Near Zero Interest Rates, FCMs And The Inevitability Of Shakeouts

Includes: MFGLQ
by: Craig Pirrong

Near zero interest rates are wreaking havoc among FCMs. I recall reading something about that. Heck, I remember writing something about that about a week ago.

There is a puzzle here, though. Why don't commissions vary inversely with interest rates? The FCM business is pretty competitive, meaning that FCMs should earn the competitive rate of return, i.e., roughly speaking, revenues should equal costs plus a fair return on capital. If interest rates rise, generating more revenues for FCMs, competition should lead them to cut commissions in order to attract customers. Conversely, if interest rates fall, reducing FCM revenues, competitive pressures should induce them to raise commissions. Why have commissions remained at rock bottom levels despite the loss of revenues from interest on customer funds that the FCMs hold and invest?

One possible explanation is that due to technological change (e.g., the expansion of electronic trading) there is excess capacity in the FCM industry, and some firms should exit. The excess capacity keeps downward pressure on commissions, which will not rise until there is a significant shakeout.

Perhaps MF Global (OTC:MFGLQ), or Peregrine, or both, were unwilling to concede that they were no longer economically viable and should exit. Frequently, the need to secure external funds to keep operating is what forces unviable businesses to exit even though individual managers or owners may want to try to gamble or cheat for resurrection. Financial firms' (including FCMs') ready access to cash (even if it isn't really theirs) can permit them to engage in these sorts of actions without securing external funds. This is why financial sectors under stress are particularly vulnerable to fraud and excessive risk taking: Not only do stressed firms have the incentive to engage in this kind of conduct (which is true of stressed firms in other industries too), but they have opportunities that stressed firms dependent on external finance do not.

Disclosure: None