Rebuilding the broken futures commission merchant paradigm

The futures commission merchant (FCM) model is broken. The $5.5 billion industry is in dire straits. Once considered a low-risk activity supported by initial margin and daily mark-to-market calls, clearing today is a capital-intensive and ‘returns-challenged’ activity

The clearing operating model is an anachronism compared with the massive amounts of exposure and risk flowing through FCMs’ books. On any given day, an FCM extends unsecured credit to its clients, hoping the advance is eventually covered. In today’s world of leverage, volatility and geopolitical uncertainty – in which tens of billions of dollars of margin moves every business day – the ‘cheque is in the mail’ approach cannot survive.

Beyond spiralling concern about the risk profile of today’s FCM modus operandi, the baseline running costs have increased dramatically since the onset of the global financial crisis in 2007–08. Many FCMs find themselves with little or no margin for manoeuvre in the face of additional charges and hurdles arising from capital reforms introduced under the Basel III framework. Making matters even more challenging are the growing costs of running the day-to-day business of an FCM, driven by the imposition of new regulatory and reporting requirements in many jurisdictions.

Against this backdrop, many FCMs have thrown in the towel, either unwilling or unable to recalibrate their risk, pricing and business models to accommodate this rapidly changing context. Attrition among FCMs is driving an alarming concentration of exposure – and therefore risk – among the largest FCMs. According to recent statistics published by the Commodity Futures Trading Commission (CFTC), the top five clearers in the US held 68% of the $288 billion of client margin for futures – and an even more concentrated 82% of the $146 billion for cleared swaps. The status quo is not sustainable and urgently needs to evolve.

The model needs to move to a new paradigm in which both the velocity of margin-related movements and the model itself must be radically redefined. This transformation needs to occur on a massive scale, drawing on the latest developments in the technologies that support network communications, cloud computing and risk management. This transformation also needs to call into question the modus operandi of the clearing model itself, starting with how clearing houses interact with the broader clearing ecosystem.

Networks are power

Just as nature abhors vacuums, banks abhor unsecured exposures. By nature, the sequencing of margin and payment cycles results in the creation of unsecured exposures between the FCM and its clients. Central counterparties (CCPs) demand and obtain quasi-immediate payment for intraday and overnight margin calls based on the direct debit authority they exercise over their members’ funding accounts.

Against a CCP’s ability to immediately collateralise its members’ exposures, an FCM waits at least overnight – if not longer when taking into consideration time zones, holidays and weekends – for its clients to perform on the payment of their margin obligations. Why the wait? One need look no further than the antiquated, batch-based networks underpinning global clearing that serve to perpetuate and exacerbate the exposure and capital-related issues that have driven many FCMs to the exits.

Breaking away from legacy processes and protocols is within the reach of any FCM seeking to reclaim control of the risk-capital nexus in derivatives clearing. Distributed ledger technology (DLT) – which has seen dynamic evolution over the past decade that has been surprisingly underrepresented in today’s market infrastructure space – could transform a static, multiday exposure to an on-demand workflow resolved over the course of several minutes. This would be a major step forward for FCMs in dynamically managing their risk topologies, capital footprints and business models.

A permissioned distributed ledger is a network over which data is transparently shared and replicated in a synchronous and irrefutable manner among an ecosystem of authorised participants or nodes. In addition to data, distributed ledgers also enable shared workflows, allowing permissioned nodes to interact with the data and affect state changes, which are immediately acknowledged, shared and made visible to all other permissioned network participants.

The benefits of applying DLT to the proactive management of unresolved margin exposures between an FCM and its clients are significant. This innovation could be applied to dramatically increase the mobilisation and velocity of margin collateral and the resulting impact to the clearing paradigm. In its simplest form, a distributed ledger servicing the movement of margin would require three nodes: the FCM, its client and the CCP.

On receipt or in anticipation of a margin call, an FCM would be able to immediately initiate movement of collateral, whether in the form of cash or securities, to cover the new payment obligation – not in hours or days, but in minutes. This would empower the FCM to cover its CCP exposure in near real time. For the first time in the history of central clearing, an FCM would be able to demand and receive – hence covering its exposures – with immediate effect. The FCM will also be able to act quickly if faced with a client unable to cover its margin obligation – radically changing the risk, credit and, potentially, capital profile of its business. 

Baton Systems has proved that DLT can successfully operate for on-demand, riskless foreign exchange settlements with legal finality. By extension, this logic can be applied to dramatically accelerate the payment and settlement of obligations – and hence exposures – between FCMs, their clients and CCPs. By defining these actors as nodes in a permissioned distributed ledger environment, the benefits of non-repudiation, transparency, speed and auditability could be harnessed to deliver significant economic value to an industry in dire need of a way forward.

The disappearing FCM?

Imagine a world without FCMs stepping in to intermediate the credit and risk exposures that arise from the activities of their clients in listed and cleared derivatives markets. This world is not only conceivable but is becoming reality in listed cryptocurrency markets, a development that, in the foreseeable future, could morph into a new paradigm for cleared derivatives markets.

In March 2022, FTX US Derivatives, a derivatives clearing organisation (DCO) registered with the CFTC and, already operating a direct clearing model based on 100% collateralisation, applied for authorisation to amend its DCO licence to allow direct clearing of margined products – currently the exclusive domain of FCMs – to its participants. While focused on retail participants today, it is conceivable that, if approved, this streamlined crypto experiment could eventually be extensible to wholesale participants in listed legacy derivatives markets.

The foundational premise of the streamlined margin model resides in the exchange’s technical ability to continuously calculate and directly action margin payments with immediate effect. While CCPs have the ability and authority to assess intraday variation margin, collecting and applying it is a protracted process that results in unsecured exposures over extended intervals at the FCM level – while good for the goose, it is not good for the gander.

The FCM remains the weak link in the chain as the risk of default of a given client – while arguably remote but very much a plausible outcome – leaves the FCM, its clients and the broader clearing infrastructure shouldering the risk and potential cost of a default occurring. Near real-time exposure and margin calculations – alongside the actionable and immediate ability of the exchange to collect margin directly from market participants and to liquidate under-margined positions partially or entirely – can create a safer, more robust environment for cleared derivative markets. The vision of FTX US Derivatives, combined with a bold stance by its regulator, the CFTC, will open the door to a new age in cleared derivatives risk management.

Markets today operate under the uncertainty of unprecedented socioeconomic, environmental and geopolitical concerns, which translates into the continual risk of rapid emergence of extreme market outcomes. In considering the impulse and dynamics driving the growth of cleared derivatives markets, it is clear that, without fundamental changes to the models and technologies underlying the management, movement and settlement of the hundreds of billions of dollars of risk moved daily through cleared markets, a very big problem is only ever one volatility spike away.

There is no single solution, panacea or ‘big bang’ that can right all that is wrong with market infrastructure today. However, there are very clear, viable options and entry points available to the market and its participants that act to deliver the security, enhanced control and immediacy required in today’s market environment. The potential to dramatically increase the velocity of margin collateral among FCMs, their clients and CCPs, and the proposed change to margined derivatives models to allow direct clearing and margining of exposures between exchanges and their participants, are two very compelling and exciting opportunities on offer.

These changes will pave over the furrowed paths that have defined cleared derivatives for decades. They will require open minds, innovative spirits and thought leaders from the fintech, FCM, CCP and regulatory communities to create a cleared derivatives ecosystem capable of standing up to the challenges of the 21st century.

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