OTC Energy Brokerage: What’s Next

Economic, regulatory, and technological trends are driving the OTC onto electronic regulated trading platforms. What we are concerned with here is how this affects OTC Energy Brokers. Both independent brokers and bigger firms will be affected the same way.

Here’s what will happen:

1. Horizontal consolidation- independent brokers in the fragmented OTC industry will not be able to maintain profit margins against bigger firms. First, individual shops will roll up to mid-size independent firms. Then, mid-size firms will roll up to bigger OTC shops (witness Choice’s actions this past year)
2. Cost Reductions- back office redundancies in acquired firms will be removed. Then less profitable individual producers will be let go.
3. Value Added Partnerships- the remaining firms will seek to add value either by creating technology or partnering with a firm that has it.
4. Hybrid Exchanges- the smarter firms will then morph from dark pool operators into regulated OTC firms. All others will begin to see their volumes slowly decrease as regulatory issues hamper their business.
5. Vertical Consolidation- bigger firms seeking exposure in energy will buy Order Flow, Data, and/or Technology to create their own full service Energy Brokerage divisions. Their preference will be to buy a company that has all three already. Banks and exchanges will be the most likely buyers. Banks need to replace the business they lost from the CDO/credit debacle. Exchanges because it makes sense. Exchanges are big brokers. Why not buy and lock in order flow?

Why It Will Happen:

Economics – There’s a lot of fat in OTC brokerage. Margins for Voice brokers are in the 20% area. Electronic brokers are in the 40 to 50% area. This is incentive enough for an equity broker to step in and take market share.

Technology – the OTC market is a closed, opaque business. Technology creates operating efficiency which pairs well with an open architecture business model. In short; tech creates more money from more clients with less overhead.

Regulatory – In general, the government reacts slowly to macro trends in business. But when they move, they all but close the lid on competing business models. In this case, they are reacting to the credit crisis that stemmed from the CDO market collapse. Regulatory agencies have no choice but to oversee the situation now.

Setting the Table:

Those are the macro trends that are changing the business. That is just the beginning. In the next stage: economics, technology, and regulatory factors will specifically target the OTC to get with the program or lose out to exchanges.

And So it Begins:

Here are three specific developments that have come across our table in the last month alone.

1. Clients are Demanding Compliance – Soon, if you are a broker and want to trade with a major bank, you will have to be NFA registered, Series 3 licensed and most likely have had a background check done by that client. The brokers without these will watch their client universe shrink considerably.
2. Enter Bloomberg – The brokerage business model centers on four services: Execution, Liquidity, Data, and Technology. Firms like Bloomberg and Reuters, already possessing Technology and Data can easily create the Execution and Liquidity piece and become formidable competitors to OTC brokers as well as Exchanges. In fact we are pretty sure Bloomberg is making a move to do this right now. We expect they will announce a JV with one or more OTC brokers and begin offering execution services on their screens. They already have the eyeballs, it makes sense. (You want fries with that shake sir?). Other competition will come from the Equity side soon thereafter.
3. The CFTC – They are now proposing specific changes to regulate OTC electronic platforms. This is their proposal to regulate all OTC electronic trading platforms. At first glance it may seem to have no effect on the voice-broker population. But that is a mistake. This plays right into point number one above. “If you aren’t regulated, we cannot trade through you.” It only highlights brokers as unregulated participants.

A land grab is about to take place, where banks, exchanges, tech and clearing firms all seek to protect their current franchises while growing their business.
Those that understand these changes can stay ahead of the curve. There are 2 groups:

1. Brokers who have developed good technology (real ECNs, not a computer with a hamster on a wheel inside) to ring-fence their business, and
2. Exchanges who are willing to be regulated by the CFTC. The rest may have to charge their last remaining client $25,000 per lot to survive.

Next Up:

• Who the likely winners and losers are.
• Marketmakers face the same fate.

For more information, contact Vincent Lanci at (212) 223-1000.