For a decade until March 2020, the dual headwinds of low interest rates and subdued volatility had a significantly detrimental impact on revenues for sell-side clearing providers.
During the last 12 months, rapidly rising rates have combined with sustained volatility and associated higher volumes in derivatives markets to create an abrupt reversal in the economics of clearing. For the first time in years, FCMs are pulling in substantial net interest income revenue from their clients’ margin, without having to adjust their business models significantly.
The question today is what impact this shift will have on the number of sell-side firms and therefore competition in the market.
The conditions of the previous decade have not just been detrimental for firms, but for the wider market too.
According to the CFTC register of Futures Commission Merchants (FCMs) the number of US entities registered has dropped from 151 in 2008 to 62 today. While these numbers are distorted by firms with multiple entities consolidating registrations and effectively dormant FCMs cancelling their registrations, there has been a clear and significant drop in the total number of firms offering services to the market. Globally, the total number of FCMs has dropped from 170 before the financial crisis to 70 today.
This is having a disproportionate impact on competition in some areas of the market. Smaller hedge funds and high-frequency proprietary trading firms in particular are facing limited choices for clearing providers.
However, a recent study by Acuiti, in partnership with ION, suggests that the tide is about to turn on the decline in clearing firms in the market.
In the wake of increased volumes and interest rates, incumbent clearing firms are expanding their offerings. Almost two thirds of clearing firms are planning to increase the number of memberships they hold in the next five years — driven by client demand and rising volumes, organic growth and interest rates.
Significantly, only 7% of respondents to the survey did not think that interest rates would remain high for long enough for them to expand their business with confidence.
And while existing firms are expanding memberships, boosting competition in more markets, new firms are also eyeing launches in clearing.
These firms are drawn from a disparate range of company types, from institutional brokers eyeing one or two memberships in specific asset classes, to retail brokers looking for broader access in a specific region.
In addition, Acuiti understands that discussions are underway at several tier 2 and 3 banks about developing clearing offerings.
Starting out in clearing is no small undertaking. Capital costs can be punitive and the time to apply for and gain memberships is extensive.
However, with few clearing firms on the market that could be considered acquisition targets, many firms will have to develop their offerings organically.
In this respect, firms will have to buy or build the technology required to offer clearing services. The survey found that firms experience significantly more difficulty in building in-house than in partnering with a third-party.
For firms outsourcing trying to accelerate entry into the market, some key product companies to the market, such as ION, offer entry level technology to give firms a rapid and cost-effective means of starting out in clearing, without the levels of investment and lead times associated with traditional full, scale builds.
Such technologies will be crucial to firms that want to enter the clearing business and scale up as quickly as possible, to latch onto the surging growth in interest income and hopefully build a virtuous cycle of investment and increased competitivity.
Download the full report here: https://www.acuiti.io/the-growing-opportunities-in-derivatives-clearing/
