FCMs: Fund Managers Swap One Cost for Another

Fund managers can no longer assume all is well in their relationships with their futures commissions merchants. As many face changing or even lost relationships with their FCMs, the big question they are forced to answer: What do we do now?

Their choices: either find another FCM, reduce the number of centrally-cleared swaps transactions they trade, or take over some of the operational workload the FCMs were handling. The bulk of that workload involves collateral management, pre-trade risk analytics, and market access.

FCMs, the financial intermediaries that have been providing a broad range of services in addition to trade execution and clearance, are starting to refuse to provide more than the basics unless a fund manager can prove its business is lucrative enough. Even worse for fund managers, some bank FCMs are exiting the swaps clearing business altogether, because new regulatory requirements have made the work unprofitable.

Discussion in fund management shops on how many FCMs to use, which ones, and how many operational functions to move inhouse has led to heated internal debates, buy-side swaps operations managers tell FinOps Report. Post-trade operations staff, trading desks, compliance departments and even financial units are all involved in figuring out the new costs of technological and operational changes — and whether they can afford it.

“We have decided to just use our FCM to execute and clear trades while doing the rest of the processing work on our own,” says the operations manager of one US fund management firm. Yet another operations executive says his firm has enough deal volume to negotiate a better contract — the same fees with more services –with its current FCM.

Fund management firms seem willing to deal with the higher counterparty risk that results from using fewer FCMs, if improved cost-effectiveness is the trade-off.  “Some of our fund management firms are relying on a single FCM to do all of their clearing and a back-up FCM in case of emergency,” reports Eleanore de Vial, product manager in London for the investment management division of Misys, a financial technology firm. “They don’t see the value of splitting their business among multiple FCMs, because with a single FCM they often can gain the lower initial collateral requirements involved with cross-margining.”

For fund management firms deciding what they can accomplish in-house effectively and what they must still outsource, numbers crunching becomes critical. They must not only calculate the costs of changing or adding applications and employees, but also determining how much business in the form of executed orders, custody or financing they have to promise an FCM.”Execution and clearing services go hand-in-hand, so FCMs will not want to offer clearing without being assured they will also retain the more lucrative execution business,” says Michael Barrett, vice president of Genpact, a New York based financial services consultancy.

The Tradeoffs

So if the fund management firm then promises its swaps trading activity will be reasonably high, will that be sufficient to guarantee a bank FCM contract? Not necessarily. The FCM business for banks has now become a seller’s market, so fund management firms may have to turn to a new breed of FCMs cropping up to eat the banks’ lunch.

“Non-bank FCMs, such as brokerage firms, recognize bank exits as an opportunity and have historically specialized in access to regional markets that clients need but global bank FCMs may find unprofitable to offer,” says Steve Woodyatt, chief executive for Object Trading, an independent market access provider in London. “Non-bank FCMs also have the flexibility to provide bespoke solutions to buy-side firms. Some brokerages further develop their own cross-margined products and risk management methodology for better pre-trade margin efficiency.” The result: buy-side firms can efficiently allocate their available capital and limit using additional collateral.

Collateral management is a necessary evil regardless of whether a trade is cleared through a clearinghouse or bilaterally — that is, outside of a clearinghouse. Granted, collateral management is more complicated for centrally cleared trades because of the extra party at the table –the clearinghouse which acts as a middleman between the fund manager and its FCM. However, trading only bespoke bilateral swap contracts isn’t always the ideal answer. They too come with a hefty pricetag in the form of new regulatory requirements for higher initial margins, which could offset the benefits of operational simplicity.

For smaller volume fund management firms that can more easily keep track of their inventory, and communicate with custodian banks holding their assets about transferring margin to the FCM, handling collateral management functions in-house might be an attractive option, according to Barrett. By contrast, fund management firms active in the swaps market might consider outsourcing some of the collateral management process to one of several large global and regional custodians offering the full range of collateral management services ranging from back-office mechanics to collateral transformation and optimization.

As reported by FinOps Report in May (“Outsourced Collateral Management: A Calculated Choice“), fund managers need to consider qualitative and quantitative factors before making a decision. Those include the size of the firm, its internal capabilities, the number of deals processed and whether it wants to outsource optimization and transformation, according to a study completed by Sapient Global Markets.

Insourcing for Profitability

“Collateral management is clearly now a component of the front-office investment process because of the potential for portfolio drag if the use of collateral is not optimized,”agrees Barrett. “Therefore, the question that must be asked is if there is anything to be gained by outsourcing optimization. In the case of collateral transformation, if the fund management firm has a repo desk, that unit might broaden its scope to collateral trading at a lower cost [than outsourcing].”

Other areas to consider for insourcing:  risk analytics and market access, which  are often provided by an FCM in conjunction with trade execution. There are plenty of software firms which offer pre-trade margin analysis, portfolio attribution and performance metrics so fund management firms don’t need to rely on their FCMs. Neither do they have to accept the market access service provided by their FCM, historically provided as a premium on the contract.

The reason  greater efficiencies may be found inhouse, says Woodyatt, is the patchwork used by FCMs of trading screens, coupled with proprietary market access systems relying on disparate data sources and methodologies for performing pre-trade risk checks. That scenario can prevent a fund manager from understanding its investment risk correctly, thus leading to suboptimal strategies and higher costs.

Woodyatt recommends that buy side firms take control of their market access, but not use a single vendor to provide trading screens, risk analytics and market access. His argument: the underlying technology for independent screen vendors was not built to support the performance demands of high performance algorithmic trading.

Instead, he says, fund management shops should decouple market access from order generation and risk management by using a vendor-provided direct market access (DMA) service platform as a gateway for normalized market data and order execution with pre-trade risk constraints and real-time middle-office connectivity built in. Such a single interface will integrate with all of their preferred trading screens on the front end and all of their brokerage relationships required for managing risk constraints on the back end.

“This new approach allows for fund managers, regardless of trading strategy, size, style or frequency, to measure their risk more easily, test strategies on new markets more quickly, improve trading results and reduce costs,” says Woodyatt. What’s more, bringing such technology to the negotiating table with the FCM, he believes, will make the fund management firm a more attractive client because the FCM won’t have to increase its own costs.

Of course, just how much time it will take for the fund management firm to implement the DMA platform and at what pricetag varies depending on the number of locations involved, whether the DMA is offered as a licensed application, managed software or platform as a service, and the amount of time it will take for the fund management firm to be onboarded by the FCM. At the very least, the DMA will likely be more cost effective for the largest global fund management firms with multiple forms of electronic trading. Cost efficiencies can reach “six digits per year” estimates Woodyatt.

Regardless of just which FCM a fund management firm selects and for which services, one outcome is certain. “Fund management firms who still want to play in the over-the-counter derivatives market will need to take a long hard look at whether they can afford the costs,” says Matt Rodgers, senior manager for global consultancy Sapient Global Markets in New York. “FCMs are charging a lot more for their services and doing any of the additional operational work inhouse won’t come cheap.”