Prepare yourself for a enlightening journey into the world of derivatives clearing, where rising interest rates are opening up new avenues of growth. Join our host, Jim Jockle, for an engaging and comprehensive discussion along with expert insights from Acuiti's head of research, Ross Lancaster, and Udi Sela of Numerix. All three explore the revitalization of revenue streams for firms and the potential for the derivatives industry.
Prepare yourself for a enlightening journey into the world of derivatives clearing, where rising interest rates are opening up new avenues of growth. Join our host, Jim Jockle, for an engaging and comprehensive discussion along with expert insights from Acuiti's head of research, Ross Lancaster, and Udi Sela of Numerix. All three explore the revitalization of revenue streams for firms and the potential for the derivatives industry.
Welcome to Trading Tomorrow, navigating trends in capital markets. I'm your host, jim Jockel. In my decade plus of working with numerics, a global leader in capital markets risk management technology, I have launched our thought leadership division, a place where insights, innovation and expertise converge, just like this podcast. Through my journey in the financial realm, I've had the privilege of witnessing firsthand how the capital markets landscape has transformed the complex dance of market trends, and innovative technology has redefined how the finance industry operates. With game changing innovations just around the corner, we now stand at a crossroads, one where it is more crucial than ever to understand the interplay between these realms. That's what we do here. We talk about current and future processes and technologies you need to be aware of moving forward.
Speaker 1:Survey conducted by acuity found sell side derivative clearing firms are expanding their memberships and expecting more completion in the market as interest rates rise, adding hundreds of millions of dollars to global revenues. But what will this mean, and can you get in on it? And joining me for this discussion, we have two guests today. First, ross Lancaster is head of research for acuity, the company launched in 2019 with the goal of providing increased transparency to operations across the global derivatives market. Since their launch. They've expanded their audience to over 3,500 senior derivative executives. Ross is the former global capital derivatives editor. Also joining us today is Udi Sella, currently a senior VP of product and field marketing at numerics. Udi has been very active in the derivatives industry for the last two decades. First is a derivatives trader at city and JP Morgan, then in product management roles at leading financial vendors. Ross, let's start with you. I found the report the growing opportunity in derivatives clearing to be illuminating. For those of you who might not have read it, can you just provide us with a brief summary of the findings?
Speaker 2:Yeah, sure. So this was a report that we undertook in spring and summer of this year, when most of the clearing industry had been operating in a rising interest rate cycle for about a year, and while this dynamic has obviously had mixed effects across finance as a whole for futures commissions, merchants or FCMs, as I'll refer to them from now on it's had one clear benefit, and that is the return of net interest income on client margin as a revenue stream. We can talk about this in more detail later, but the bottom line is that this has rapidly improved the economics of clearing to the extent that income firms now looking to expand and other firms are considering entering the space, and that trend is what we set out to explore with this report.
Speaker 1:This is positive and a big change from the past few years. Can you explain why?
Speaker 2:Yeah, so before the near decade of zero interest rate policies that would just come out of the net interest income the FCMs earned on client margin was significant. The estimates put it at between one quarter and one half of clearing firms revenues. And that got wiped out when the major central banks started cutting rates towards zero after 2007-08. Now that obviously hit FCMs hard, and their pain was then compounded by the reduced volatility of that period, which lowered volumes in many previously profitable markets, such as interest rate options. Those conditions led many firms to cut their commissions in an effort to capture market share and that ultimately led to lower revenue across the industry. These dynamics had such negative impact on FCM business models that many pulled out of the industry altogether. But now, with interest rates as well as volatility rising over the last year, those two negative forces are reversed and that has boosted the FCM business model.
Speaker 1:Why are interest rates considered to be a positive factor for businesses in the derivatives industry?
Speaker 2:Show some surprising. Interest rates have required adjustments from the zero just rate period across financial markets. As we seen over the last year, that's led to significantly higher levels of volatility and increase trading volumes, which is good for the derivatives industry as a whole. That includes FCMs, which have also benefit from the lift to net. Interesting and the revenues that they're now enjoying, which come about with very little change to existing business models, so high that they can now consider investment or even acquisitions that would be hard to justify during the last decade.
Speaker 3:For me, markets always kinda have two dynamics right or two main motivations for moves. One is green and one is fear. When you just rate, we're hovering around zero. For people that need the festival, that will not many market opportunities to actually put on trade, ideas and trade, and the other thing that will not be. There are too many reasons to hedge against the rising rates Because basically the central banks provided a free option and this changed. So, right, we had the covid and then we had the still have, unfortunately the war in Ukraine and then inflation. So basically the central bank, starting with the fed, woke up a little bit late. So then they needed to be really aggressive in terms of hiking rates and that was kind of a global phenomenon. And since this happened, basically people started needed to put some festival to hedge against, you know, a floating great risk and then also that was also a market opportunity. We've seen recently that you know, very large investors in the US were shorting the 10 years. So again, uncertainty, fear, greed, hedge, and this is good for us.
Speaker 1:Ross, it seems like you agree.
Speaker 2:Yeah, definitely, and you know. You only have to look at the, the figures for kind of volumes over, you know, since 2020, and how much those have increased massively from from the last decade, year on year, to agree with you these point well, how might the reversal of a decade long decline in the number of futures commissions, merchants, fcms, impact the overall derivatives market?
Speaker 2:So, as mentioned earlier, you know, one of the results for lower interest income and volumes was the exit from clearing market by some FCMs and consolidation between others. This wasn't something that just happened at the margins. The total number of FCMs globally has fallen from 170. Before the 2008 financial crisis to 70 today, so really material change. And that's reduced competition in the sector, obviously, but now to the extent where many would be clients can calling out for more FCMs, and the hope is that more FCMs will then help the industries a whole to Handle the rise in volumes that we've just discussed in a cost efficient way, as well as mitigating concentration risk. For my perspective.
Speaker 3:So, with regards to the FCM, so I do understand the consolidation and, when you think so was clearly mentioned the fact that need to cope with the rising volumes right, but I also think that as an FCM and this is also true for clearing houses you can either, you know, add more products, add more clearing houses, or offer more value add solutions, just like drone camp, mentioned from the town systems.
Speaker 1:What would some of those value added solutions be?
Speaker 3:In my opinion, it's mostly about optimization tools Where's the best place to clean, Where's the best place to trade? So basically getting more return on each bucket that I trade. So some of that gap can be filled with technology Absolutely and in fact, we do see vendors out there and there's a lot of demand from clients for decision support tools in this area, so I think it's a massive opportunity.
Speaker 2:Ross, how about you? Yes, definitely, and the rise in interest income that we've been discussing so far is also going to support that, because there's cash available for investment in technology in a way that there hasn't been for the last decade for many, many players.
Speaker 1:How do you think the increased competition in the derivatives clearing market can influence the overall market dynamics?
Speaker 3:First of all, I think it's good for the market and I think it's good for the players, and I think that we can expect competition on prices, we can expect competition on services and also about in terms of more markets to address. So I think, all in all, I see this as a positive development for anyone in trades.
Speaker 2:Yeah, Our research is showing that rising interest rates and the effect on interest income isn't the only poor factor for expanding or joining the FSC space at the moment, and actually 95% of the clearing exectives that we surveyed were increasing the number of clearing memberships in the back of increasing volumes in specific exchanges or regions, and it's a very interesting tilt to emerging markets, so it could lead to increased access to markets like China, Brazil, Mexico and Poland.
Speaker 2:I think another interesting point is that we're also, like our research indicates, that we're likely to see more firms that made their names in other markets branching into the FCM business. So names that you usually associate with cryptocurrencies or retail brokerage may well be coming online and then offering clearing for more tradfire products in the next couple of years, and that will increase the diversity of FCMs, which will be a good thing. Why is that, Ross? If you look at so I can take cryptocurrencies it's probably the best example. Obviously, you've had a couple of years where they've been in the limelight and lots of people have been looking at the big returns you can get there. Those returns have become under a bit of a challenge in the last couple of years For a variety of reasons, one of which is, you could say, rising interest rates. So those business are having to diversify and branch out into other offerings.
Speaker 3:For people that work with specific FCMs, the fact that they branch out into more clearing houses, more markets, basically means more markets to trade and more opportunity, and this is really positive. So you can express your view in a specific economy. Now you have the access and you feel secure and everything all your margins are kind of managed in one place. So this also gives you operational efficiency.
Speaker 1:How hard is it to make a jump like that?
Speaker 3:So this is why I think the entry by areas are pretty high in terms of cost, in terms of training personnel, in terms of understanding the local regulation for market if you work with it. So, yeah, definitely it represents more cost, for sure, but then hopefully the opportunity for the FCMs to have the clearing houses also increases and then you get more volumes. So always, you know, one of the biggest problems when you trade in markets is the liquidity. The more international players that you get and work in local markets, it adds and contributes to the liquidity which in turn reduces volatility and gets you debt. So typically international investors like to invest in markets. That you know. We always say easy to get in, but how to get out? That you can also get out of the position. So, like, liquidity is super important. So the more FCM branching into more markets, the better it is for the trading community.
Speaker 1:Higher interest rates could lead to operational challenges for FCMs. Can you explain what some of these challenges might be and how FCMs could address them?
Speaker 2:I wouldn't say kind of necessarily that higher interest rates per se present specific operational challenges. But you know, for anyone setting up an FCM business looking to clearing the operation or barriers are very high. You've got issues to consider like technological connectivity, license fees with vendors, legal fees. You know, as Udi just touched on, these are all considerable sunk costs that any entrant will have to take on and it can be a multi-year process of onboarding onto new exchanges and CCPs. Beyond that, firms then also have to train their staff in the different processes at different CCPs and allocate resources for default fund contributions and other upfront costs. Also, adding new asset classes will require integrating new risk management systems that are built for those markets. So yeah, the costs are considerable and Udi how about?
Speaker 3:you. The only thing I would add is what Rust touched at the beginning. So we spoke about rising interest rates. I think what's more interesting is just the fact that the interest rate rise. It's more about rising volatility, because rising volatility means rising uncertainty, which is basically the drive of the most training decisions. We always say you know, vote is good. Can you provide an example of?
Speaker 1:how technology could help FCMs optimize their operations in a changing market.
Speaker 3:Yeah. So I think this is not just you know for the topic of our session today. From the, let's say, 80s to, perhaps you know, a few years ago, the focus was really on getting you know front to back workflow picking and covered. And now what people are looking to use technology for is really improving the decision making. So, from our conversations with our clients, with our prospects, with our partners, et cetera, or just peers in the industry, it is really about decision support tools. So in the case of and this is also mentioned in Ross's article right, how do I optimize, how do I use my collateral in the most optimized way? What is the best allocation? Is it by cash? Is it government bonds? Is it corporate bonds? Is it something else? What is the right proportion of each? In which markets should they actually use that? How can I? Because everyone is not.
Speaker 3:We see that you know, since the subprime crisis and the regulation that came afterwards, that everything that has to do with regularity, with regulatory capital for banks, the requirements are increasing. As you know, the regulators don't want to bail out banks anymore. Everyone is tied on regulatory capital. So any, even you know, marginal savings that one can apply are very much well received and this is where I think specifically banks but not just banks are reaching out to technology vendors looking for solutions to optimize that. To me, that's really critical and this is why I see technology coming here and helping. And then also remember, if you are trading in multiple, multiple markets globally, this is a big operational hassle. You deal with different currencies, with different products, with different markets, with different regulations, so you need that, you need to manage this operational risk in the most efficient way. And again, this is where vendors kick in.
Speaker 2:Yeah, I completely agree. I think the importance of collateral optimization you know one other my part of the technology stack I'd point to ties into it. He's got an earlier point on kind of volatility and how fast moving today's markets are. If you know, the need to hedge off and on an intraday basis means that kind of risk management systems that are able to move away from end of day calculations and towards that kind of intraday monitoring I think are gonna become very important. As I said earlier, people now have cash on the back of the rising interest rate dynamic we just discussed and the opportunity to finally invest in these sort of systems has arrived.
Speaker 1:We've come up to the final question of this podcast, the one that I find to be the most exciting. Ross, this question is for you. If you could only track one trend for the next few years, what would it be and why?
Speaker 2:I think I'd be very interested in seeing how the balance of OTC and exchange-traded derivatives develops in the next few years. Regulators have taken steps over the last decade to make OTC trading more onerous since the great financial crisis. Recent research that we've done elsewhere suggests that some firms, such as ProcTrade, are actually increasing their use of these markets. How that develops will be a very interesting narrative to follow. Udi, how about you?
Speaker 3:I'm not sure that it's tied a little bit tied to what Ross said. I think that we would see banks moving away from market making for vanilla products. I think that the market making would come off on the buy side, the likes of Suscahana Citadel, etc. I think there will be much scrutiny again, with banks focusing on trading businesses which generate high returns and moving away from low margin business unless you have the economies of scale and then it works. So for me, these are the trends that I've kind of seen.
Speaker 1:I'd like to thank you both, Ross and Udi, for joining us on this conversation. Coming up next week we'll dive deep into the world of virtual reality trading desks. Get ready for a Don't Miss episode. But first, if you enjoy the podcast, make sure you hit the subscribe button, Leave a comment, a like and check out our other episodes. Thanks for joining.