DERIVATIVES are among the most feared and least understood beasts in the financial menagerie. Few people understand the many ways they affect our daily lives, giving us fixed-rate mortgages, keeping the price of petrol stable at the pump and protecting the value of our pensions.
Even less appreciated is the fact that Britain can boast a world leader in the fast-expanding derivatives market. Icap — the word is a contraction of its original name, Intercapital — is the world’s biggest inter-dealer broker. Such firms stand between the banks and big financial institutions that need derivatives, bonds and other arcane financial products.
They act as a marketplace through which those institutions can deal on a secure and confidential basis. Unlike City investment banks, they do not build up big positions in the instruments they deal in, making their money from commissions on the deals they facilitate.
They act less like traditional brokers, says Mike Sheard, Icap’s director of corporate affairs, and more like exchanges such as the London Stock Exchange: “All we are doing is gathering liquidity and price flows and creating a market through which people can deal.”
Of the 2,900 people employed at Icap, 1,700 are dealers. The company has 23 offices around the world and substantial operations in the three biggest financial markets, London, New York and Tokyo. Last October Icap opened in South Korea; it is currently awaiting clearance from the authorities in Beijing to operate in China.
The company deals in a bewildering array of products. On the securities side, there are corporate and government bonds, including the all-important US Treasury bond; derivatives proper include swaps and options, allowing dealers to take a view on the future direction of interest rates and similar instruments tied to exchange rates.
Then there are various contracts tied to oil, coal, gas and electricity prices and, most recently, a market in emissions trading. This started earlier this year, on the back of an EU directive that was Europe’s way of implementing the Kyoto Protocol, and allows businesses to trade in “permission to pollute”.
When derivatives dealing began in the early 1980s, trading was done by phone. There were no electronic systems, and the market was understood by only a few key players.
Today an increasing proportion of business is carried out on screen. Icap made the transition with the 2003 purchase of BrokerTec. Phone-to-phone or voice broking is suitable for more complicated products, often tailored to clients’ individual needs, where the market is illiquid and volumes are low.
Electronic broking is, inevitably, cheaper and easier. It is used on more commoditised instruments that are more widely understood, where there is a liquid market and a significant level of trade.
In the 2004-05 financial year, global revenues across the industry from all the derivatives Icap deals in totalled $5.1 billion, according to market estimates. Electronic trading stood at $730 million, about 14 per cent of the total.
But the level of electronic trading had itself grown, coincidentally, at a rate of 14 per cent over the previous year. Voice broking, although counting for the greatest proportion of all trades, grew by a more sluggish 3 per cent. The electronic slice of the pie can only increase.
Michael Spencer, the chief executive, says: “I envisage a day not too far distant when the majority of Icap’s services, apart from a few very illiquid or structured products, are available electronically.
“This does not at all mean the end of voice broking but it will see an evolution of the voice broker’s role. More customer coverage, more cross-selling, more value added and higher revenue productivity.
“We are at the cutting edge of another transformation in the marketplace. We have seen the cycles of change in the past affect first foreign exchange and more recently bonds. The next wave will take in over-the-counter derivatives as well. I have in my mind’s eye a view of the future. It is electronic.”
His enthusiasm is met with scepticism from much of the rest of the derivatives industry. Several of Icap’s competitors do not have electronic dealing systems; many had assumed that the future would be entirely voice broking.
Icap, in its preliminary figures for 2004-05 issued last month, was able to show impressive growth from its electronic activities and signs that the business, initially loss-making, had turned the corner.
Profits before interest grew fivefold, from £4.7 million the previous year to £23.9 million; more significantly, this was on revenues that were up by only a third to £84 million.
Icap now claims about 28 per cent of the world inter-dealer broking market, although firm statistics are notoriously hard to assess. This puts it slightly ahead of the second force in the market, Collins Stewart Tullett. After that, the competition tails off. Tradition, the Franco-Swiss group, probably has 12 per cent; two or three other firms are a little behind this.
Icap’s high market share would probably preclude any takeover of the handful of other players in the industry, although Spencer has made it clear he is interested in small add-on acquisitions. He says: “Looking ahead our strategy remains unchanged — to grow both organically and through selective acquisition to take our share of the combined voice and electronic market from an estimated 28 per cent to exceed 35 per cent over the next few years.”
Last month, along with the annual results announcement, came the news that one of his longest-serving lieutenants was leaving. David Gelber is standing down as chief operating officer at the annual meeting next month, although he will remain a non-executive director for a further year.
There has been speculation that Spencer himself, aged 50 and with a fortune approaching £400 million and a string of outside investments, will in due course decide to lessen his involvement with the business he founded. But he has always insisted he is committed to Icap for the foreseeable future, even though he may eventually move up to the chairman’s seat.
