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Getting Squeezed: Introducing Brokers Numbers Waning, Growth Wanting, Future Questioned

New Introducing Broker numbers hit historical low; IB Numbers Shrink 17 percent Since Financial Crisis

One FIA is here

There is a funny story about former MF Global CEO Jon Corzine, when he held his first all company conference call with employees. He said he was impressed with how many investment bankers the firm had, having no clue that the number of IBs affiliated with MF Global actually meant introducing brokers. The fate of the company was probably sealed right then and there.

While investment bankers have had their own problems in recent years, it is introducing brokers whose best days seem behind them. A combination of factors, from regulation to technology along with user preferences have changed the structure, relationships and future between futures commission merchants and IBs.

Last year produced the lowest number of new IBs of any year since the firm category was established. Just 80 new IBs registered with the National Futures Association in 2015, a dramatic drop of 47.7 percent from 153 in 2014 and further still from the 185 launched in 2013, according to data from the NFA.

The number of NFA registered IBs has fallen to 1,236 at the end of 2015, down 17.6 percent from 1,500 in 2008. Meanwhile, FCM numbers have seen a steep drop since the Global Financial Crisis, with just 61 at the end of 2015, down from 139 in 2008, according to NFA data.

And here is what it looks like with what is left. Of the 61 FCMs still out there, just 13 FCMs have IB relationships, according to industry sources. And of those, about 80 percent of the IBs clear through just two firms, ADM Investor Services (ADMIS) and RJ O’Brien.

“Independent introducing brokers,” or IIBs, guarantee their own compliance and have financial standards to meet. An IIB may do business with as many FCMs as they can manage efficiently. A “guaranteed introducing broker” has its financial and compliance functions guaranteed by a single Futures Commission Merchant, or FCM. A GIB may only do business with one FCM.

The number of GIBs dropped to 682 in 2015, from 801 in 2012. Some of this is attributed to GIBs associated with Vision Financial Services that were not taken on by ADMIS as GIBs after Vision was forced to close the FCM operation in 2014. Probably not coincidentally, the number of IIBs rose to 580 at the end of 2015 from 523 in 2012.

Post Crisis’ Impacts

One reason for the rise in IIB numbers is the implosion of MF Global in 2011 and the Peregrine Financial Group, or PFG Best collapse in July 2012. After that, IBs did not want to be associated with just one FCM anymore, assuming they survived the chaos of MF Global and Peregrine.

For most of the time I was an associated person at The Price Futures Group, Inc., the firm was a GIB to Man Financial, then MF Global after it went public. Although The Price Group had moved to an IIB status by the time MF Global imploded, most of the company’s accounts were with MF Global. Due to quick work by Tom Price, The Price Group was not allocated to the receiving FCMs, rather it moved by its own accord to ADMIS amid the heart-pounding chaos.

FCMs are also taking a much harder look at new IBs looking for a place to clear. With the regulators in a fine happy mood these days, the risk of taking on someone inexperienced running an IB is amplified.

There was always lower tier, higher risk IBs in the industry and FCMs who would cater to them. This would allow a firm, or associated persons, with regulatory problems to be able to stay in business. Or, it would allow someone new to the business to start up a new IB operation. But the number of firms catering to this tier of IB has collapsed as firms like LFG, Alaron and PFG disappeared from the industry via mergers and scandal.

Another factor to look at is where do new IBs come from? I came out of an FCM and moved to an IB. With dwindling numbers of FCMs today, that could mean fewer potential sales people willing to start their own introducing broker business. And with the trading floors consolidated in Chicago and essentially closed spare a few options pits, there are fewer phone clerks who could become sales representatives while moving off the floor.

My friend Jon Matte came from the ranks of retail traders to start his own IB and CTA firm. He cleared Alaron because it was the only FCM he could find at that time which would guarantee a new start-up IB. The number of FCMs offering the guaranteed status today is very narrow and the industry probably would not have found a place for his new firm from an unknown party.

New Way Of Doing Things

Today, some IBs have been chased out because their production levels were too low. Even before MF Global’s collapse, there were pressures on firms to increase production or face higher rates. It just did not pay to continue supporting some of the low production IBs.

Part of this whole phenomena also has to do with the rise of the house style business of an Interactive Brokers or TD Ameritrade and away from an associated person model. As an associated person at an IB, I was essentially my own profit center, competing against not only outside competitors, but also internal competition. Everyone was a competitor.

However, the Interactive Brokers’ and TD Ameritrade’s of the world don’t use that model. They pay salaries to employees who handle the customer business, not commissions.

This was part of the problem that MF Global faced, as it had a very expensive AP business model. Because of the numerous and various separate deals done at MF Global with in-house brokers and various IBs and FCMs, an increase in volumes traded did not translate into higher profit margins for the firm.

Firing brokers at MF Global would not solve the problem either as many if not most customers are more loyal to their personal broker than they are the clearing firm behind them. In fact, many brokers will change firms multiple times during their careers, with customers following them loyally. That was my experience, my customers mostly followed me wherever I went.

But now, there are fewer places for brokers to go and it is harder to get a new IB started.

Part of this is the regulatory cost increase the industry has faced since the financial crisis and the passage of Dodd-Frank. The new capital requirements on the big banks also had a residual impact on FCMs and IBs.

Another big part is the low interest rate environment which has permeated the markets in recent years. FCMs make money on the interest rate of the funds they hold for customers. With interest rates near zero, FCMs have had a harder time making money.

Another factor is the high cost of being in the customer business from a technology standpoint. We have seen massive consolidation in the last 20 years as electronic trading has become the dominant platform for order execution. It used to be the cost of multiple telecom lines going into the exchanges that was the easy rationalization. Now, it is also the high cost of keeping up with the burden the FCMs and trading firms must absorb from exchanges to stay current with new products and their latest technology upgrades.

It has not helped IBs that so many commodity and index products are readily available as an ETF or ETN.

It was the high cost of lawsuits that saw the creation of the FCM and IB model after the wirehouses complained to Congress nearly 35 years ago. Many wirehouses in the late 1970s and early 1980s had branch offices all over the country and there was high interest in commodities due to the roaring ag and metals markets of the 1970s. But supervising those two-person offices in the far reaches of the nation was hard to do for the wirehouses, who were the deep pockets sued, and good name besmirched, when the branches misbehaved.

The resulting regulatory structure created a layer between the deep pockets of the wirehouses and their good name, and that of the broker in the field.

With the creation of the NFA in the early 1980s, came the regulations that created FCMs and IBs. It was even later in the 1980s when the two IB categories, GIB and IIB were created, allowing for FCMs to remove both compliance and financial guarantees to the new IIBs.

I remember in April of 1984 when there was a massive layoff in the industry due to overcapacity, and the new regulations coming through. With the NFA established in 1982, new rules and structures were being developed for the industry. In 1984, the first year the NFA had records for IBs, there were 498. By 1985 there were 1080.

In 1984, firms like Merrill Lynch closed hundreds of commodity offices around the country amid low grain prices, low volatility and high cost of operations. Many of those offices, with new names and levels of separation from their previous owners, would become part of the IB industry in the years to come.

It was in 2006 that we saw the top of the number of IBs, with 1812. That same year there were 176 FCMs. The high in the FCM numbers came the very first year of numbers were kept, 1985, with 385 FCMs registered with the NFA.

Information At Your Fingers

The role of the IB has changed over the years. No longer are they they source of exclusive market information gleaned from the trading floors they once were. Today, anyone with an Internet connection or a cell phone has as much access to information as most IBs. And with more people comfortable conducting commerce over the Internet, fewer people need an IB to enter an order on their behalf.

Of course, some IBs have rolled with the punches and added new services to continue to connect with clients. This is particularly true in the agricultural, metals and energy areas where IBs specialize. Some IBs have offered more that just futures brokerage services by getting deeper into the cash markets for customers.

However, we may have reached a tipping point, where fewer people need an intermediary doing what an IB does in the age of self-directed and mobile trading. We’ve seen this in many other industries, with intermediaries under attack by the likes of Uber disrupting Taxis, Airbnb upending hotels, travel booking sites negating travel agents. The days of the IB may continue to wane.

One could even throw in the threat of blockchain to completely upset the status quo as a factor in the fewer number of IBs being created, but that is too far from where we stand today. Tomorrow is another thing.

There is still a core of quality IBs in the industry to keep the traditional structure in place. But with the number of new IBs waning, and headwinds in place to keep it that way, the future for the IB category is more uncertain than ever.

(Edited by Jim Kharouf, Doug Ashburn & Sarah Rudolph; Infographic by Doug Ashburn)

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About Author

Lothian is executive chairman and CEO of John J. Lothian & Co. and editor of the John Lothian Newsletter. He publishes MarketsWiki.com, MarketsReformWiki.com, MarketsWikiEducation.com, JohnLothianNews.com and three industry newsletters.