The rise of “prime of prime” brokerage firms

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.