The following document is an approximate, but not exact, transcript of the Operational Leaders podcast conversation between host Terrance J. O’Malley and guest Tim O’Shea.

Please support the production of this podcast by downloading the Tim O’Shea episode.

Narrator 0:05
Welcome to the Operational Leaders podcast featuring leaders and innovators in the investment management industry, where we discuss the business of running the business with host and top industry executive Terrance J. O’Malley.

Terrance O’Malley 0:22
My next guest has been in the financial services business for over 30 years, having started his career on the floor of the Chicago Board of Trade. He is recognized as one of the leading experts in operations and technology. And he is the President and Chief Operating Officer of Thales Trading Solutions. Please welcome Tim O’Shea.

Tim O’Shea 0:43
Thanks, Tery. Thanks for having me. Appreciate the opportunity.

Terrance O’Malley 0:46
Tim, it’s great to have you here today. So we’re going to have a high-level discussion about derivatives and especially listed derivatives and the futures market. So by way of background, can you introduce us to Thales Trading Solutions.

Tim O’Shea 0:59
Thales Trading Solutions was founded in 2012. And we were a spin out of a fully integrated brokerage operations team from New Edge. When we spun out in 2012, we looked at the market. We saw quite a few different scenarios occurring with bankruptcies and financial services firms struggling. Certainly, we all know what happened with Bear Stearns and MF Global at that time. And we felt that representing a single brokerage firm had a liability to it in the fact that our clients, as well as us as employees, felt we needed to have a structure where we would be able to have relationships with multiple brokers and provide our clients access to utilize the services of multiple brokers, while still providing them the conduit of a single point of contact and a single level of service around our business. So, in 2012, we formed Thales Trading Solutions.

Tim O’Shea 2:08
We are a registered entity under the CFTC. We’re known as an introducing broker which has some positive and some negative connotations. But we do feel that type of introducing broker we are we deal with only institutional clients. I think the introducing broker moniker tends to have a more of a retail feel to it as it was started years and years ago around the CBOT and assisting farmers, small farmers providing them access to brokers and providing solutions around hedging. So while the introducing broker has been around for a while, we do feel that the world is changing a bit. And our new view of this, we really call it more of an independent broker. And again, we provide brokerage services, capital technology and a single point of contact for our clients to diversify their business across multiple brokers, which is a key issue right now with most customers.

Terrance O’Malley 3:09
Tim, earlier we mentioned technology, and your firm is invested a lot in technology. How is that overall impacting your business? And how is it impacting the market, particularly the market for futures trading,

Tim O’Shea 3:22
Most people are using electronic platforms to execute. And there’s a handful of products: Bloomberg has products, Trading Technologies, Odessa. There’s many, many vendors that provide trading access to the various markets around the world. Back in the day, all the FCM thought they we were going to build our own electronic platforms to access the markets. But I think it was clearly identified that the FCM themselves weren’t experts in that area and quickly exited that development to focus on client portals, which allows clients to access their trades, their positions, their data, provide reconciliations tools and provide allocation tools and other types of transparency into their portfolios. So that’s what all the FCMs today currently offer – a portal. And all the portals are different and provide different supporting, different data sets, different modules, different applications.

Tim O’Shea 4:20
So with that, what Thales invest our technology dollars in was to aggregate all these different portals into a single portal so that clients, regardless of who they use to clear and/or execute, we have a single platform that takes data from all 18 different FCMs and brings it into a single platform so clients can have a single report, a single data set, a single reconciliation tool, or tool to do allocations or run risk. And that’s really where we focus. So when clients in the futures market need to diversify – and most do so because the idea of having all your eggs in one basket no longer works. Certainly from a fund perspective, or hedge fund or CTA, from an operational due diligence investors want to make sure that clients have multiple outlets so that if there was a problem with one of the FCMs, they’re not going to lose the ability to trade and or wouldn’t be able to transfer the positions from a broker who might be in trouble to a broker who is not in trouble.

Tim O’Shea 5:25
So, what Thales really is here to do is help our clients manage those multiple relationships and then provide a technology overlay and a service overlay over those brokers so that a client can utilize and have the best of both systems, and not make a decision of whose broker is better or what FCM is better based upon their technology, but based upon maybe exchange access or based upon credit balance sheet. What’s really more important to these clients is that, and not what portal is better than the other. Because if you bring it down to the technology basis, you’re probably going to overlook some of the credit and other important needs that customers have when choosing an FCM. So Thales levels the playing field, I would say across the various FCM community by providing a single technology platform that clients can rely on to get the same service level, both from a technology perspective as well as the middle office perspective to help and assist them in managing their brokerage relationships.

Terrance O’Malley 6:25
So Tim, tell us how did you end up in the derivatives market? I mean, you’re based out of Chicago, and obviously the Chicago Board of Trade is out there. It’s been a dominant player for years. How did you get involved?

Tim O’Shea 6:38
That’s exactly it. I started in 1986. As a runner on the Chicago Board of Trade agricultural floor. It was a way to make some money between the summers between my college years and it felt like an interesting business I wanted to get into. I saw the opportunity to look at the trading side being a broker, staying on the floor, versus going upstairs to becoming an operational person. And I felt that my mind and my skills were better fit in the operational area. So it just happened that my sister worked at a firm and got me a job as an entry level runner, running orders from a desk on the floor into the various trading pits, and making sure that I was delivering the orders to the right brokers for the right months. Quite a chaotic and hectic time, but certainly was an interesting and fun time back then. And it’s certainly changed over the 20 some years that I’ve been involved with business,

Terrance O’Malley 7:34
And then how did you end up at Thales?

Tim O’Shea 7:37
Thales was the natural progression. I was at a firm called Fimat Futures USA. I joined them in 1992. And I worked with them all the way through to 2012 even though there were a few name changes there. But in 2002, two of my partners now – Steve Salomon and Mark Cohen – moved their business from Prudential Bache to Fimat at that time, and I was introduced to them. And I was asked to help with the integration of their business into Fimat’s at that time. And over the four, six years from 2002 to 2006, I helped manage their business and helped them build their business. And then they offered me a full-time position to join their group. So I became the general manager of the group there called the Financial Services Group. And then I was with them from 2006 to 2012. Then we all moved together as a group from New Edge with the name change, and after the merger of Calyon and Fimat. And we all moved from New Edge at that time to create Thales in 2012. So I’ve been with the same firm, in essence, since 1992.

Terrance O’Malley 8:46
Thanks, Tim. So let’s transition now over to the derivatives market and listed derivatives and futures. So when somebody says derivatives, right, they could be talking about a lot of different things. And so, right from the start, we’re talking about a definitional issue?

Tim O’Shea 9:01
Absolutely. I think it’s a very broad term.

Terrance O’Malley 9:04
So let’s clear up derivatives versus listed derivatives.

Tim O’Shea 9:08
I think derivatives in general can represent OTC products, products traded off an exchange. And I think the definition of a listed derivative is one that is actually listed on exchange and traded through a more organized fashion. Furthermore, if you take listed derivatives, in my view, that can represent security products as well as futures products. Thales’s expertise is around the futures component of listed derivatives, even though we do have a broker dealer as well as an introducing broker. So we have the capacity to help clients with securities transactions and securities execution. But our core business has always been around the listed futures derivatives, which include options on futures but not the security components.

Terrance O’Malley 9:50
Okay, so let’s get into futures and listed futures. What are we talking about here?

Tim O’Shea 9:55
Sure, future derivatives may encompass many, many different products and categories. Commodity futures and options, which we probably most likely think of as grains corn and beans. There are also products in soft commodities, coffee, cocoa, sugar. There’s obviously the energy complex which has probably been seen the biggest growth over the last 20 years with all of the OTC cleared contracts that we’ve seen. But besides the commodity futures, you know, we have metals – precious metals, other metals, silver, gold, copper, aluminum; currency futures traded on pretty much all the major currencies and some of the mid currency products that are exchange traded; and cleared, interest rates, futures, you know, the Euro dollars and other interest rate benchmarks that we have all over the world. And then I would say the last two involve stocks. We have the equity index futures and then we have single stock futures. But most people to get the exposure into those products are going to use the underlying equities, not the futures.

Terrance O’Malley 11:00
So, Tim, for firms that don’t focus on commodities and futures as part of their core strategy, how are they likely to encounter those instruments? Where are they most likely to encounter those instruments?

Tim O’Shea
I would say that most of our clients, certainly if we look at the CTAs – commodity trading advisors – who are investing on behalf of their customers and who have entrusted their money to trade and make a return, are focusing on really global strategies. So they are going to look at interest rate components, currencies. They’re going to look at some commodities, equity indices for sure. Hedge funds themselves use futures as well to help the returns. And then obviously, as you said, the commodity users are easiest to explain because if you look at why these markets were originated, certainly the Board of Trade started as a place to transact grain transactions. The CME started in the 1800s as a butter and egg exchange to trade and buy and sell butter and eggs between the producers and the users. So it’s obviously gotten much more complex with listed derivatives or financial futures that you can trade. But people are using them for all different things: managing interest rate exposure, currency exposures to foreign sales processes and foreign revenue. Certainly, airlines use futures to hedge their jet fuel consumption and pricing. So it certainly has become from being a small exchange focused on grains, butter, and eggs to becoming a global financial marketplace.

Terrance O’Malley 12:38
So Tim, still big picture here. Can you talk a little bit about the differences between trading futures and trading equities? And maybe discuss a little bit some of the mechanics.

Tim O’Shea 12:49
Sure, absolutely. So there’s certainly a difference between equities and futures from many different standpoints. First is registration. To be a futures broker or be involved in servicing futures business, you need a series three. Obviously from an equity perspective, it’s a series seven and a series 63 and various other supervisory series. So I would say there’s obviously a fair amount of oversight, both of those from FINRA on the equity side and the CFTC and the NFA from the future side. But the big difference I think between equities and futures, is when you trade an equity, you really don’t know who your counterparty is. Ultimately, if you have an account at Schwab and you’re trading on their electronic platform, you really don’t know where that trade is being executed. You know, it could be executed – Schwab could take the other side or Schwab’s broker dealer could take the other side. There are various liquidity pools for trading equities. But certainly there is a centralized settlement process with equities.

Tim O’Shea 13:46
Whereas futures, when you trade a futures contract, there’s a single point of execution, and in the old days that was in a trading pit. You had to call the floor and place an order with a firm. And that firm would then run the ticket into the exchange pit, and some independent broker in that pit would execute your order for you. Today, with the advent of electronic trading more and more – certainly, I would say almost the majority of futures contracts – are executed electronically in a single electronic matching system that’s managed by the exchanges. So when you trade, you are going into the same liquidity pool as all the others trading that product and the depth of market – the bid offer spreads are real for all of the users of that market. There’s no other means to execute that futures contract besides going to that same marketplace that all the other customers are using. So I think from that perspective, that’s probably the biggest difference in the execution.

Tim O’Shea 14:46
Certainly in the clearing and settlement of those products, equities settle in two days and futures settle immediately and T one. Futures you don’t have to pay full notional value for. You don’t have to pay anything but the initial margin requirements that’s set by the exchange. That’s the only collateral required to hold a futures contract. So you have a lot of leverage in futures. For equities, you’re usually paying for that security upfront, although they do have some margin Reg T and other margin utilizations that clients can take advantage of to increase a little bit of their leverage. But I’d say that’s the biggest difference between equities and futures.

Terrance O’Malley 15:25
So given what you just described as some of the differences between the futures markets and the equities markets, do you tend to find the same brokers executing both types of financial instruments? Or do there tend to be separate players in each market,

Tim O’Shea 15:38
So a firm that focuses on futures is normally called an FCM, which stands for futures commission merchant. And it’s a registration that the NFA CFTC recognized and the exchanges recognize that you are required to be an FCM to hold customer funds and provide clients access to the markets. Obviously on the securities side, you have to be a broker dealer to allow clients access and hold securities and hold clients cash. So right there, because of the difference in the regulatory structure, a firm would be required to be both a broker dealer and an FCM to carry both futures and equities.

Tim O’Shea 16:18
And although we thought we would make a much larger stride in accomplishing this, there really is very little, in my opinion, that’s been done to provide clients with that single statement, being able to see your futures and your equity positions on a single report, utilize collateral for both, obviously use them to offset risk from a margin perspective. So while there are firms out there that have the capacity to do both, from a technology perspective, the systems and also the regulations aren’t there yet to allow a firm to carry those onto a single statement. Just off the top my head, I can really think of one, but it’s a very retail-oriented broker that provides that kind of service. But still, the firms wouldn’t be able to cross margin because from a regulatory perspective, the exchanges on the equity side and the future side are really requiring them to fully fund that account. So you’re not getting the benefits from a financial perspective, of an offsetting portfolio between those two if you were to have one. So long answer short is that it’s not there yet. And I’m not sure if we’ll ever get there until we see a more streamlined regulatory environment from FINRA and from the CFTC.

Terrance O’Malley 17:38
Tim, we talked earlier in the show about technology, but circling back, how is that impacting the futures market including trade execution and settlement? You know, we’ve seen a lot of activity on the equity side. Are we seeing similar activity in the futures market?

Tim O’Shea 17:54
You know, certainly a lot of players out there, a lot of players trying to get into the space. Certainly, the futures market is not as large as the equity markets. So it probably takes second fiddle to many of the technology providers. So I would say from a technology perspective, the biggest issues we have are around margin calculation. transparency into margin calculations, obviously risk, looking at value at risk and stress tests. And also just the middle back office processes which focus on receiving trades from various executing brokers and be able to get them to the proper clearing firms through allocation methods and reconciliation methods. But there’s a fair amount of development going on there, but I would say it does play second fiddle to equities. I would say most people find a solution for their equities and then tend to try to backfill that system to work for futures as well, especially if you’re trading both products, or credit or other financial instruments.

Terrance O’Malley 19:00
So Tim, what are some of the trends you’re seeing in the market?

Tim O’Shea 19:03
I wish I had a crystal ball and could give you an exact answer there. I think from my perspective, certainly we’re seeing from a technology perspective and an execution perspective, we’re seeing more and more algorithms being applied to the execution of orders through the various third party technology vendors who compete directly with the bank FCMs or many of the FCMs who have their own proprietary algos. So that’s going to be interesting to see how that really ends up because in most cases, a third party technology provider is charging a fee to use their algos and the banks tend to just use their algos as more of a marketing and way to capture business for their flows. So that’s one area I think that clients are certainly looking at and becoming more in tune with in terms of algo use upon execution of orders.

Tim O’Shea 19:53
Besides that, there’s still – and I’ve heard it for years, I mean the FCM community – the regulatory environment, cost of capital, and the amount of capital that the FCM is required to carry for customers is becoming more and more of a burden. And I think we’ve seen some FCM have scaled back to their operations because of these costs. Commissions continue to go down for customers, which is good. But at the same time, we’re also seeing that FCMs don’t have the appetite for some of the mid-sized clients. And even some of the larger clients whose cost of capital and balance sheet usage is so high that, it’s sad to say, but even if someone’s generating $100,000 in commissions a month for an FCM, it might not cover their cost of capital. So, you know, the FCM community is getting much more in tune with that, and being able to look at profitability on a client-by-client basis when they take into account not only the hard costs, but also the soft cost of capital and balance sheet usage.

Tim O’Shea 20:55
So I think a firm like Thales, we’re really here to help the FCM and help clients pick the best partners. I just don’t know if there’s going to be relief there. There’s talk of a balance sheet and capital relief, and if that comes that will certainly be well received by the FCM community. And hopefully with the continued deregulation, some of the smart deregulation we’re seeing, this will help the FCM community provide more value and be more profitable because it has been difficult over the years to make money in this area, especially with interest rates being as low as they are.

Terrance O’Malley 21:30
Those are some great points and some great insights. And, Tim, thanks for joining me today. It was terrific to hear more about listed derivatives in the futures market. Some of the people like me who came up on the equity side don’t know as much about it but sometimes need to know more. And Tim, if people want more information about Thales and about you, where can they find that?

Tim O’Shea 21:49
Yeah, we have a website WWW dot Thales dot com. The site has a lot of information about our firm and the various services we provide from a capital and from a brokerage as well as technology perspective. And people want to reach out to me directly, my email is and my phone number is 312-854-2685. And I’ll be happy to continue a conversation with anyone directly or help anybody who’s looking to make their processes more efficient or find better ways to utilize the listed futures market to provide investments and speculative opportunities.

Terrance O’Malley 22:32
Tim, again thanks for coming by today. Much appreciated.

Tim O’Shea 22:36
Thanks, Tery. Appreciate the invitation.