The effects of the economic, geopolitical and health crises are complex and multi-layered. While they are felt in every corner of the market today, the smaller and medium-sized NBFIs are poised to suffer the most. Even before COVID-19, banks were tightening credit conditions and raising asset requirements for accessing their prime brokerage clients. Over the last few years, this has squeezed out smaller market participants from trading opportunities – a pain keenly felt during a time of unprecedented market volatility.
As the world begins its slow push towards normality, how market participants in the prime broker space react will set the tone for years to come. Is it likely to be more of the same, with more and more participants being squeezed out of the market?
At a time of volatility and rising volumes, the FX market remains strong. Access to a prime broker and all the benefits and security they offer have never been more important than today. Luckily, as the pool of market participants has expanded over the last decade, banks are no longer the sole providers of prime brokerage services.
Access to better trading opportunities, liquidity and the security of trading through an established broker and credit provider are available at faster and cheaper entry rates than traditional tier-one banks. The use of prime-of-prime brokers is an avenue that small and medium-sized hedge funds, emerging market banks, retail brokers, asset managers and high-frequency trading firms should carefully consider.
Managing credit risk in times of volatility
While capital market participants are no strangers to volatility, no one could have been ready for the stress brought by the COVID-19 pandemic. Trading volumes hit record highs in some areas while ceasing altogether in others.
Like banks, the biggest challenge for most brokers offering prime-of-prime services is often how to manage credit lines efficiently across a range of platforms. Given the volatile nature of the foreign exchange (FX) markets, the prices offered by trading platforms vary significantly, meaning that clients may want to trade across several platforms at any time in order to hedge their exposure effectively and get the best prices.
A true prime-of-prime broker can help manage this exposure with low-latency software and by conducting thorough pre-trade credit checks on every trade that goes to the system.
Accessing the best liquidity
Without a prime-of-prime broker, smaller trading institutions are not only cut off from the best pools of liquidity but also see stunted trading opportunities. Trading solely with institutions of the same size can limit trading opportunities as market participants are constrained by the size of their trades and the frequency of their counterparty’s trading activity.
By leveraging a prime-of-prime broker, a neutral intermediary that facilitates access into a bigger and bolder trading space, such constraints are less likely to occur. Participants can have more trading opportunities at better prices, and trade at a greater frequency with bigger institutions.
As the growth of NFBIs in FX is set to continue, the market environment should complement an all-to-all trading model, whereby users can act as both liquidity providers and liquidity takers. While some brokers will use the words ‘prime’ to suggest they offer these services, not all offer the same depth of institutional liquidity that should rightly be expected from a prime broker.
In this respect, its key to recognising the difference between those offering direct market access to multiple venues while acting as a clearing partner, and those offering access to their own liquidity pools while claiming to be a neutral prime-of-prime broker.
The challenges facing the prime community
One of the biggest challenges for brokers offering prime-of-prime services is managing credit lines and risk exposures efficiently for multiple clients. Typically, trading institutions prefer to access multiple platforms to achieve the best possible execution and use their allocated capital across different trading venues.
If a customer is allocated a net-open position of USD100 million, for example, and has access to five trading venues, some prime brokers can only offer USD20 million for each platform to ensure fair access and distribution of capital across trading venues. This limits a customer’s ability to use the allocated capital efficiently and achieve the best trading experience.
To counter this, some prime-of-prime brokers have occasionally found themselves extending credit lines of USD100 million for each venue, exposing them to significant operational and credit risks if their customer were to default. When replicated across hundreds of customers, these institutions become a potential source of systemic risk.
It’s therefore critical for prime-of-prime providers to incorporate robust risk and credit management mechanisms. Low-latency solutions have permeated many areas of financial markets such as trade execution and analytics; prime services and credit management should not be exempt from this innovation.
The technology exists for service providers to enhance their business by operating a unique low-latency software that automatically conducts a pre-trade credit check on every trade that goes through. This ensures its customers have access to sufficient credit across all venues so that their trading is not impacted.
Credit is the lifeblood of the FX market, yet many lenders were delivering credit largely in the blind, with no idea if the borrower is good for that amount. Pre-trade credit checks are therefore essential and must have the capacity to operate seamlessly in the fast-paced nature of the FX market.
Not only should it deliver checks but taking our own pre-trade credit solution as an example, it should be able to provide aggregation, SOR and TCA capabilities and all back-office requirements that an FX participant should want.
Broadening the trading community with smaller participants
The increasing participation from NFBIs in the FX market is a welcome development. Prime-of-prime brokers can take on the exposure that prime banks are unable to provide and help support this all-to-all trading environment. In today’s conditions, we should look to develop trading opportunities rather than limit them.
A broader trading community with a diverse range of actors and institutions is not only necessary for the growth of our dynamic market, but it is a rapidly materialising reality thanks to the growth of prime brokers.
As the access to bigger and better trading opportunities is widening, a true prime-of-prime broker can be the solution to greater market access, greater liquidity, and ultimately, greater profitability.