2017 will be a year of FX industry M&A: A very detailed analysis on the changes that lie ahead
Recent M&A deals have been hundreds of millions as massive venues mop up institutional FX firms – not retail client bases for a few million. We examine in great detail what will cause consolidation this year and why it will be much higher up the ecosystem and for very high values, including perspectives from senior industry figures.
Two years ago may only be a very short time in most business sectors – even in today’s technologically free world in which cloud hosting and flexible design has caused the development cycle to shorten by an exponential length of time.
For example, Tesla Motors revolutionized the motor vehicle but a two year old Tesla Model S still appears as futuristic as it did when it was launched.
This is not the case in the FX and electronic trading industry, as the development cycle here is far quicker than pretty much any other business sector in the world, partly due to the technological arms race that is now well under way in the retail sector and is not just the preserve of the institutional giants with their proprietary systems and in house developers, and partly due to the difficulties in liquidity distribution and access to Tier 1 credit that the major interbank FX dealers foist upon the entire OTC business during the course of this year.
Two years ago, there was a sudden focus on consolidation via mergers and acquisitions in the industry, some of which entailed public listing on London’s Alternative Investment Market section of the London Stock Exchange as in the cases of Plus500, and others involved the acquisitions of client bases as per FXCM’s purchase of IBFX’s MetaTrader 4 client base for $4.4 million as IBFX began to divest from the United States market during the course of three regulatory penalties that ended up costing the US subsidiary of Japan’s MONEX Group $2.2 million before the National Futures Association removed its membership, leaving OANDA Corporation to soak up the remaining 2200 clients that were using IBFX’s proprietary platform Tradestation.
This type of scenario was relatively common during the course of 2014, during which the focus was largely on regulatory matters and operating costs, those being the major two factors that created the environment for consolidation. On one hand there were brokers that had not been able to navigate extremely well organized retail markets such as that of the United States.
As the previous decade drew to a close, many retail FX firms with their origins outside of the United States began to weigh up the viability of retaining business here.
Just four evergreen domestic companies now dominate
The result was a wave of exits from the United States at the turn of this decade by major firms including Alpari, FXSolutions, GFT, IBFX, and ILQ to name a few, as well as vast consolidation with FXCM having bought the client bases of various firms, and GAIN Capital acquiring GFT, meaning that in the space of just three years between 2010 and 2013, the approximately 25 retail OTC FX firms that had operated in America became nine.
Now, it is quite simply dominated by just four domestic companies.
At that time, many pundits noted that the exodus from the United States was down to retail viability in a now very stringently regulated market, and that lack of ability to survive there was the reason for the discontinuation of overseas firms from doing thier business there.
This has proven to be incorrect, as most of the companies that exited the market post Dodd-Frank Act implementation no longer exist at all in any market.
Capitalization and execution are cornerstones of the American FX industry’s pedigree and quite simply, time has shown that those that cannot cut it in America, have been unable to do so throughout their business operations anywhere globally.
Never mind the SNB – Try getting a bank to give credit to OTC firms – it can cost as much as a Black Swan
It was convenient to blame the inability to operate on over zealous regulation, or a net capital adequacy requirement of $20 million, however the US giants that remain do not find this difficult at all. Even FXCM, which was exposed to a vast and unexpected surge of volatility when the Swiss National Bank removed the 1.20 peg on the EUR CHF pair in January 2015, was not called up on its execution methodology, commercial leadership or capitalization.
Meeting with CEO Drew Niv earlier this year in New York, FinanceFeeds gained perspective on this, with Mr. Niv explaining ““If you look at FXCM today, it is effectively the same company as prior to January 15 2015. Most of our customers stayed, almost all of the staff stayed. We did sell some non-core assets and for a few months we had some losses, however we kept the market share in tact. What many people don’t realize is that we effectively plugged the capital shortfall with Leucadia’s loan.”
In terms of actual impact on the business as a result of attrition, Mr. Niv explained “The customers that we lost were mainly some of the large customers. The total number of our clients that were actually affected by the market volatility that followed the SNB’s decision approximately 3,000 customers which comprised of around 200 here in the United States, and the rest were overseas.
This is a small amount, especially when bearing in mind that some were inactive customers. There were also some customers which stayed with FXCM but deposited less funds because, for example, they were happy to continue trading but would prefer to hold $50,000 in the company rather than $1 million.”
CFD turmoil – The cause and effect
Meanwhile, Britain’s retail OTC electronic trading giants continued to organically grow their businesses. No need to acquire smaller firms or attempt to enter new territories for the spread betting and CFD giants of London, whose three decade long domination over their own domestic market customers who trade via proprietary CFD and spread betting platforms has been a steady build up to publicly listed multi-million dollar enterprises whose specialization in their own specific British market niche is cast in concrete.
Whilst the American companies were growing two years ago by acquiring client bases, technology vendors and smaller brokerages all over the world in order to gain a global economy of scale, British firms were building internally.
The focus globally then shifted to CFDs, notable example being GAIN Capital’s acquistion of British CFD and Spread Betting company City Index, which was completed in April 2015, the actual transaction between City Index and GAIN Capital at the time of bid in October 2014 was reported to be $118 million, however subsequently, it emerged that the net purchase price was actually $82 million, which included $36 million in cash.
A massive drive toward CFDs ensued among retail OTC giants at that period, particularly in the aftermath of the Swiss National Bank’s decision to remove the 1.20 peg on the EURCHF pair in January 2015, creating a wave of volatility that put many brokers into a situation in which their clients had negative account balances, thus causing some retail firms, such as Alpari UK and LQD Markets, to become insolvent.
CFDs were considered an antidote to this potential problem to some extent, hence the wish to expand what had traditionally been an intrinsically British business overseas, and once again, the acquisition and consolidation question was raised in order to achieve this.
All of this seems so distant now, largely because a far larger elephant in the room has appeared since, that being the restriction of counterparty credit to OTC firms by Tier 1 banks, especially those with the largest market share in FX dealing.
Citigroup, the largest Tier 1 FX dealer in the world with 16.5% of global FX order flow going through its books, generated a report this summer which stated that it estimates a potential default ratio of a quite astonishing 56% on the extension of credit to OTC derivatives firms.
Barclays, Deutsche Bank, HSBC, JP Morgan and Goldman Sachs have followed suit and have restricted the availability of credit substantially.
This in 2017, in our opinion, will create another wave of mergers and acquisitions, however this time it will have nothing to do with maintaining regulatory precision or ability to access new markets, and everything to do with gaining enough capital to maintain existing prime brokerage relationships with banks and, if at all possible, establish new ones.
Just one month ago, CFH, a company which provides institutional liquidity, brokerage technology and bi-lateral clearing, was sold to Playtech.
The deal was reported as being valued at $120 million, however FinanceFeeds examined this closely and understands that although a figure of $120 million has been considered as a ballpark for the acquisition, such a figure should not be taken as a given, as the details of how the deal is structured are far more important to consider.
Upon concluding the acquistion which was due to conclude at the end of November, an initial consideration of $43.4 million was agreed, on a cash free and debt free basis, for 70% of CFH’s fully diluted share capital, representing a multiple of approximately 7 times the current EBITDA run rate.
In addition, consideration for the remaining 30% of CFH Group has been set forth, which will be subject to a put and call option which is exercisable in 2019 at a multiple of 6.0 times CFH’s adjusted EBITDA for the year ending 31 December 2018, capped at $120 million less the initial consideration $76.6 million for the 30%.
This means that it is entirely possible that the firm will not be acquired for $120 million. Our guess is that the entire firm will be sold for $43.4 million in total, consisting of paper and cash.
The question is, however, why was CFH sold at all?
The company had customers, and whilst absolutely not in anything like the same league as compatriot Saxo Bank, was established and had a good reputation.
It is our estimate that, having conducted substantial research within the industry on the matter, CFH was sold to Playtech because such a deal would provide a capital injection which would help CFH to maintain its existing prime brokerage agreement, given that banks are currently not only refusing to set in place new prime brokerage agreements for OTC participants, but actually removing existing ones willy nilly, largely as a result of waning capital bases.
Just five years ago, it was possible to gain new and maintain existing prime brokerage relationships with Tier 1 banks with just a $5 to $10 million capitalization, however that was before the wave of retail traders entered the live markets via direct market access systems, leading the banks to look at the capital bases of the brokers providing such services.
Nowadays, a firm would need $50 to $100 million on their balance sheets which could be put in an escrow account in order to maintain existing or gain new prime brokerage agreements, therefore Playtech’s cash injection allows CFH to carry on its business as a genuine direct market access liquidity provider and does not create a situation where the firm’s Tier 1 banking relationship is curtailed due to lack of capitalization.
Thus, it is entirely possible that the firm was sold just to maintain one interbank prime brokerage relationship, which is a lifeline.
Liquidity providers such as Sucden Financial never come under this kind of scrutiny, as eFX is a smaller part of the overall business of a large commodities and raw materials firm, its capital base being substantially higher than any possible exposure to FX negative balances, thus banks rest easily knowing that should an event happen, Sucden would be able to cover it with capital from its vast raw materials and commodities business. As a result, relationships with Tier 1 banks are a breeze in this circumstance.
At Saxo Bank’s London office this summer, Lucian Lauerman, Head of API at Saxo Bank explained to FinanceFeeds that attempting to reduce capital cost by matching off trades against two prime of primes is futile, and therefore highlights the credit issues. “The liquidity and collateral issues are arising from the use of prime or prime providers or brokers at the same time” he said.
“The rationale for using two prime of primes makes sense as a contingency, when one of those is a primary provider and the other one is a secondary provider. However, the reason for using a single prime broker at any given time is to consolidate positions in one place for more efficient use of collateral” said Mr. Lauerman.
“If you lodge $5 million in total, use 5 prime of primes, put $1 mio at each prime and then are long at number 1, and then short at number 2, then long at number 3, you will lose out on netting benefit re your use of collateral, and have a complex issue to manage re ensuring you minimize your funding costs” – Lucian Lauerman, Head of API, Saxo Bank
In terms of explaining how Saxo Bank conducts its bank relationships, Mr. Lauerman explained “Because of our balance sheet and our status as a regulated bank, we have stable, decades long relationships with the largest liquidity providers in the market, and are able to effectively evaluate the new entrants to the market. This is a major differentiator.”
However institutional providers that specialize only in FX and CFDs are now under the scrutiny of banks, and have also become a target for Britain’s FCA which is implementing a set of new rules that have been proposed to severely restrict the method by which CFDs are provided, and CFDs are a core business for many brokers in Britain.
This will create a two way difficulty. The first is that maintaining Tier 1 bank relationships is currently increasingly capital-hungry, therefore $50 to $100 million must be tied up in that alone. The second is that if the reduced leverage and restrictions take place, it will provide much less margin for OTC firms offering CFDs, yet they will still have to please the banks by lodging a fortune in capital. This will create a squeeze.
Regualatory ulterior motive – to force the CFDs away from OTC
FinanceFeeds agrees with Francois Nembrini, Global Head of Sales and Liquidity Management at AFX Group’s QuanticAM institutional asset management division, who is an absolute expert in Tier 1 bank relationships, having spent 12 years as Managing Director of FXCMPro, where he had extensive relationships with banks, central banks, hedge funds, brokerages and investors globally.
Mr. Nembrini believes that the regulatory authorities in countries where the FX industry is populous, those being the United States, Britain, Australia and certain parts of the APAC region have an agenda in which they are setting in place a procedure in order to have the entire OTC FX and OTC derivatives migrated to an exchange model.
“It is quite apparent that the regulators, along with other institutions are setting in place the framework to have the entire non-bank OTC business revamped on exchange” said Mr. Nembrini.
“This is apparent from many things, one of which is the advertising bans which have been imposed on non-bank retail FX firms in France, Belgium and soon Germany while you can easily advertise the same underlyings on exchange” he continued.
Another angle from which pressure is mounting is from within the large exchanges, which Mr. Nembrini believes are attempting to lobby the regulators as well as to gain influential controlling stakes in OTC businesses in order to attempt to push all retail trading onto exchanges.
Recent M&A deals have been hundreds of millions as massive venues mop up institutional FX firms – not retail client bases for a few million
“CME Group is looking at a project whereby they come up with a rolling spot contract which is a direct competitor to OTC derivatives firms” said Mr. Nembrini.
“This is not a consolidation in my view, it is an attempt to move the non-bank retail FX business globally to a different model. The exchanges have woken up to the fact that a large part of their retail businesses has moved off exchange and they want to get the business back. Scandals in the OTC industry, bankruptcies related to SNB type events and binary options scammers have given ample justifications to exchange lobbyists to argue against the OTC retail industry. In the end who do you think has more clout with the FCA? The LSE or IG markets ? It is obvious who is going to win. ” – Francois Nembrini, Global Head of Sales & Liquidity Management at AFX Group’s QuanticAM
Then there was the acquisition by Deutsche Boerse in July 2015 of FX trading platform 360T for $796 million.
Mr. Nembrini also quite correctly highlights a series of recent mergers and acquisitions which have involved large electronic marketplaces buying controlling interests in OTC electronic communication networks (ECNs).
“This direction is quite easy to see, especially when looking at some of the recent institutional level acquisitions that have taken place” said Mr. Nembrini.
“For example, Hotspot FX, one of the world’s most renowned OTC FX ECNs was bought by BATS Global Markets for $365 million in January 2015. It is also important to look at EUREX’s direction in which by September this year, the venue had extended its listed FX Futures and Options portfolio to include six new currency pairs while the overall minimum block trade sizes was reduced across all currency pairs to further improve hedging opportunities” explained Mr. Nembrini.
FinanceFeeds is also aware that this has been a focus for Deutsche Boerse for some time. Back in 2011, Deutsche Boerse took a minority stake in British FX technology solutions provider Digital Vega which was a technology vendor to buyside and sellside firms in the OTC derivatives sector.
At that time, the idea was to increase Deutsche Boerse’s positioning in the provision of pre-trade price transparency in the derivatives area for institutional investors and taking an initial footprint in the FX derivatives space. An investment agreement was signed last week, whereby Deutsche Börse will pay a US dollar amount in the single digit million range.
“EUREX bought the 360T treasury system , with the intention of moving the entire FX structure from an OTC bilateral system into an exchange clearing structure in my view. Another example of equity exchanges moving into FX was NASDAQ which wanted to launch NASDAQ FX but were unable to do so as they failed to understand the nuances of liquidty provision in an OTC trading environment vs the exchange traded products dynamics. In any case there is a clear movement from exchanges into the OTC world. said Mr. Nembrini.
“ICE tried to buy FastMatch in July last year” he also pointed out.
Indeed that is correct, the Chicago-based electronic derivatives market place having prepared itself to buy FastMatch from its three shareholers, Credit Suisse, BNY Mellon and FXCM, for around $200m-$250m.
As the FX market continues to fragment, and higher regulatory costs for bilateral trades start to bite, exchanges are no doubt eyeing an opportunity to get closer to the FX market by offering capital efficient client clearing/counter-party risk mitigation solutions to the OTC markets.
It would therefore make sense for ICE as a vertically integrated exchange with a strong clearing capability, to look to enhance their position by buying a relatively small but growing FX platform like FastMatch.
This is a matter that will likely prevail across 2017, and will require some very swift thought processes at boardroom level to be able to navigate it.
CMC Markets is leading the direction toward defending and protecting not only its own customers, but the entire industry in Britain against this regulatory propsosal.
Last week, many British mainstream news sources erroneously reported that the firm was looking to leave the UK and head to Germany. These reports had absolutely no basis whatsoever, and do not make sense. Any firm looking to leave the heartlands of London for socialist Germany would never be serious, and even if they did, what will that achieve? Very high taxes, lack of infrastructure and local understanding of the entire business components, no technology and given that most British CFD firms have 70% of their client bases in Britain, they would still need to abide by FCA rules in order to service British clients.
FinanceFeeds spoke to CMC Markets on this subject, and most certainly can deduce that with no basis whatsoever, and referring to a generic corporate statement made by CMC Markets last week following the FCA’s announcement, the British newspapers (often with a liberal anti-capitalist bias) decided to make up their own story.
The statement said “The board of CMC will consider all options open to the business to ensure that shareholder value is delivered whilst continuing to offer the highest levels of customer protection. Until CMC has finished discussions with the UK and German regulators as part of the consultation process the board is not in a position to make any comment on the outcome of its review.”
Not at any point, publicly or privately, has CMC Markets stated that it is to leave the UK, and to report such is indeed misleading.
The mere circumstance that Britain’s FCA has proposed leverage restrictions as well as a series of other criteria which will have to be adhered to by CFD brokers when many electronic trading firms in Britain herald CFDs as a core business activity, yet BaFIN in Germany has stated that it will allow unlimited leverage and will insist on insurance against negative balances (thus encouraging trade warehousing rather than a more transparent ecosystem) is absolutely not a basis to assume that any British firms will up sticks and move to Germany, in the same way that Tier 1 banks which distribute FX liquidity from London will not be moving out of the world’s most advanced financial center post Brexit, to Europe, which is a wasteland by comparison, as was incorrectly suggested by many mainstream newspapers.
CMC Markets confirmed to FinanceFeeds that they will take the lead in lobbying the regulators with regard to the new proposals.
“What has happened thus far is that we are going through the process of consultation with FCA and with the German regualtor, BaFin, which also issued a consultation paper on CFDs, and part of the consultation process is that as an industry, as well as a corporation, and in the interest of our clients we are lobbying the regulator and putting our point of view across, and hopefully there will be revisions to the consultation paper. As a consequence it is impossible to agree to anything before we have the full information on all of these factors” explained a senior CMC Markets executive to FinanceFeeds.
With all of this in mind, 2017 will likely be a year of significant corporate change, and any acquisitions, mergers or change of commercial direction will likely revolve around two factors: Bank credit and CFD regulatory proposals.
Featured image: Royal Exchange Buildings, London. Copyright FinanceFeeds