, they've been influencing and shaping investment decisions over the last decade. The future's markets are essential to companies in managing risk, improving [00:19:00] transparency, and also providing liquidity, which aligns with many of the ESG principles that are there.

As we see products aligned to these asset classes, which we do today, this growing trend that we're gonna see in the market for participants to invest and to trade in actively. Will, from your perspective?

Will Mitting: Yeah, I think I think ESG and Crypto both huge opportunities for clearing firms, but in different ways.

On the ESG side, you're seeing the conversion of a lot of existing benchmarks into ESG benchmarks, beginning with equity markets and obviously now moving into Fixed Income, so it's growing the overall pie and the overall choice for investors, which obviously is good for clearing businesses. Crypto is a bit more complicated. You currently have a deeply bifurcated market between onshore regulated and offshore regulated exchanges with CME EUREX offering some market share and some opportunity for FCMs and SIBO Digital in the US as well.

But ultimately, [00:20:00] FCMs are currently, the traditional FCMs, are currently predominantly unable to access much of the crypto market. Firms like Deribit, it's very difficult for them to offer access and obviously the clearing model in the native crypto market is very different to the clearing model in traditional markets.

But I expect that will converge over time. You already see and clearing houses coming on stream, offering institutional grade clearing for crypto markets. And I think FCMs across the world will be looking at the development of those ventures hoping that it will open up some of the market to them.

As we discussed earlier, there does need to be a lot more regulatory certainty, particularly in the US before FCMs can properly engage with that market and sees the opportunities. 

Ali Curi: Let's continue with you for a minute. What does the Acuiti Report tell us about technology's role in the growth of Derivatives Clearing?

What tech advancements have been particularly influential and which technology can FCMs leverage to stay competitive?

Will Mitting: Since 2020 and the volatility around the outbreak of Covid, technology has, [00:21:00] post-trade, has become a C-suite issue for many banks because we saw a lot of infrastructures were overwhelmed by volumes.

And it's an area that historically has been under-invested in by FCMs compared to the front office. But that has now changed in two years. I think that's completely changed. And you've seen vendors come out with new products with updated technology and also technology at different levels.

You have entry-level technology now available to new entrants to the market, which as we discussed, it eases the barrier or eases the process of entering the market. I think looking further ahead, I think blockchain technology will ultimately be a game changer for clearing and the ability to have a real-time mutable views of positions continue to create more and more efficiencies. 

Ali Curi: What were your report findings on existing FCM plans to invest in new technology from, say a third party to support the growth of their clearing memberships? And how did those decisions come about?

Will Mitting: So we found that 42% of firms were planning to invest with a third party to support their growth plans.

And I [00:22:00] think that is a fundamental shift that's occurred in the market over the past 10 years. Very few firms these days are going to be building everything in-house. I think the ease of development via third party, the mutualization of costs, the ability to get best-in-breed from a third party and crucially the lack of reliance on key staff who may have had an important role in building the technology is all driving firms to look to third parties. And at the same time the quality of third party offerings on the market has really improved dramatically over the last five years. Despite the fact that the relative competition and post-trade for derivatives for technology is limited compared to, say the front office.

You still see large amounts of innovation in the market. 

Ali Curi: Bruce, from your experience, what are the three most important requirements a newly formed FCM needs to consider when working with a new technology or technology product vendor? 

Bruce Roberts: So it is great question. Clearly entering any new business line, being technology driven as [00:23:00] clearing is, there's a big investment that has to be made.

And as part of that "build versus buy" decision is critically important. And one is really having a realistic expectation about the ability to execute on the build and not fail in doing that. And there's a lot of firms that start that journey and then aren't able to successfully deliver it.

The other, factors that I would consider really, if you're gonna work with a product firm externally, what are the front to back solutions that they provide in the ability to automate workflows for you to do, reduce your dependency on costly personnel and then the others, really, real-time risk management. With the volatility we've seen since 2020, it's becoming an ongoing market dynamic and the ability to manage the credit risk and your capital requirements is key. And then the final component I would've said is [00:24:00] really the flexibility to scale your business as you grow. And I believe the days of kind of one size fits all is not really appropriate for firms who have so many different requirements, as Will described, in terms of, looking at more regional or specific markets.

Making sure that the firms that they partner with can help them manage their technology cost effectively, but ultimately their entry into the market is key. It needs to be a long-term partnership if you go down this path and capabilities as a key decision within that.

Ali Curi: I wanna hear both of your takes on the following question.

What is the one big thing you hope listeners will take away from this episode? Bruce, let's start with you. 

Bruce Roberts: So there's a risk/ reward ratio for any investment or entry into a market. Clearing works on the same basis, and it's important to do your homework. I would've said before you embarked on this type of investment, that would be my advice. 

Ali Curi: And [00:25:00] Will, same question. 

Will Mitting: I think the key takeaway, I have both in the research and this podcast, is that there's huge opportunity in derivatives markets for the sell-side to come in and innovate and launch an FCM. I think there's just, yeah, the economics are great.

There's a huge demand for competition. So hopefully it will spur boardrooms to consider.

Ali Curi: And Will, where can people find your report that we've discussed today? Because there's much more in there that our listeners can learn from. 

Will Mitting: Sure. So reports available to download from the ION website or the Acuiti website.

Ali Curi: Bruce, I've asked you about career advice in previous episodes, but my question today is are there any specific habits or routines that have contributed to your success?

Bruce Roberts: I would treat your career as a marathon, if I can describe it like that, and not a sprint. So it's important to achieve success over time, but sometimes you may move sideways or take a step back.

Before you move forward again. So [00:26:00] I'd encourage being patient over that promotion or compensation adjustment for your longer term career growth. And I'm not saying, not to take risks, but if you're learning and growing, I think you can take a lot out of that and take the long-term view would be what I think's benefited me. 

Ali Curi: And Will, same question, are there any specific habits or routines that have contributed to your success? 

Will Mitting: I'm not sure it's a habit or a routine, but one of my first bosses once said that I was "like a dog" that no matter how much he knocked me back, and said no, I always kept coming back, which at the time I was pretty offended by, but having run a startup now for four years, I think that "acting like a dog" is actually a pretty good pretty good philosophy when it comes to building and growing a business.

Ali Curi: All right. I like it. Sounds like great advice Will. Bruce Roberts, Will Mitting. Thank you both for joining us again on the podcast.

I hope we see you again soon. 

Bruce Roberts: Thank you. It's been a pleasure. 

Will Mitting: Thanks, Ali. 

Ali Curi: And that's our episode for today. You can follow ION Markets on Twitter and [00:27:00] LinkedIn. Thank you for joining us. I'm Ali Curi. Until next time.