The FX Prime Brokerage and FX Prime of Prime scenes have undergone dramatic changes. In 2008 we witnessed the take-off of FXPB, a domain that was once the domain of hedge funds, with major banks expanding into the sector and to service various FX market participants such as mutual funds, insurance companies, corporations and even retail FX brokers.
Growth had been set on exponential trajectory and it wasn’t until the Swiss Franc peg removal crisis in early 2015 that things started to take a major turnaround. In recent years, the Tier1 FXPB sector has been shrinking, with many major players reducing their exposure to FXPB and some exiting this business entirely. In this article, I will go through the origins of FXPB, and Prime of Prime, and dive deeper into how the sector has changed following major market events and industry re-shakes.
What is FX Prime Brokerage?
FX Prime Brokerage effectively allows FX market participants to source liquidity from multiple dealers while maintaining a credit relationship with a single entity. FX Prime Brokerage allows clients to trade with banking institutions, that they would not normally be able to face directly, using their Prime Broker’s credit profile and infrastructure. Clients sign a single legal agreement with a Tier 1 Prime Broker, therefore eliminating the need for multiple legal and credit documents with each of their trading counterparts.
What is FX Prime of Prime?
The next level after the Tier1 Prime Broker is the “Prime of Prime”- in this scenario a brokerage has an account with a Tier 1 Prime Broker and extends those services to other market participants such as retail FX brokerages, FX funds and other institutional players.
The Prime of Prime’s role is to extend interbank market access to clients who do not have access to credit. To put it another way, it helps create direct market access for those clients who do not meet the stringent collateral and credit criteria that is needed in order for them to establish their own, direct Prime Broker relationship with a bank. The main value that a real Prime of Prime delivers is non-latent access to institutional trading, in a secure and regulated environment.
Prime of Primes are bridging the gap between the institutional and retail FX markets by offering faster onboarding processes, access to interbank liquidity and the latest technology advances all bundled into a single offering.
Prime of Primes will generally offer higher leverage than a Tier 1 PB as well as plug-and-play integration into a single aggregated feed via an industry-standard FIX API or via established adaptors/connectors to other trading platforms.
In order to mitigate reputational and transactional risk, a true Prime of Prime (PoP) will typically not work directly with retail FX clients, unless PoP services are a part of its overall business model. They will also have higher account opening standards, more in-depth due diligence, when compared to a retail FX broker and higher deposit requirements.
By working with a Prime of Prime, institutional FX market participants gain the following benefits:
1. Access to Interbank Liquidity and Non-bank Liquidity
FX Prime of Prime Brokerage allows clients to trade with multiple financial institutions around the clock including, for example, second and third Tier banks, and those banks specializing in exotic currencies. In the years post-SNB crisis, non-bank liquidity providers (hedge funds and others) are gaining a stronger footing as liquidity providers. For the most part, these non-bank LPs do not accept client funds on deposit, they only work on credit agreements so therefore Prime of Prime has become a unique gateway to unique source of pricing.
2. Faster Time to Market
A Prime of Prime typically offers a pre-aggregated liquidity package that is already up and running, one that doesn’t require any pre-certification process, technology onboarding and integration, or post-trade mapping configurations.
Therefore, the Prime of Prime’s clients reap the benefit of shorter lead time (2-3 weeks compared to 6-12 months).
3. Higher Leverage
Prime of Prime adds value by leveraging its balance sheet and extends even greater value to its clients in the form of higher trading leverage.
4. Significant Technology Costs Savings
By working with a Prime of Prime, market players can tap into savings by accessing an already operating setup without incurring any hefty entry fees or technology maintenance fees. Prime of Prime’s are able to significantly lower the technology fee barrier by using the advantages of the scale.
5. Full Netting Capability
All the trades executed are “given up” to the FX Tier 1 Prime Broker under the existing credit agreement, with the Prime Broker(s) effectively guaranteeing the Prime of Prime’s credit risk and that of their counterparties. The FX Prime Broker then consolidates the trades and the Prime of Prime calculates a single margin payment/requirement for the client to cover all of their trades.
6. Reduced Margin Requirements
By consolidating trade exposure into one net account, FX Prime of Prime Brokers can reduce the amount of collateral that their clients need to post to execute their FX trades.
Why are once burgeoning FXPB and FX Prime of Prime sectors shrinking?
The growth in the FXPB industry from 2008 to 2015 has been driven by the expansion in high frequency algorithmic trading, retail FX trading, and the growing popularity of FX as an asset class (a trend that has led to a marked increase in the number of currency managers and currency-orientated hedge funds).
The dramatic price moves in the wake of the Swiss National Bank’s removal of the Swiss franc’s peg against the Euro on 15 January 2015 sent shockwaves through the FX industry, causing Tier 1 Prime Brokers to raise fees, and collateral requirements, and to cut clients. This contributed to reduced participation by hedge funds, and other leveraged players in FX markets, as they had already been experiencing low returns.
Some banks also cut their business exposures to the retail margin brokerage sector, which affected market access for retail aggregators. A number of major Prime Brokers raised capital requirements, introduced tighter onboarding procedures and raised clearing fees. As a result, Tier 1 Prime Brokers have focused on retaining large-volume clients, such as large trading firms engaged in market making, while shedding retail aggregators, smaller hedge funds and some high-frequency trading firms.
In order to access interbank FX liquidity, many players shifted towards Prime of Primes that were still able to source the same liquidity under preferential conditions. As this sector started to boom in 2015, many firms, including some from the retail aggregator space, started to develop their own Prime of Prime models. Unfortunately, over time the PoP term has started to be misused and some well-known retail brokerages, without a Tier 1 bank Prime Broker relationship themselves, were creating “Prime” brands in an attempt to capture some of the more sophisticated clients. Retail market-makers also started to take advantage of the trend, named themselves Primes even though they were actively taking risk in-house as opposed to passing it on to the interbank market itself.
Fast forward to 2019, Prime of Primes (real and quasi) are shrinking following record low FX volatility, that has heavily impacted hedge fund strategies, the capital-intensive nature of the business and tightening margins. Retail aggregators are increasingly looking to either take more risk on their own books or pass it on to an aggressive market maker that can provide a rebate or a share of the profits from the flow.
A handful of true Prime of Primes remain and these are offering genuine services to those market participants looking to access deep interbank market liquidity, achieve better fill rates, have total transparency and receive better protection for their trading funds.
What is Margin aggregation?
This article would not be complete without mentioning the phenomenon known as Margin Aggregation. It has become omnipresent amongst retail aggregators in recent years, as their access to credit dried up due to the reasons outlined earlier in this article.
FX Margin Aggregation is a way of pulling together FX price feeds (typically using best bid/best offer logic) from Prime of Primes, the “institutional” divisions of retail FX brokers, and from retail FX market makers themselves. Unlike the pure institutional, direct market access trading environment, where a Prime Broker facilitates the settlement of counterpart transactions, FX Margin Aggregation has no such clearer, and the retail FX broker itself is solely and ultimately responsible for all trade reconciliation.
However, there are a significant number of cons associated with the model. While improved spreads are great, paying double spreads with your counterparties is not so great. There are also inefficiencies in margin management, over-paying of overnight swaps and the issue of double-hits.
Despite the shortfalls, Margin Aggregation is popular these days as many players are now at arm’s length from the original sources of FX liquidity.
When the Prime of Prime industry began circa 2008, the FX market was given impetus by the world’s global financial crisis. Today, it is a global industry servicing the FX needs of organizations all over the world. The innovative solutions that Prime of Primes have delivered to their clients, and the skill sets which Prime of Prime experts employ, are well suited to the changing global marketplace. While there have been a few setbacks for the FX industry in general recently, I think the growth of Prime of Primes is set to continue, making Prime of Prime an integral component of the overall FX market.