Letter from the Co-CEO, Lynette Lim "Direct Funding Participant and its possible impact on FCMs"

One of the hardest things about working for a clearing FCM is explaining to people what I do and what the company does.  Well of course I am only joking, but to explain what we do in the most concise clear way requires some extra thought.  So far, I think I have failed rather miserably at the elevator pitch.  The explaining is especially tricky in a taxi ride situation when you only have about 30 seconds to 2 minutes.  After I try to explain some of the processes which a clearing firm does, they will reply with a blank look on their faces. “Oh, so you are a trader?”  And my best comeback line is “No, I don’t trade, but I make sure that traders don’t blow up.”  

Well in part this is true.  We do manage the risk of our customers, but it is not the complete story.  Essentially, as a clearing firm, we act as an intermediary between the exchanges and the customer.  We face the customer, and the exchanges face us as members of the exchange.  We face the customer to provide account opening, trading and execution services, customer statements, and to receive customer funds.  And we the FCM face the exchange for regulatory trade reporting, capital payment, and collection of margin.  In a nutshell, if a customer goes under due to trading losses or misbehavior, we are on the hook with the exchange.

The next obvious question I anticipate you would ask is: “why does the exchange need intermediaries like you?  Why can’t traders just go directly to the exchange?”

Well the simplistic answer to that is the exchange does not want to deal with the individual customer for collection of margin, and does not want to manage the risk of the individual customer.  It would take too much capital, investment in systems, and manpower involved to manage the risk and payments for every single customer.  It is more efficient for the exchange to deal with a couple of members of the exchange who then will deal with individual customers and companies.  And to qualify as a member of the exchange and have the ability to clear the trades of customers, you need a lot of capital.  And to be more exact: 8.0% of overnight maintenance margin.  This is to safeguard the customers so that in the event of default by a customer, the FCM can take the first hit.  Hopefully I have convinced you why we play a pivotal role in the trading industry.

That is why a new type of membership which CME is introducing in fall - Direct Funding Participant(DFP) is especially intriguing and terrifying to FCMs at the same time. This type of membership allows the customer to place the margin deposits directly with the exchange instead of the FCM.  The DFP will need to establish a relationship with the settlement bank to do the same call/collect cycles that the clearing firm does for its customers.  For this privilege, the DFP has to put up half of its regulatory requirement, and the FCM puts up the other half of the capital requirement. And here is the big BUT.  In the event the customer defaults or fails to pay margin when the exchange calls, the exchange will go to the FCM.  That is why I consider it to be a hybrid model between becoming a clearing member of the exchange and a customer of a FCM.  As a DFP you have a certain direct relationship with the exchange, and the FCM is still on the hook for default.

I suspect that this DFP type of membership arises from customers who are large corporations that were concerned about the nature of segregated funds whereby it is all lumped together with other customers.  They would rather their money and their money alone be kept separate with the exchange, and they do not want to become self-clearing members themselves.

While this idea of customers going directly to the exchange and thereby reducing the importance of the FCM is terrifying if thought out to the extreme, we must also realize that the DFP membership is certainly not for everyone on the street.  Not many firms will be willing or capable to invest in extra manpower, systems, and capital to increase the security of their funds for the unlikely event of a default.  For the FCM who is undertaking DFP as a customer, it also means a loss of potential interest income from the funds while still having to undertake the risk of the customer.

So what are the FCMs to do?

In the face of the blurring of lines and relationships between the customer, FCM, and the exchange, to stay relevant the FCM needs to be creative to generate other forms of income from the customer to ensure the relationship to the customer is still viable.  In this case, the FCM can offer facilities management for customers who want to take up DFP memberships.  PhillipCapital is fortunate in this way that we do have our own back office solution so that we are able to offer facilities management as an option to customers and other FCMs.  

As an FCM, I think that we also need to also blur the lines between rivals and partnerships.  There is healthy competition between FCMs to provide the best solution for the customer, but we also need to be willing and open to work with our “rivals” and become partners with them for different solutions to the customers.

Recently, I have been reading books about the brain, and the multiplicity of the brain within the brain; and there are if you will, multiple resources fighting for different reactions.  If we can have different roles as a person – as a parent, a friend, a daughter, a coach, a boss, a neighbor - as a company, why can’t we also be different things to different customers?

Think about it.

PS. I also hope you like our new layout.