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Interdealer brokers and futures commission merchants have been hit hard by the run-up to the euro, maturing markets and screen technology. Radical downsizing may be just around the corner.

By J.C. Louis

Pity the guy who stands in the middle. The two critical groups that grease the wheels of capital in the derivatives market—interdealer brokers and futures commission merchants (FCMs)—are in deep trouble. Maturing markets are forcing spreads to levels that threaten their very existence. And if that wasn't enough, both groups face additional challenges as electronic trading changes both the way business is done and who is doing it.

For interdealer brokers, consolidation among the investment and money center banks is reducing the ranks of their clientele at a time when fundamental developments, such as the euro, are diminishing the range of product. For FCMs, some of the biggest problems involve changes in the over-the-counter market that drives much of the world's futures trading.

Of the two sectors, interdealer brokers have particular cause for alarm. In the past few months, they have been watching helplessly from the sidelines as their key customers—investment and money center banks—develop an apparently insatiable urge to merge. The deals involving SBC Warburg/SwissBank/

Union Bank of Switzerland, Manufacturers Hanover/Chemical/Chase, and Salomon/Citibank/Travelers have moved consolidation issues to the top of nearly everyone's agenda. "The major dealers, who account for 75 percent of the business, do not require more than 10 brokers to service them,” says Grant Biggar, head of credit derivatives at Intercapital in New York. "The dealers are currently overbroked for the amount of interdealer business being transacted.”

But the mergers do more than simply reduce client lists. Interdealer brokers now fear that traders at the new larger entities may have little need for their services. The merger of Citibank and Salomon, for example, "builds a powerhouse with a huge balance sheet and superior credit,” says the head of a leading interdealer desk. "That can hurt interdealer brokers because the merged organization builds an internal sales forces that will by-pass brokers.”

Numerous insiders view mergers as an inefficient way of gaining coveted human assets, particularly brokers and their contacts. Acquiring a rival's personnel is preferable to acquiring the company, and indeed interdealer brokers have gone after one another's talent aggressively. Protecting loyalties in a heated competitive environment is difficult. "Overall, this is a tough business,” observes Clive Cook, CEO of EXCO USA. "Not just managing the customers but managing one's own people.”

The contraction of spreads presents the clearest indications of change. "The brokerage community has come under great pressure to reduce commissions,” says Cook, "which have certainly been trending significantly lower over the last five years.” He is quick to note, however, that the percentage dealers charge has remained the same and that volume is up.

But other factors are working against rising volume. "Traders trying to make their P&L in a declining spread environment have budgets that leave scant room for brokerage,” moans one former swap trader. "Brokerage is wafer thin,” says another source. "Banks never wanted to pay brokerage and they are more reluctant to pay it now.”

Fundamentals such as declining interest rates are another big crimp on spreads. Tight credit is still another. "We used to trade in cash against the one-year swap,” a retired trader recalled. "The Japanese banks that were major players are much less significant now because of the tight credit situation. Whenever credit lines are under review, spreads can narrow as pressure on margins goes up, but trading volume often does not.”

The end of European currencies as we know it is also wreaking its own form of havoc. Layoffs in foreign exchange dealer desks have been followed by similar purges on broker desks. "EMU will put brokers under more pressure because the amount of product under their disposal is diminished,” says EXCO's Cook. "Many of the layoffs are a result of what is happening with the euro. But dollar-mark, dollar-franc and dollar-lira are also factors in the foreign exchange layoffs, and will leave less dealer product on the table.”

Man or machine?

Interdealer brokers are feeling additional pressure from electronic brokering, which has already made major inroads into currency spot trading and caused several firms to get out of spot foreign exchange entirely. These days rival electronic foreign exchange systems from Reuters and EBS are likely to be found on foreign exchange trading desks. Users enter buy and sell orders, which match and execute the trades and inform who's on the other side of the trade. Traders can either enter the price they are prepared to deal at or merely hit a price flashing on the screen. "Voice brokering in spot foreign exchange took a hit at first,” says one insider at a top interdealer broker. "The layoffs hurt to the point that foreign exchange brokers were afraid it was going to go entirely.”

"The worst may be over in the decimation of the voice-broked spot foreign exchange market,” adds Derek Tullett, president of Tullett & Tokyo Foreign Exchange. "Those wholesale market brokers involved in the spot foreign exchange market have reacted to the declining market and are ideally placed to take advantage of their new technology. There is a probability that these brokers will offer their clients a multiple choice of services—one being an electronic deal-matching service enhanced by voice. The best of both worlds. It will not be easy to recover market share, but we intend to compete with the electronic systems.”

Despite all the talk about inevitable broker consolidation, little has actually occurred. In 1997, EXCO's Cook told the Financial Times that the industry was "ripe for consolidation,” and then promptly demonstrated what he meant by merging the firm's capital markets brokerage unit with a securities broker handling Treasury mortgages, emerging markets, corporates and convertibles. By building greater product and customer reach, he believes the new entity called EXCO USA "is an attempt to ensure that, should the top 15 dealers decide to restrict their customer bases, EXCO will still be one of them.”

In France, however, brokers are busy merging successfully, and possibly suggesting the course the subsequent consolidations may follow across the Channel. Last year, Viel, a substantial Parisian broker, took over rival DeBausse, which had taken over Degez. Viel now also holds an interest Tradition, originally Switzerland-based Tradition Lausanne.

"The information is changing, tick by tick,” says Dan Calacci, global head of credit derivatives for the financial products group at FIMAT USA. He believes time is the main pressure. "Twenty years ago, you could have spreads that lasted for weeks. With price dissemination and instantaneous trading, we have moved from a slow, liability-driven world to a fast-paced, asset-dominated business.”

Some, such as Boston-based headhunter Rich Williams, say the problem is endemic to the field. He asserts that money-center banks look down on prospective recruits from the interdealer ranks because of a feeling that they lack trading expertise and market knowledge. "You have to have your own P&L to be anyone in this business,” he says. "Interdealer brokers were a more important function at one time, but now it has become a leftover business.”

The FCM Dilemma
Futures commission merchants are better poised than their interdealer broker colleagues to face challenges from electronic trading, the euro and exchange realignments. To remain viable, however, they are being forced to make some drastic organizational adaptations, including moving from agent-only executions to becoming specialist arms of larger financial service conglomerations.

But their biggest problem is readapting themselves to the rapidly changing derivatives exchanges. Brokers have spent years building up operations servicing the open outcry pits. Now their world is increasingly based on electronically traded contracts. "With electronic order systems coming to the cash market I think it won't be long before almost everyone trading in the interest rate complex will prefer trading though a screen. In futures it can be an order-routing system to the floor or a matching system like Project A or GLOBEX,” says Larry Mollner, president of Mariah Trading Partners and former head of Carr Futures. "The FCMs are going to be hurt—they are going to find it necessary to take a good look at their current organization and structure. They will have to redo compensation systems, and be prepared to operate in an electronic world.”

FCMs are now adding up the costs of staffing standing armies at derivatives exchanges all around the world—and are looking for alternatives. "You cannot continue to have pit trading as it has been,” says Ed Kassakian, president of Carr Futures. "It requires a tremendous investment in human resources. You either maintain memberships in all those marketplaces and keep people on location, or you make strategic alliances with other firms providing access to those markets. Either way, it's not cost effective.”

In many cases, that means taking people off the floor and moving them to terminals. "Instead of arm-waving, they will be waving their fingers over a keyboard,” says one broker. "But the skill base for staff people handling electronic trading is quite different.”

"Whether he was on the floor or upstairs, the human broker's value-added has been lessened,” adds another. "He will either adjust his compensation—that is, work for less—or he won't work at all.”

FCMs will also have to reorganize their operations to deal with a trading day that lasts 24 hours. "It's just common sense,” says Carr's Kassakian. "Over time, the 24-hour electronic framework is an important growth area.” Bill Marcus, senior vice president of sales at Sakura Delsher, notes that FCMs will have to face new staffing demands to achieve the twin goals of improved order entry and lowered trading costs. "You may need fewer people on the floor but more back-office staff to handle these electronic systems.”

Demands for these kinds of cost efficiencies are encouraging many FCMs to shed their image as standalone, commission-only executing agents. A number of forward-looking FCMs are repositioning themselves not as commodity brokers per se but as segments in the larger business of providing financial services, with more of an emphasis on service. "One can still be profitable in the futures business, but you simply cannot raise commissions,” says Kassakian. "Anyone who believes that commission rates will increase after a consolidation is dreaming. The only way to expand margins is to reduce costs.”

Eventually, predicts Mollner, "futures commissions will decline to the point where they become even more commoditized. Eventually, clients will pay only to clear and process trades. Execution will be done solely on a matching system. The execution portion of a commission will be nil. The surviving firms will be those that electronically match order entry, capture the clearing via the back office and provide capital.”



Brokering Credit Derivatives
While interdealer brokers of asset derivatives have been characterized as a fatigued, battle-scarred lot facing the pressures of a maturing industry, interdealer brokers in the credit sector present themselves as innovators—one part cynic, one part believer—energized against a maze of obstacles. Some credit derivatives players believe the value-added of credit derivatives to banks and other credit-sensitive institutions overrides some of the trends dogging some of the noncredit derivatives markets.

"All markets need to grow up and learn from other markets,” says Garry Rayner, global head of credit derivatives and structured assets at Tradition. "In that sense, a lot of what has happened in the credit area is not totally unexpected. As a risk management instrument, credit derivatives are a growth area. Their acceptance is rapidly accelerating. In that situation, a quality business will overcome pressures. It tries to use them as opportunities. If there is pressure, we tend to treat it as positive pressure.”

"I expect that some of the brokers who were late to the market are struggling,” says Intercapital's Grant Biggar. "There is no doubt the broker market got ahead of itself. The early growth we experienced in credit derivatives caused many observers to compare it with the early days of the swaps market, but a lot of the potential of the product remains unfulfilled.” Brokers geared up in anticipation of growth that has not yet occurred.

For John Tompkins, head of credit derivatives and structured assets at Prebon Yamane in London, the biggest pressure is finding credible prices. "The scarcity of prices means that the ability to find a counterparty is highly valued by clients. Those prices that do exist, however, are being disseminated much more quickly, and there is competition between the brokers. This brings good and bad things. More brokers is good for market liquidity, but too many means that banks are being bothered by brokers who don't understand their requirements.” He notes that the bid-offer spreads for some credits have tightened significantly during the last six months, while for others it is difficult to find any counterparty with a price, let alone where the next price is coming from.

Spreads at this stage are also far from predictable. "Spreads generally narrow when there are more participants in any market,” observes Tradition's Rayner. "But if there is negative outlook on the active credit of any underlying debt or if there is a threat of default on, say, Eastern Europe, Asia or Latin America, spreads will widen, regardless of participation.”

In the credit derivatives market, interdealer brokers also find themselves spending an enormous amount of time educating their less-experienced clients. "Credit derivatives provide default protection and thereby address the most sensitive aspect of any institution's appetite for risk,” explains Rayner. "A bank must ask what the client is buying risk protection for, and then price every different type of commoditized package—sovereign, corporate, junior and senior debt, duration. He adds that the interdealer credit derivative broker must also try to be sensitive to these different risks with an eye toward matching the client's historical likes and dislikes with an appropriate counterparty. As a result, it's easy to misconstrue the broker as a principal.

Another problem is dealing with the often arcane approval process associated with new instruments. "One day, a major international bank approves a trade,” says FIMAT USA's Dan Calacci. "Two days later, they call back and say ‘Sorry, we don't have the authority to trade.' Or, ‘I cannot trade through a broker with such and such a client.' Many banks are still liability driven. They want to lend only to the credit-worthy, yet they wind up taking credit risk that they do not want. They do not understand that credit swaps give them more credit protection because they are settled ahead of other senior debt in bankruptcy situations.”