By most quantitative measures, the cleared derivatives industry is bigger and better than ever before. But based on comments at FIA Expo conference in Chicago on Oct. 30, future growth may not be as easy to achieve, and success may be measured by more qualitative measures such as compromise and communication.
At an Expo panel discussion titled simply "The Health of the Industry," a diverse group of market participants discussed a myriad of factors shaping the cleared derivatives industry now as well as their expectations for the future.
The participants started by noting the current vibrancy of derivatives markets, such as record exchange traded derivatives volume of more than 30 billion contracts in 2018 and first-half data that indicates 2019 could top even that high-water mark. They commented however that the industry faces very real challenges such as concentration risk, margin requirements and "skin in the game" in clearinghouses--well-worn issues that will require coordinated industry responses through more transparency and honest dialogue between all parties.
Consolidation and Competition
Jerome Kemp, the global head of futures, clearing and collateral at Citigroup Global Markets and chairman of FIA's board of directors, noted the marketplace is at a "very important moment" amid "a growing disequilibrium" between what he noted as the long-term decline of futures commission merchants and the increasing dominance of central counterparties. He added that even though the number of FCMs has declined, that has not resulted in higher profitability for the firms that have remained in the business.
"You might think we're making a lot more money with less competition, but no -- we're taking on a lot more risk and exposure," Kemp said.
Dan Berkovitz, a member of the U.S. Commodity Futures Trading Commission, flagged the issue of concentration risk in the FCM community. He noted that while Dodd-Frank reforms have created greater competition and transparency in swaps markets via SEFs that some measures have fostered "competition at the cost of competitors" thanks to smaller margins and the overall costs of registration and providing liquidity in swap markets.
Stephen Brodsky, chief strategy officer of R.J. O’Brien & Associates, a leading non-bank FCM, noted that competition is not a black and white issue, as the derivatives industry and its regulators are "trying to balance virtue."
"Competition is a good thing, but a vibrant ecosystem is a good thing," Brodsky said. "It's about balance, but what I think you're hearing from the FCM community is that it's out of balance right now" thanks to rising technology and compliance costs that create barriers to entry, among other challenges.
David Goone, chief strategy officer for Intercontinental Exchange, offered the exchange perspective. He asserted that "we only exist because of our clients, our customer base" and that a more diverse marketplace would benefit all participants.
"No one wants to have just one exchange, or just one customer, or just one clearing firm," he said. "It's like one hand clapping."
Margin and 'Skin in the Game'
Another well-worn topic that requires perhaps an even more delicate balance is the issue of "skin in the game," the amount of money that CCPs contribute to the waterfall of financial resources that comes into play when a member defaults.
Sharon Bowen, a former CFTC commissioner who is now a director for both Intercontinental Exchange and Neuberger Berman, noted that there should be "no surprise where the risk is in the system" after post-crisis reforms to cleared derivatives markets.
"The difference is that it was all opaque and we couldn't see it before. So now the concern we have about CCPs being too big to fail, you have to understand that we knew where it was going to go," Bowen said. She added the global financial system should not fear the fallout of a default "as long as the risk tests and methodology is sound."
Jerome Kemp of Citi agreed, but noted the "very important feedback loop" between initial margin and skin in the game. Margin is "the first line of defense around anything we do in this market" and if done right, "skin in the game becomes a secondary issue."
"If we take that interplay as a point of departure, we have much more to discuss than simply whether skin in the game should be set at 5%, 10% or 20%," Kemp said.
Representing the clearinghouse perspective was Bryan Durkin, president of CME Group, who noted that CCPs are "not risk makers or takers, we are risk mutualizers."
"When you talk about skin in the game, we've never said there shouldn't be skin in the game," Durkin said. "There's not an argument there but there is at what levels should that be set for a CCP. Because then you start marching into scary territory that poses more risk transferring onto the CCP, which totally goes against the model that has served this industry really well for over a century."
Communication and Transparency
Facing these nuanced challenges is "a bit like whack-a-mole," said moderator Rob Creamer, chairman of the FIA Principal Traders Group and president and CEO of Geneva Trading, a Chicago-based trading firm.
"Anytime you have points or costs start to spread across the industry, you eventually lose market participants and diversity. And you lose the resiliency that we're all so proud of in this industry," he said.
That may mean taking a step back from day-to-day decisions to think more broadly, and to continue recent work towards fostering greater communication and transparency across the industry.
ICE's Goone noted that CCPs "keep an eye on each other" regarding margin. "If we have a similar product in oil and I see another exchange's model is significantly higher or lower than ours, I want to know if there's a mistake in my shop or if we're overcharging."
On the regulatory side, the CFTC's Berkovitz noted that there is "better integration among financial regulators" and "a better exchange of information than ever before," within the CFTC as well as with other federal agencies as well as international counterparts.
It all boils down to what RJO's Brodsky called "a culture of continuous improvement" across the entire cleared derivatives industry as it faces new challenges, with better communication, more transparency and ultimately more accountability for all market participants.
"What worked a short time ago isn't working anymore," Brodsky said. "There are always the practical issues like how to we attack this or that tactical solution, but there are bigger issues about [whether] we are structured the right way and governed the right way for the future of these markets."
