Given that it’s summer, and if you are reading this, I hope it is on a beach or with a drink that has an umbrella, I felt it was time to discuss the ‘why’ of “Why We Did That”.
In the last year I have just about heard it all from the naysayers:
“Don’t set up a retail Introducing Broker (IB), everyone is trading crypto.”
“Don’t set up a retail IB, there’s too much competition.”
“Haven’t you heard, Robinhood is setting up an FCM.”
“Regulatory requirements are too onerous for IBs these days.”
“IBs are a dying industry.”
Given the (mostly negative) opinions we received, I felt it was appropriate to spend some time outlining who does what in the industry, why their roles are specific and important, why there’s still room for us in the pool, and make another plug about bringing competition that will benefit the end-user. I firmly believe in American business magnate Sam Walton’s mantra: “Set high goals, encourage competition, and then keep score.” (1)
Customers
First and foremost, let’s examine the most important entity in any business ecosystem, the customer. Within the industry, customers are broadly categorized as either hedgers, which the CME defines as those using futures to manage and offset risk, and speculators, who assume market risk for profit (2). This simple transfer of risk arrangement between hedgers and speculators plays out at all levels of the industry. It ultimately informs the whole structure and flow of the industry from customer to broker, broker to FCM, FCM to exchange, and exchange to clearing house.
But who are the customers of the futures industry, really? Traditionally, futures were utilized by the producers in the industry to hedge risk. In softs, this was farmers and grain elevators, in livestock the ranchers, feedlots, and beef processors and in metals the miners and smelters. The onset of financial futures in the 1970s not only brought in more potential hedgers (banks and businesses with currency and interest rate exposure) but also new speculators, as hedge funds and proprietary trading groups saw greater opportunity to trade a wider range of futures markets.
Today, thanks to the wide range of futures products available and the near 24-hour accessibility of the markets, folks with risk capital and a risk appetite can speculate (3).
Brokers
Just like customers, within the industry brokers are also categorized into two broad segments, Independent Introducing Brokers (IIBs), and Guaranteed Introducing Brokers (GIBs). IIBs are nominally free to ‘introduce’ business to any FCM they have an agreement with, but they must maintain a minimum amount of capital dedicated to the business and be prepared to show regulators that they can meet those capital requirements. GIBs are ‘guaranteed’ by one FCM and do not have the same capital requirements as IIBs, but they can only introduce customers to the FCM guaranteeing them (4).
Within that framework, brokers can fulfill many varied and niche roles within the industry. Some focus only on sourcing liquidity for their customers while others only transact bilaterally. One service that they all provide is that they are the guarantor for their customers. Generally speaking, FCMs look to the broker to know their customers and to share the risks associated with the customers. This distribution of risk occurs daily – if the customer is in a deteriorating position the broker is expected to not only know about it, but to be proactively handling it. If the customer has a margin call or the account balance is debit, it is the broker, not the customer, who the FCM is calling.
In addition to sharing the risks, the FCM looks to the IB to:
- Acquire new clients
- Educate and support their client base
- Facilitate account opening and collect all the necessary forms and signatures
- Ensure customers are in regulatory compliance
- Be the primary point of contact for their customers and resolve all aspects of customer service
Crucially, an IB cannot accept money or other assets from or on behalf of clients, all money must be transferred directly from the customer to the FCM.
The FCM
FCMs are categorized as either clearing FCMs or non-clearing FCMs. Non-clearing FCMs will clear their business via an omnibus account arrangement with a clearing FCM.
The CFTC defines the FCM as an entity that solicits or accepts orders for the purchase or sale of any commodity for future delivery on or subject to the rules of any exchange and that accepts payment from or extends credit to those whose orders are accepted (5).
As part of this primary duty, all orders entered by customers must be routed to the exchange via the FCM, either with FCM credentials supplied to the customer or via the FCMs own connectivity to the exchange. This order routing requirement creates a whole host of other responsibilities for the FCM, including:
- Risk management
- Capital and collateral management
- Guarantor for the customer at the exchange/clearing house
- Clearing and settlement of customer orders
- Compliance oversight
Bearing in mind that all futures transactions involve a transfer of risk, it is ultimately the primary job of the FCM to effectively risk manage their customers. FCM’s must strike a balance between recognizing every customer’s unique appetite for risk and their liquidity and understanding that “the market can remain irrational longer than you can remain solvent,” to quote John Maynard Keynes. Much as the IB is the guarantor of the customer to the FCM, the FCM is the guarantor to the exchange and clearing house.
Similarly, it is the primary responsibility of the FCM to ensure they have adequate client funds on hand to satisfy exchange margin deposits, and that these funds are kept separate from the firm’s own capital (segregation of funds requirement (6)). Additionally, FCMs are required to post either $1 million or 8% of the customers’ total risk margin requirement (whichever is greater) as collateral at the clearing house (7). If customers’ deposits are short of the required margin deposit as a result of trading losses or increased margin requirements, it is the responsibility of the FCM to collect the required amount by issuing a margin call.
Within its scope as guarantor, the FCM is also responsible for clearing and settling all customer transactions for the trading period, generating customer statements, and maintaining accurate books and records for all customer and firm activity. When required, FCMs must also facilitate physical delivery for customer accounts (usually in the form of warehouse receipts for softs, but energy product delivery can get tricky).
Finally, it is the responsibility of the FCM to manage all of this while ensuring everyone involved is in regulatory compliance and managing compliance inquiries from the exchange(s) or regulator(s).
The Exchange
One of the key differentiators between the futures and equities industry is the concept of the Central Limit Order Book (CLOB). Unlike equity markets, where customer orders can be internalized or matched off at any number of exchanges or ATSs’, all exchange-traded derivatives (i.e. futures) must hit and be matched off in the central limit order book of the exchange that lists the futures contract.
A central limit order book collects, organizes, and displays all buy and sell orders (i.e. facilitates price discovery) for an instrument in one centralized location (8).
CLOBs rely on the exchange’s matching engine (usually proprietary to the exchange, but some exchanges white-label their software to other exchanges – looking at you, Nasdaq) to match off customer orders (usually in a First In First Out (FIFO) manner, but some products have unique matching algorithms based on order size).
CLOBs work well for futures because they are transparent (all participants can see and interact with the order book for every product), they provide the best liquidity (all participants must come to the same place to transact), they are efficient (all transactions take place realtime), and they are anonymous.
In addition to matching off trades in a centralized manner, exchanges also define and standardize the products that participants can trade, and surveil their markets to ensure participants are transacting fairly and in accordance with the exchange’s rules.
The Clearing House
Once the order is matched off at the exchange, it flows to the clearing house for settlement and netting. This is not broadly understood outside the industry, but the functions of the exchange and the clearing house are usually separated for risk management purposes, even if the same entity owns both, as is the case with CME Group.
Some clearing houses stand alone, like Options Clearing Corp (OCC), which clears equity options for a variety of exchanges, while others, like CME Group, generally only clear their own exchange.
Clearing houses are a key player in the industry because of novation. Novation is the legal process whereby the clearing house becomes the counterparty to every buyer and seller in a transaction, eliminating fails and counterparty risk(9).
Given the leveraged nature of the industry, the clearing house is the ultimate risk manager for the products they clear, and they all have detailed and highly scrutinized procedures in place for addressing market stress and the potential default of one of their clearing members.
In the CME’s case, they have risk waterfalls(10) in place to ensure that even if their largest member defaults, there is a financial cushion in place to ensure the market is minimally impacted.
In Summary
This industry is layered as it is because each layer dilutes and manages risk, and each layer has a role to play in ensuring an orderly, efficient, and fair market for all participants. We started MetroTrade because we still believe there is a role for a broker, not only as a salesperson, customer service rep, and risk and compliance manager but also as an advocate, teacher, translator, and storyteller.
The reason I am saying this is because while the industry has grown (a lot), from $77 billion in combined customer seg assets in May 2004 to $291 billion in seg assets today, the number of registered participants has dwindled(11).
For example, in May 2004 there were 182 FCMS registered with the CFTC, while today there are 64. In an article just published on July 11, 2024, Futures and Options World(12) reported that the top 5 US futures brokers increased their market share in May 2024 by 6.6%, and now collectively hold 54.75% of all customer seg assets.
And on the IB side, just in the past year, the number of IBs registered with the NFA has dropped 5%, from 974 as of February 2023 to 919 today. While a 5% attrition rate doesn’t seem so bad, there were over 1200 IBs registered with the NFA in 2018, resulting in an overall attrition rate of over 20% over a six-year period.
Given this, it is in the industry’s best interest to encourage competition – to distribute risk, to increase transparency, to improve liquidity, and to level the playing field for all participants.
And that’s why we did that.
(1) https://www.azquotes.com/author/15269Sam_Walton/tag/competition#google_vignette
(3) Trading in futures and options products entails significant risks of loss which must be understood prior to trading and may not be appropriate for all investors. Trading in futures and options could result in a loss in excess of the initial investment. Therefore, carefully consider whether such trading is suitable in light of financial conditions. Risk capital is money that can be lost without jeopardizing one’s financial security or lifestyle. Only risk capital should be used for trading, and only those with sufficient risk capital should consider trading in futures and options. Past performance is not necessarily indicative of future results.
MetroTrade LLC does not provide investment or tax advice; any decision you may make to buy, sell or hold a futures or securities position on any trading recommendation is entirely your own and not in any way deemed to be endorsed by or attributed to MetroTrade.
(4) https://www.nfa.futures.org/members/ib/regulatory-obligations/ib-requirements.html
(5) https://www.cftc.gov/LearnAndProtect/AdvisoriesAndArticles/CFTCGlossary/index.htm#F
(7) https://www.govinfo.gov/content/pkg/CFR-2023-title17-vol1/xml/CFR-2023-title17-vol1-sec1-17.xml
(11) https://www.cftc.gov/MarketReports/financialfcmdata/index.htm
(12) ANALYSIS: Top five US clearing banks boost market share | News | Futures & Options World (fow.com)