Streetwise Professor

July 21, 2012

Sounds Familiar

Filed under: Derivatives,Economics,Exchanges,Financial Crisis II,Regulation — The Professor @ 6:30 am

Near zero interest rates are wreaking havoc among FCMs. I recall reading something about that.  Heck, I remember writing something about that about a week ago.

There is a puzzle here, though.  Why don’t commissions vary inversely with interest rates?  The FCM business is pretty competitive, meaning that FCMs should earn the competitive rate of return, i.e., roughly speaking revenues should equal costs plus a fair return on capital.  If interest rates rise, generating more revenues for FCMs, competition should lead them to cut commissions in order to attract customers.  Conversely, if interest rates fall, reducing FCM revenues, competitive pressures should induce them to raise commissions.  Why have commissions remained at rock bottom levels despite the loss of revenues from interest on customer funds that the FCMs hold and invest?

One possible explanation is that due to technological change (e.g., the expansion of electronic trading) there is excess capacity in the FCM industry, and some firms should exit.  The excess capacity keeps downward pressure on commissions, which will not rise until there is a significant shakeout.

Perhaps MF Global, or Peregrine, or both, were unwilling to concede that they were no longer economically viable and should exit.  Frequently the need to secure external funds to keep operating is what forces unviable businesses to exit even though individual managers or owners may want to try to gamble or cheat for resurrection.  Financial firms’ (including FCMs’) ready access to cash (even if it isn’t really theirs) can permit them to engage in these sorts of actions without securing external funds.  This is why financial sectors under stress are particularly vulnerable to fraud and excessive risk taking: not only do stressed firms have the incentive to engage in this kind of conduct (which is true of stressed firms in other industries too), but they have opportunities that stressed firms dependent on external finance do not.

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  1. I suspect that there’s an element of the “free checking” syndrome here. (The bank gives you free checking and terrible interest rates on your cash. Many people used to pay hundreds per year in forgone interest for the “free” checking.) Customers respond more negatively to rising fees than they do to below-market interest rates. Yes, I know that many of these customers are fairly sophisticated, but you’d be surprised how many sophisticated people will not see interest that they “should have earned” while seeing clearly fees that they are paying.

    Comment by Highgamma — July 22, 2012 @ 1:32 pm

  2. SWP- you raise an excellent point. Most FCMs are collecting a toll (or rent) for providing access to futures/options markets. These markets are available on the internet without a toll (ie InteractiveBrokers) and large FCMs like MFGlobal or FCStone should look for a new business model. An upstart has a good chance of getting customers by putting customers money in an electronic vault. However I am afraid Gensler will squash new entrants with rules and protect the toll model of MFGlobal and FCStone.

    Comment by scott — July 22, 2012 @ 10:31 pm

  3. @Scott

    I think your thoughts of “upstarts having a good chance of getting customers by putting customers money in an electronic vault” is spot on.

    The whole investment paradigm has to change. Investors would need to have real-time or, at least, on-demand access to the books of the companies they invest in – not on the level of transactions but on the level of risk, P&L and performance reporting. Furthermore, the money has to be invested with specially structured SPVs, with the fiduciary oversight with the right to pull the investments back surrendered to the trust commpanies overseaing the SPVs.

    Therefore the new generation trading platforms have to be equally oriented at meeting the fron desk needs as well as the needs of oversight by the investors.

    Comment by MJ — July 23, 2012 @ 5:29 am

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