LMAX Exchange
In the institutional market, credit lines or credit limits are the lifeblood that enables two parties to engage in the principal-to-principal, bilateral nature of FX trading in the OTC marketplace. When credit was easy to obtain and credit limits were generous, such as seen in the early part of this new millennium up to the global credit crisis of 2008 and 2009, large banks and their customers were both quite content to trade liberally both directly with each other and also via ECNs (the latter for those that are technologically advanced for electronic FX trading), backed by generous credit limits granted by these same banks’ prime brokerage units.
Then came the global credit crisis, the ensuing bankruptcy of Lehman Brothers, and the near collapse of AIG and many other large banks and global financial institutions that were all thought “too big to fail.” If it were not for the government-engineered rescues of these venerable institutions, many of them would not be around to conduct their business today. What did result from this dramatic event, however, was a dramatic tightening of credit conditions around the world—gone are the generous credit lines and limits that allowed FX market participants, banks and their clients alike, to trade freely with each other.
Although the economies of many nations around the globe have recovered a fair amount since then and a “business-as-usual” mentality has returned to Wall Street and global financial centers elsewhere, one direct consequence of the credit crisis is that the two parties entering a given bilateral dealing (e.g., an FX transaction) are now much more cognizant of the potential credit risk that each side brings to the table. This cautious approach toward credit stems from banks and clients; hence, each bank or client has potentially reduced the total number of counterparties that it is willing to deal with as well as the amount of FX exposure per transaction (with each counterparty) that it is willing to bear until the trade is settled.
Although large banks and prime brokerage units may still grant the largest multinational corporations, asset managers, ultra-high-net-worth individuals, or hedge funds generous credit limits to do FX trades, the same cannot be said of small to midsize banks, proprietary trading firms, asset managers or hedge funds, CTAs/CPOs, or active retail traders. Our conversations with industry veterans in the FX prime brokerage community indicate that in today’s environment, FX credit limits and terms have tightened by as much as one-third from the pre-crisis days of more than five years ago.
An interesting dynamic has risen out of the tightened credit environment that the industry has experienced in the past five years. A new breed of FX credit intermediaries, otherwise known as “prime of prime” brokerage firms, are leveraging their own balance sheets with the largest banks’ prime brokerage units to obtain the highest credit limits they can. Subsequently, they make credit for FX available to small to midsize active FX traders, whether they be small-to-midsize proprietary trading firms, smaller hedge funds/CTAs, or active retail traders with good credit history. Examples of such of firms would be the likes of FC Stone, BT Prime, and Saxo Prime. As long as the overall global economy continues to recover on track and the credit environment stays stable, we do see prime of prime brokerage firms playing an important role in providing FX credit to the active trader community for many years to come.
In the retail FX market, FX prime brokerage holds the key to enabling retail FX activity. The credit function of prime brokerage, however, sits squarely in the middle of the technology map of retail FX brokers. The most obvious advantages of working with prime brokerages that offer retail FX brokers are:
- Margin efficiency: The ability to keep margin (client funds) at one institution instead of keeping a margin at every liquidity source, allows the broker to earn interest on client funds that are not margined at the prime broker
- Post-trade simplicity: Prime brokers streamline the post-trade activity so that the broker does not have to keep track of trades and reconciliations with every liquidity provider
Five to 10 years ago, prime brokers were also liquidity gateways to clients, but over time, the liquidity aggregation and management functions by and large migrated to technology firms that specialize in those capabilities. While a retail FX broker client may indirectly use a prime broker’s credit and prime broker-sponsored liquidity today, it will often rely on a separate (non-prime broker) liquidity aggregation and management solution. Nonetheless, prime brokers offer a high level of integrity to the operations and back offices of retail FX clients. Prime brokers have also developed unique software to gain real-time visibility into trading activity. A list of services commonly provided by prime brokers; this list can also serve as a guide for evaluating prime brokerages.
| FX prime brokerage services | Description |
|---|---|
| Real-time dashboards | Real-time dashboard for monitoring of positions, trade status, credit line usage, margin cover, cash management, and post-trade events |
| Prime brokerage experience | Years offering FX prime brokerage, level of experience serving the particular needs of retail FX brokerage firms |
| Customizable report and views | Ability to customize reports by user-defined variables |
| Position rolls management | Flexible ways to monitor and execute position rolls: with desk, via bank savings deposit programs, via give-up, or anonymously |
| Margin alerts | Ability to set up various types of margin alerts (by margin levels threshold or particular account), distributed to particular client teams, through different media—email, audible, visual |
| Strong search and filtering capabilities | Ability to customize views and search data by user-defined filters such as margin level by sub-account for a particular master account |
| Knowledgeable and proactive client service team | Size of client support team available at different times of the day, average time these employees have been with the firm |
| Access to many FX counterparties | Global FX footprint, access to various types of liquidity: disclosed counterparties via Master Give-Up Agreements, anonymous counterparties via ECN venues, and internal bank liquidity via bank single-dealer platform or API |
Source: Aite Group ‘Global FX Market Update 2013: Increased Market Transparency, More Competition’, June 2013
Prime brokers carry substantial clout and can set expectations and even mandate that broker clients meet evolving regulatory requirements such as real-time position reporting and intraday risk management. Indeed, larger prime brokers are ideally suited to support a broker’s business across cleared and uncleared trades and to support expansion beyond spot FX. The larger FX prime broker firms today include ABN Amro Clearing, Bank of America/Merrill Lynch, Barclays Capital, BNP Paribas, Citibank, Commerzbank, Credit Suisse, Deutsche Bank, HSBC, J.P. Morgan, Morgan Stanley, and UBS.
Source: Aite Group ‘Global FX Market Update 2013: Increased Market Transparency, More Competition’, June 2013
Video Transcript
The rise of “prime of prime†brokerage firms
Scott Moffat: So, we’re talking about the evolution of prime brokerage, and in particular the “prime of prime†offerings that have come to the marketplace recently. I think that everybody is fully aware that credit is important to the money markets and trading but it’s of vital importance in the OTC bilaterally traded spot FX market. I think pre-2008, prime brokerages gave credit lines fairly easily, counterparty risk was seen as relatively low, so credit was kind of freely available. Post-2008, and in particular the Lehman’s bankruptcy, counterparty risk for obvious reasons was viewed very differently, and the risk departments in prime brokerages analysed and scrutinised their risk very differently, they looked at their exposure to their direct clients and they looked to reduce this, they looked to their exposure to particular counterparties and individual counterparties and looked to reduce this, they also looked to reduce the amount of different counterparties that they were exposed to as well as the different types of clients they’re exposed to. They were perfectly happy to take on multinationals, big asset managers and larger banks but less so inclined to take on your small hedge funds, high net worth’s and trading houses. And it’s this reluctance which has created an opportunity for your prime of prime offering, the likes of BT Prime, Saxo Prime, etc, have come into the market particularly to address this issue. So how do they address this, essentially these businesses leverage their balance sheet and the relationship they have with their current prime brokers to get as much credit as they can and then offer this out to their direct clients, so essentially their direct clients are piggybacking of the back of the credit-worthiness and the credit that they have with their prime broker, and essentially this has massive benefits for the end customer who can’t get his own prime broker, they get all the benefits of traditional prime brokerage, the margining, the efficiencies, the ability to have your money in one place rather than spread over different liquidity venues, the off-set you get by having it all in one place, as well as the post-trade simplicity, as a direct client you have all the risk in one place, you can see it, you can manage it you’ve got all your trades in one place, so there’s huge benefits there. And, also for the provider of the prime to prime, there’s a benefit in terms of stickability, if your customer wants to access another liquidity source, why give them the opportunity to withdraw money from you and go and open an account there rather give them the opportunity to access that liquidity but keep all their money in one place. So, is prime of prime going away? I don’t think so, I don’t see the risk profile of the current big Prime Broker players changing much in the future, in fact we’ve actually seen a couple of big players in the prime broker space actively take a step back from it, and then also the benefits for the direct clients that I’ve just mentioned, I think prime of prime is here to stay and I think there are going to be more entrants to this market space.