Commodities brokers move to fill the gaps

When MF Global collapsed in October 2011, there were those who forecast the demise of independent commodities brokerages, anticipating that the market would become increasingly dominated by the global investment banking groups. In reality, the opposite seems to have happened. Numerous independent firms, some long established, some recently launched, have hired staff who came either directly from the wreckage of MF Global, or had left the firm before its downfall.

Sucden Financial, the brokerage arm of soft commodities merchant trader Sucden, hired several former MF Global executives in Asia. US commodities broker-dealer and futures commission merchant (FCM) INTL FCStone bought the entire MF Global metals team. Agricultural products merchant trader ED&F Man hired Chris Smith, MF Global’s chief operating officer until 2008, to lead the expansion of its capital markets division. Another ex-MF Global executive, David Mudie, became the chief executive of US broker RJ O’Brien’s recently launched European operations in London in October 2012. RJ O’Brien took on more than 20,000 client accounts from MF Global in a weekend, bringing its total to about 100,000.

This growth and diversification is in stark contrast with the overhaul of commodities divisions in the major investment banks. UBS is retaining precious metals and commodity index businesses that serve its wealth management clientele, but wound down its trading in other commodities in late 2012. Barclays departed the open-outcry floor of the London Metal Exchange (LME) – known as the 'Ring' – in November 2012. That left just two banking groups – JPMorgan and Société Générale – holding Ring-dealer status on the exchange, plus the joint SocGén/Crédit Agricole brokerage NewEdge.

“When we joined the Ring in 1994, we were the 17th member. Now there are only 11," says Michael Overlander, chief executive of Sucden Financial. "This is partly the result of mergers and acquisitions, but additionally, the constraints on bank balance sheets have prompted a number of LME clearing firms to pull out, especially where their business was less client driven. I have no doubt that they will return at some stage, because this business is too important for them to stay out permanently.” 

New customers

John Wall, who stepped down as head of investment banking at UBS in 2011, subsequently joined Marex Spectron as chief executive in October 2012. He believes that the commodities business is going through structural change.

“Either because of scarce capital or through legislation such as Dodd-Frank, banks’ mandate is shrinking, they are being forced to retreat from many activities or apply more capital to those activities they are staying in. That means the opportunity set is significantly reduced, and a brokerage is definitely a more interesting place to be,” says Mr Wall.

There is a general consensus among non-bank brokers that proprietary trading previously accounted for a significant proportion of the largest banks’ activities in the market rather than client business. As the US Volcker rule and other regulations constrain proprietary trading, the business case for commodities units in investment banks may become weaker. Sean O’Connor, chief executive of FCStone, has the impression that even those banks remaining in commodities trading are gradually dropping mid-sized clients that are marginal to them, but core for specialist firms such as his own.

“The evidence is anecdotal, but it seems as if banks have been tightening their pricing for smaller clients. What we know for sure is that we used to have 80 to 100 new clients approaching us per month, and over the past couple of years that has risen to 400 to 500. At least some of that new business must be coming from the banks,” he says.

In practice, commodities brokers operate a range of business models, some of which are closer to inter-dealer brokers for which banks are part of their client base. Mr Mudie at RJ O’Brien does not regard banks as direct competitors. “We are a specialised firm and we know exactly where we sit in the market. All of our business is customer flow, we do not hedge against our clients, and that is our advantage because there are not many market participants who can say that,” he says.

Adapting to the market

One commodities FCM that has a growing balance sheet behind it is Bache, an LME member purchased by investment bank Jefferies from insurer Prudential in 2011. Prudential had been attempting to sell the firm as a non-core asset since 2004, leaving it relatively underdeveloped, so Jefferies’ main focus has been on building scale around Bache’s established futures expertise.

The company was already strong in metals and agricultural commodities and became a Ring dealer on the LME in September 2012. Jefferies is now building out an energy team. That growth process was further reinforced by the $3.6bn all-stock acquisition of Jefferies by agro-industrial group Leucadia that was completed in March 2013, says Patrice Blanc, head of futures at Jefferies and chief executive of Bache.

“Leucadia has given Jefferies weight in the market and built customer confidence after some inaccurate negative rumours in the wake of the MF Global collapse. We are not a mega bank saddled with legacy assets, but nor are we tiny – we are just behind the heavyweights,” says Mr Blanc.

Despite the increased size, Bache is maintaining an agency broker model without proprietary business. Mr Blanc says Dodd-Frank and other measures make products such as over-the-counter (OTC) energy trading business, which carries large market and counterparty risks, less attractive. That suits the Bache model of focusing on listed futures products and value-added service.

“We are accustomed to a client-based model across the firm, and we look at the Bache business in terms of cross-selling opportunities with other products such as equities or fixed income for financial institution and hedge fund clients. The industry is changing, and the old model of banks trading commodities with a lot of balance sheet usage in a separate silo from the rest of the sales and trading activities is likely to fade, even if it takes some years,” he says.

By contrast, Mr Wall says Marex Spectron “cherishes” covering commodities from both listed and OTC angles. He views it as a product lifecycle, with many derivatives starting out as OTC products before evolving into the listed markets as usage increases.

Most brokers aim to maintain a relatively balanced portfolio of producer, consumer and financial clients to maximise the opportunities for matching client trades. Mr O’Connor says FCStone is tilted towards commodity producer clients, with a limited focus on the speculative investment community. He estimates the firm’s coverage at about 50% of US agricultural producers and 30% to 40% of those in Brazil, adding that the firm is seeking to build up its consumer client portfolio. 

Technology challenge

Top-tier equity trading is increasingly dominated by electronic execution, with 151 multilateral trading facilities registered in Europe. This has whittled away margins in equity trading, with all but the largest broker-dealers increasingly opting for low-touch direct market access platforms for clients.

Opinions are mixed on how far this trend will continue into the commodity space. In the short term at least, the reduction in bank proprietary trading and hedge fund leverage activity has reduced the number of speculative and volatility players in the market, with some impact on liquidity.

“Prices have been moving with more speed and more gapping as a consequence. In foreign exchange, it is pretty straightforward to buy a $10m spot position and roll it automatically on a daily basis. But in commodities, three months is the most common benchmark, and clients need to discuss with their brokers information on the bid/offer spreads and when to close the forward position,” says Mr Overlander.

Mr Wall says that the market depth for most commodities is still a far cry from blue-chip equities or bunds, and purely electronic execution cannot guarantee liquidity at a given price point. But there is general consensus that competition remains tough and margins are often under downward pressure. Mr O’Connor says a pure agency brokerage model, especially one based on large financial clients, is difficult to maintain.

“It is not just prices that are readily available onscreen, there is plenty of free research out there as well. Some FCMs are chasing hedge funds and high-frequency traders to try to get the volumes. Our approach is to focus on mid-sized corporate customers that lean on us for broader market knowledge and services, not just an execution platform,” he says.

FCStone has also diversified along the value chain with the purchase of Singapore-based exchange ClearTrade in May 2013. Mr O’Connor says FCStone does not have a naturally acquisitive strategy, but the firm already pays about $80m a year in exchange fees, and it made sense to add capabilities and be able offer a service to clients that does not stop at the door of the exchange.

“We will not become a competitor to any of the largest exchanges any time soon, but we are looking to list swaps and structured products that existing swap execution facilities in the US are unlikely to offer,” says Mr O’Connor.

No avoiding regulation

The move to trading through swap execution facilities is just one of many aspects of US legislation that are driving up the costs of OTC business in particular, and brokerage in general. This is squeezing smaller FCMs and forcing many players out of the swaps business altogether. There are only a handful of companies that have registered as swap dealers under Dodd-Frank regulation – Bache, FCStone, RJ O’Brien and Cargill in terms of commodities players – that are not banking groups or bank-owned brokers such as NewEdge.

That creates an opportunity for those brokers able to stay the course. However, brokers are concerned that it is difficult to avoid increased costs for clients. Mr O’Connor says his compliance team has quadrupled in size, and many clients do not have large in-house legal teams to handle the sweeping documentation changes stemming from Dodd-Frank. The scrapping of a five-day grace period on futures margin posting is particularly painful for corporates that do not carry large amounts of surplus liquidity.

“Only the largest FCMs will be able to post margin on their clients’ behalf, the rest will face the prospect of asking their customers to increase margin by about two or three times. Many companies will not be able to do that, they will simply stop hedging, which is not a good outcome for risk management,” says Mr O’Connor. 

His view is that firms such as FCStone that can offer some degree of cross-collateralisation across futures and swaps products will be at an advantage, as companies will not want to use separate FCMs and swap dealers any more. But Mr Wall at Marex Spectron says the bundled service proposition could be under pressure because clients, especially fund managers, are increasingly required to demonstrate best execution, which means retaining a panel of different brokers.

“Clients will go where the liquidity in the market is, and in some sub-segments we are seeing 20% or more of the activity, so it is hard to find liquidity without coming through us,” he says.

Room for growth

Despite the regulatory pressures, most commodities brokers still find cause for optimism. Asia and Latin America are major points of attention, with both producer and consumer clients growing in number and size rapidly. Mr Wall identifies Singapore and Hong Kong as growth businesses for Marex Spectron, with iron and coal (linked together by their role in the steel industry) showing good potential in terms of specific commodities. The firm is also rounding out existing expertise to complete its product sets – for example, extending its strong energy franchise to include biofuels.

China is the largest marginal consumer of commodities, but most Chinese financial products are still non-deliverable, so trading is restricted to domestic players. That means markets such as the LME, Chicago Mercantile Exchange (CME) and IntercontinentalExchange remain dominant in terms of global commodities trading. But that could change over time. The acquisition of the LME by the Hong Kong Stock Exchange in 2012 has not yet had an impact on day-to-day business, but its long-term significance is clear.

“As LME shareholders we never underestimated the potential of Asian markets, and the attraction of ownership by an Asian exchange for shareholders was to ensure that the relationship between London and Asian clients would be enhanced. The US has been so dominant in commodities and exchange mergers that it seemed logical to think the balance will gradually shift in the other direction,” says Mr Overlander, who was one of the LME directors during the negotiations.

And even in low-growth Europe, RJ O’Brien has shown there is room for expansion. Having closed its first trade in Europe in January 2012, the firm has just taken a lease on a larger office after running out of space. Mr Mudie says its mostly listed products offering in Europe will gradually extend into OTC products.

“Following the recent high-profile events in our industry, clients are understandably cautious about their choice of firms for execution and clearing. We are the only surviving founder member of the CME and will be celebrating our centenary next year, so we are not a new entrant in that sense, it has been a case of explaining our pedigree to European clients who are less familiar with us,” says Mr Mudie.