Pressure on execution fees, low interest rates and a growing regulatory burden have all combined to create a very tough environment for exchange traded derivatives (ETD) brokers in recent years – and things look set to get even tougher. European Markets Infrastructure Regulation (EMIR) is demanding that clearing brokers disclose the prices and fees associated with their services. Client segregation stemming from this demand will increase operating costs and erode net interest revenue further. In addition, more Central Counterparty clearing houses (CCPs) are coming into existence, all requiring default fund contributions and demanding more capital from brokers.
Brokers need to take action to defend falling profitability in this evolving environment but many firms have already reduced costs as far as they can: automation is high as are straight-through processing (STP) rates, staffing is lean and off-shoring has been explored. What, then, are their options?
Three areas – the way services are delivered, the way clients are charged and the way risk protection is funded – provide particular scope for developing an industry better placed to survive the difficult times ahead.
Reducing costs by changing service delivery
Changing the way services are delivered is the most promising, remaining area where brokers might reduce costs. Not all the services that brokers offer differentiate them from competitors. For example, you are unlikely to win clients because they prefer your daily statements to those of your competitors. Differentiating services should be retained in house, but for some brokers, it may be worth exploring whether they could provide non-differentiating services more efficiently by collaborating with others, through a joint venture across multiple brokers.
Increasing revenue by charging differently
Brokers have typically charged clients flat rate fees. But what about unbundling services and levying fees to reflect the cost of providing each service? Fees for reports or payments could be isolated, electronic trading fees could become message based to reflect infrastructure utilisation. Discrete services could then be re-bundled for specific types of client – low-volume clients may need different things from higher-volume client, just as clients involved in high-frequency trading may need different things from asset managers.
This approach would help brokers understand which services are important to their clients and focus on improving these specifically. If industry concentration continues and client access becomes an issue, this kind of approach could allow for the development of standardised, no-frills packages for smaller clients. The complex invoicing associated with this approach could be a constraint, but it nevertheless feels like something the industry should consider.
Reducing costs with new funding for risk protection
Lobbying to reduce the level of mutualised risk at CCPs could help brokers to reduce their capital costs. Currently, total protection by a CCP is made up of a client-funded initial margin (typically around 99.7% of market risk), with the residual being covered by a broker-funded default fund. Increasing the proportion of total protection accounted for by the initial margin and reducing the size of the default fund would reduce brokers’ capital requirements. It would also reduce entry barriers, although participant integrity could be ensured through other membership criteria, such as the size of a firm’s balance sheet.
To explore options for protecting profitability, contact us now.