CFD bombshell: Senior FX executive speaks out “The entire OTC FX industry will move to exchanges” in very comprehensive analysis

“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.”


This week will most certainly be remembered as a milestone in the history of the retail FX business, as it is the week in which the Financial Conduct Authority (FCA) in Britain issued a consultation paper which detailed its proposals to restrict the method by which contracts for difference (CFDs) are provided to retail customers.

The immediate result was that the share prices of some of the major CFD and spread betting firms were decimated, largely due to investor confidence being dented as a result of CFDs being a core business component for the vast majority of British companies.

In the UK, spot FX is relatively rare, largely due to the tax treatment of spread betting and CFDs which is very favorable as profits can be subject to no tax whatsoever on the basis that it is a ‘bet’ on the future outcome of the value of certain asset classes.

Britain’s highly advanced, publicly listed CFD and spread betting companies have been in existence for the best part of three decades and are bastions of expertise, serving a very loyal and sophisticated domestic audience via high quality proprietary trading systems.

The level of expertise within the senior management of such firms is absolutely there to see and it is fair to say that the flagship companies that provide retail trading environments to discerning customer bases are the large established firms of North America and Britain, those being Hargreaves Lansdown, FXCM, OANDA Corporation, IG Group, CMC Markets, Interactive Brokers and GAIN Capital.

Why is the FCA taking such a stance? 

Surely there are far more pressing issues for the FCA to address than the conduct of such well organized and well recognized companies, such as the FCA’s upholding of PacNet’s regulatory approval despite PacNet being listed as a criminal organization by the US Treasury recently. The FCA, instead of following the US Treasury’s lead, responded to the sanctions by defending PacNet.

Additionally, the FCA allows binary options fraudsters to run amok in England when other nations have issued outright bans and in some cases resorted to police investigations on the perpetrators.
Instead of tackling this, the FCA has decided to impede the progress of the nation’s finest.

Why would the regulator that presides over the most sophisticated and developed financial center in the world do such a thing?

FinanceFeeds spoke today to Francois Nembrini, Global Head of Sales & Liquidity Management at AFX Group’s Quantic AM institutional asset management division, who is a highly experienced institutional FX senior executive, having spent 12 years as Managing Director of FXCMPro, FXCM’s institutional division, where he had extensive relationships with banks, central banks, hedge funds, brokerages and investors globally.

Francois Nembrini
Francois Nembrini

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.

“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.

It is clear from our research that listed derivatives exchanges are indeed moving toward attracting a larger group of retail clients.

Exchanges are onboarding retail platforms and firms such as Trading Technologies in Chicago have redesigned their entire trading environment to attract retail customers who would trade listed derivatives.

Also, CBOE LiveVol recently launched a brand new site that is aimed at providing news and data – otherwise prohibitively expensive and inaccessible – to a retail trading audience via an Amazon-style user interface.

Mr. Nembrini said “If you stay in the OTC business, you have to be conscious of the trend and be reasy to compete in a much harder environment with lower margins, higher compliance & regulatory costs and lot more competitors. Stockbroking is a good example, as in that sector, it is all about extra services you give to clients. Execution has almost no value unless you do very large trades and brokers need to win business on the value of their technology or their market research.”

“Firms like IG on the contrary made money on tax advantages attracting clients & a trading model which allow them to profit from unsophisticated traders burning themselves through leverage like mosquitoes on an incandescent light. Markets will have a much harder time competing in markets where the broker’s interest is 100% aligned with its clients. In those markets you get the trade because you give good research and not because you can convince an unsophisticated client that high leverage might lead to fast money. Exchanges have seen the margins in the OTC business and do not mind destroying the business model to get some scraps out of it. Arguments they are pushing to regulators are also very hard to argue against when you look for instance at retail traders profitability versus market makers profitability on the same trades” continued Mr. Nembrini.

“In 3 to 5 years, the number of OTC derivatives and FX firms will likely be reduced and there will be stiff competition from listed products. IG and Saxo for instance have introduced listed products on their platforms but those are aimed at attracting listed product traders into trading OTC at a much higher profitability for IG or Saxo. If CFDs become comparable to listed products in leverage and execution standards, OTC firms will have to be ready to compete in a much tougher environment with much lower margins – Francois Nembrini,  Global Head of Sales & Liquidity Management at AFX Group’s QuanticAM

FinanceFeeds asked Mr. Nembrini if he considers that many OTC firms will now expand their product range in order to attempt to diversify and avoid the implications of new rulings.
Mr. Nembrini, who has for many years maintained very close and solid relationships with the eFX divisions of global banks and understands their requirements and the costs associated with execution on an OTC and listed basis, also considers that going the multi-product path is a difficult one.

“To be able to make a good multi-product system connected to exchanges is a much harder task than many OTC firms IT departments can cope with. Workflow to process a trade is very rudimentary even at places like IG markets: they check the client trade versus reference price and then book the trade into their risk book. Less than 10% of trades are routed on a one to one basis in the reference exchanges where you need to worry about problems like latencies to make sure you get the price you are trying to hit” said Mr. Nembrini.

“OTC firms have spent all resources into fancy front ends and mobile solutions but their back end are extremely weak. If IG would need to send half their trades to market tomorrow on a back to back basis I would be ready to bet that their infrastructure would melt. Very few trades get out to market in a sophisticated fashion from OTC market makers. Most of them are still hedging manually when the “risk bucket tips over” and most have no understanding on how to connect efficiently to exchanges far from their dealing rooms. It never mattered to them much as they simply copy reference prices and distribute them to retail traders without routing customers trades anywhere beyond their own servers. However the trend is clear in my view and this business model cannot survive much longer. OTC firms will have to learn to be more sophisticated very quickly and operate at much lower margins if they want to survive. ” he explained.

“One of the metrics that demonstrates this is the price to earnings ratio the market gives to OTC businesses. If you make $1 million in profit extra at the end of the year in an OTC firm you barely add 6 to 7 million in your stock valuation (Price to earnings are typically below 10)explained Mr. Nembrini.

“If you are the London Stock Exchange however, then the price to earnings is50 to 1. This is why those firms are happily gobbling up OTC retail and institutional firms. Even if profitability were to decline over fivefold in OTC firms it would still remain a good deal for exchanges to buy OTC firms and absorb their businesses. This is why they do not mind lobbying regulators to force the OTC business to move towards exchange standards. They have the experience to run such businesses and know that OTC players do not” –  Francois Nembrini,  Global Head of Sales & Liquidity Management at AFX Group’s QuanticAM

“Ultimately, a simple B-book model operating out of Cyprus or London doesn’t have any legs in the future” said Mr. Nemrbini

“You need to be able to run a successful broker model based on service only or be a sophisticated market maker competing with dozens of other market makers on each leg of a trade. I have seen a lot smart guys in the industry throw in the the towel in the past years and move into less regulated business like peer to peer lending when they realized the challenges ahead. I still believe there are great opportunities ahead in the OTC business but only if you are able to reinvent yourself and use your customer flow to create an exchange like model attracting both retail and institutions to your platform. Such an initiative has to go through a liquidity management review and the creation of balanced trading ecosystems based on better trading models and more sophisticated order routing. Those concepts are unfortunately foreign to most OTC firms and would require drastic changes in their business processes. Habits are tough to change so most firms will probably try to maintain their business models against the odds and will sink with them. This is why I believe that most firms in the OTC business will disappear in the years ahead” he said.

Various meetings in Chicago between platform providers that develop trading environments for listed derivatives exchanges concur that the client value is different when on exchange. Meeting with Ryan Hansen, in April this year, Mr. Hansen explained that in terms of connectivity to venues, Tradovate is connected to CME Group (which includes CME, CBOT, NYMEX and COMEX), ICE US & Europe, and Eurex derivatives exchange.

Andrew Saks-McLeod discusses retail connectivity to exchanges with Tradovate’s Ryan Hansen in Chicago

The costs are now reducing for retail participants, a matter which Mr. Hansen detailed “With electronic trading, the costs created by the manual element are no longer the case. For example, 1,000 contracts could be executed, or just 1 contract could be executed, and there would be no extra work for either scenario.”

“Traditional brokers charge a commission on every single contract. What we are providing is a means by which we impact value the most for customers. We therefore charge a membership fee that covers the technology cost and the brokerage in one” said Mr. Hansen.

“In futures we cannot be a market maker, as we are a brokerage, so we combined the platform and the brokerage. Futures is fragmented as there are up to four different parties that transact the trade, which are the introducing broker (IB), the FCM that holds funds, the independent software vendor (ISV) or technology platform that you subscribe to and execute trades, and a market data provider” explained Mr. Hansen.

“As far as the current device neutral focus is concerned, we have incorporated all potential hardware including a downloadable desktop platform for PC and Apple Mac, as well as an Android and iOS mobile application and web version” continued Mr. Hansen.

This is a clear indicator that retail traders are now being courted by futures exchanges. There has been much industry discussion about membership and clearing cost, however when traders have a long lifetime value and a minimum deposit of $50,000, things are quite clearly somewhat different indeed.

Featured image: Royal Exchange Buildings, London. Copyright FinanceFeeds

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