By Vivek Shankar

From liquidity to technology: How FXPB is evolving

March 2024 in Special Reports

Vivek Shankar talks to some leading providers to discover more about some of the key issues that are influencing the evolution and growth of the FX Prime Brokerage market.

The prime brokerage world has seen some significant volatility over the past year. Regulatory changes (like the EU’s impending Digital Operational Resilience Act,) the rise of multi-asset trading solutions, technological innovations, and rising exchange fees have led prime brokerage providers to rethink their business models. Despite all this, the sector’s outlook remains bullish. A recent report by Acuiti, in partnership with Standard Chartered Bank, detailed the rising demand from proprietary trading. Not everything is rosy, though. A separate Acuiti report noted concerns amongst smaller hedge funds regarding the consolidation in the prime brokerage world and its impact on execution risk. Prime brokerage service providers are facing tough questions from their clients and the industry, at large.

“Legacy liquidity providers have been evolving their business models over the last decade or so,” says Michael Ayres, CEO of Rostro Group. “Ultimately that has left a number of smaller players without good liquidity lines or provisions and as a result we’ve seen this dramatic expansion in the sector.”

So how are they dealing with these changes, and what can we expect over the next year? Let’s dive in.

Sector changes and growth avenues

Gerard Melia, Head of FX Sales at StoneX Group notes that electronic trading has increased recently. “There has also been an increase in requirements for multi-currency delivery services,” he says. “Our client base depends on our reliability and cost-effectiveness to optimise their FX operations, while our portfolio of deliverable currencies allows them to scale their business quickly and efficiently.”

The electronification theme ties into broader digital transformation narratives, with market participants increasingly seeking greater efficiency and reduced costs. James Dewdney, Associate Director, Institutional Sales at Saxo Bank, zeroes in on the latter.

“The pace of innovation in Prime Brokerage has left the door open to some rogue operators who are doing little more than recycling liquidity from multiple existing pools.” 

Michael Ayres

 “The aim of our institutional business is to help our partners leverage technology to achieve scale, with modest CAPEX/OPEX relative to the opportunity they aim to address,” he says. He adds the quality of technology solutions on offer has created a positive innovation loop that isn’t slowing down.

“The quality of tech solutions spanning compliance, CRM, risk management, dynamic credit, liquidity aggregation, trade matching, EMS/OMS, and data science are empowering smaller firms to offer service quality more akin to larger brokers.”

The Rising Risk of FX Prime Brokerage Consolidation
How hedge funds are adapting to an ever more uncertain environment for FX PB

Source: Acuiti and Standard Chartered

While regulatory changes have occupied prime brokerage service providers’ minds, the FX Global Code has had a bigger impact on operations, according to 26 Degrees Global Markets’ Chief Commercial Officer, James Alexander.

“The heightened scrutiny brought about by the FXGCC has encouraged liquidity providers to both generate and cancel far more quotes than was previously the case,” he says. “This practice has the effect of lowering the need for longer ‘last look’ windows and lowers rejection rates.”

While all of this is desirable, it has had infrastructure impacts. “It significantly increases the quote load on infrastructure and networks involved in the processing and transmission of quotes to clients,” he explains.

“Liquidity providers would rather generate a quote and cancel/replace it quickly than be seen to be rejecting an order. This trend is expected to continue as major exchange and aggregation venues lower their quote throttles and increase refresh rates.”

Coupled with these changes, Alexander says FX demand in APAC markets is strong. “ It is clear that several Investment banks continue to target this region as a key part of their growth strategy for FXPB. This is not the case for other asset classes such as Equity and Equity derivatives.”

Has the move to T+1 settlement had any effect on this demand, though? Alexander believes Asia will benefit from it. “Asian-based teams are well placed from a time-zone perspective to assist with the EOD settlement processing workflows that T+1 will require.”

“The move to T+1 settlement for certain spot instruments should ultimately drive down settlement risk and margin requirements for FX PB,” he continues, “driving growth opportunities once all parties ‘bed in’ the required infrastructure and operational changes needed for this change.”

“We feel that the traditional FXPB model is under pressure from emerging multi-asset brokers who can serve their clients’ needs more effectively than traditional providers.”

Gerard Melia

Rostro Group’s Ayres believes growth is present, but not in established markets. “Traditional markets – places like Western Europe or Australia – may be well served but growth potential here is stagnating and that’s why our proposition centres around actively reaching out to ensure underserved markets have access to the financial services that they need,” he says.

“In recent years we have seen a divergence in rates, with various central bank policy shifts triggering the rate raising cycle we are going through now. This has made the FX market a more interesting place, with carry trading, treasury risk, and FX derivatives generally starting to gain more attention.”

Dewdney adds that despite Tier 1 FXPB providers’ reduced appetite for smaller NAV clients, growth is far from reduced. A shift to ROE (from revenue) has resulted in these providers reconsidering the business, making room for alternative FXPB providers to step in.

“This has led to greater innovation and competition,” he continues. “FXPB activity is now spread across multiple players. From traditional Tier 1 banks through to Tier 2 banks, and NBFI ‘prime of primes’ who have leveraged effective technology and a specialised focus to capture market share.”

FX’s high daily liquidity (USD 7.5 trillion) and 24/6 availability offers a relatively cheap way of expressing macro views while incurring low transaction costs. 

“Fintech innovation is challenging the status quo when it comes to payments and cross border transactions,” Dewdney explains, “where increased transparency and awareness has led to greater customer scrutiny over fees.”

Meanwehile StoneX’s Melia offers a balanced perspective. “We’ve identified significant growth in the non-traditional FXPB business model,” he says. As clients discover alternatives to bank liquidity and PB, new competitors have emerged. “They are well capitalised, have high regulatory standards, and provide emerging-market liquidity to compliment their G12 portfolio,” Melia says. “In fact, we feel that the traditional FXPB model is under pressure from emerging multi-asset brokers who can serve their clients’ needs more effectively than traditional providers.”

Clearly, client expectations are posing some of the biggest challenges to FXPB’s growth. How are these evolving and how are service providers aligning themselves to cater to these expectations?

Regulatory developments have been occupying the minds of PB service providers 

Client expectations and catering to their needs

When asked why he feels traditional FXPB service providers are under pressure, Melia points to their inability to cater to client needs. “Recently, we’ve seen a handful of examples of bank PBs pulling back from supporting FX clients, and we suspect that this will continue to happen in the future.”

“Banks, for example, have significant revenue requirements from their clients that manifest in the level of support and pricing offered to mid-market clients and below,” he continues.

Melia clarifies that he believes Tier 1 PBs can offer high-touch services. Cost-effectiveness is the real issue. “They simply cannot do it in a cost-effective manner,” he says. “This has created a huge opportunity for firms like StoneX to provide high-touch services and compelling pricing to satisfy this growing mid-tier market.” 

Ayres offers a few examples of features Rostro Group is focusing on. “On the liquidity side we focus our time on building strong competitive G4 pricing and also local market access to EM pairs that can drive higher yields for both our client and ourselves,” he says.

“On technology, the ability to build out customer reports that allow our institutional clients to provide their finance, risk and support teams with a variety of information sets, bringing data to the forefront of our services sets us apart.”

Ultimately, Ayres believes that counterparties expect cutting edge technology built in a secure and robust way that will integrate readily with their existing platforms. 

Dewdney adds that agility is also a major factor powering the growth of non-bank and Tier 2 brokers. “They have shorter onboarding journeys and are more specialist to the segment they address. Prime of Prime’s work well clearing Spot FX for retail intermediaries, however, they don’t offer the derivatives products that will be required by most hedge funds.”

He points to Saxo’s suite of fully funded and derivative macro products; equities, ETFs, fixed income, listed derivatives, FX options, swaps, and NDFs as an example of the kinds of products hedge funds demand.

“FXPB activity is now spread across multiple players. From traditional Tier 1 banks through to Tier 2 banks, and NBFI ‘prime of primes’ …”

James Dewdney

Whilst 26 Degrees’ Alexander continues this theme. “As a non-bank PB ourselves,” he says, “a key advantage of 26 Degrees is our multi-asset solution which is delivered via a single facility.”

“Delivery of exchange and OTC pricing, execution, and clearing are combined with liquidity optimisation and TCA. The integrated nature of the offering is not generally available from investment bank PBs.”

Alexander zooms out and offers insight into why bank PBs are not offering these products and services, “Global investment banks continue to feel the pressure of regulatory changes in FXPB, largely due to increasing capital requirements.”

He says much of this is driven by the regulatory pressures brought about by Basel II and Basel III. Many buy-side firms as a result are now actively considering or pursuing a strategy of PB diversification.

“Many clients or former clients have become increasingly disenfranchised by the diminishing service levels and more costly access to liquidity and clearing services they face.”

The Rising Risk of FX Prime Brokerage Consolidation
How hedge funds are adapting to an ever more uncertain environment for FX PB

Source: Acuiti and Standard Chartered

This disenfranchisement combined with technological advances has resulted in clients unwilling to tether themselves to a single PB. Instead, Alexander says, they’re looking for FXPB facilities that can interoperate seamlessly between primary and backup providers.

“Efficient give-up workflows, pre-trade margining with more accommodative terms, and integrated liquidity construction, optimisation, and reporting are all now considered ‘must haves’ in the multi-PB environment,” he explains.

“The heightened scrutiny brought about by the FXGCC has encouraged liquidity providers to both generate and cancel far more quotes than was previously the case.”

James Alexander

“Specifically on liquidity, ever more sophisticated quote filtration and curation are being demanded from trading systems. Consumers of liquidity, especially those who execute electronically using algo executions or AI models rely on a well-curated price to ensure that various trading models and execution systems are running as optimally as possible,” he says.

Sector events like the exit of Credit Suisse as an LP in FX and precious metals have disrupted liquidity in spot markets. “Quote filtration logic needs to have the flexibility to address this heightened volatility,” Alexander says, “even during low liquidity periods where a smaller cohort of liquidity providers may be actively pricing.”

Saxo’s Dewdney says agility and access are top customer demands, and his bank caters to these needs on priority. “Customers of traditional FXPB’s manage technology arrangements themselves and notify their PB post trade,” he says.

Client expectations are posing some of the biggest challenges to FXPB’s growth

“At Saxo Bank, we perform a pre-trade credit check (several nanoseconds) and offer our partners a choice of managed liquidity pools, semi or fully-disclosed liquidity (including Customer2Customer), over a hosted technology stack.” 

Dewdney adds that Saxo offers execution transparency to fix message level, indicating which LPs were transacted with, at what rate, and with millisecond timestamps.

“We recognise that flexibility is also important to our partners, and this is why Saxo Bank’s FXPB offers connectivity in multiple data centres, across a variety of vendor solutions and accepts cash and securities as collateral,” he says.

PB consolidation risks and choosing a broker

While non-traditional PBs continue to rise, market participants remain focused on the elephant in the room. Namely, the consolidation of the FXPB sector and the risks emerging from it.

Ayres states that Tier 1 PBs’ shift in behaviour has its roots well in the past. “The shift stems back to the global financial crisis and was accelerated further by the Swiss Bank removing the Franc/Euro peg,” he says, “yet the market remains efficient and functioning to meet the needs of participants.”

“Arguably the biggest risk comes from a regulatory perspective,” he continues. “The G20’s Financial Stability Board recently commented that it was working to ensure NBLPs were resilient and that’s to be applauded. As this cohort accounts for an ever increasing volume of capital, it’s only prudent that robust risk protocols are in place for the benefit of all.”

Dewdney offers some perspective here. “The consolidation is really amongst the traditional FXPB’s,” he says. “Outside of that group, there are several options available to clients and I can’t imagine a world in which they cannot access credit and liquidity somewhere, albeit the counterparty type and expected workflows may differ.” 

Alexander strikes a more cautious note. “The consolidation in the FXPB sector is material and is going to continue in our opinion,” he says. “Access to credit is becoming harder, margin requirements are increasing and NOP limits are generally becoming more conservative.”

Evaluating an FXPB has always been a critical task

He notes that many buy-side firms and broker-dealers are feeling constrained. Most of them are unfamiliar with the role that a non-bank PB can play as part of the solution. 

“Integrated liquidity management and more accommodative margin terms (applied on a pre-trade basis for prudent risk management), are two material benefits,” he says. “As is the margin benefit that can come from multi-asset diversification within a single portfolio.”

He adds that the biggest commercial impact will be increased facility minimums, not necessarily higher clearing fees. Non-bank FXPBs offer a significant advantage here since facility minimums are far lower with these providers.

“Many non-bank PBs support three and four-way give-ups to various Tier 1 prime broker venues ensuring there is no loss of netting or collateral efficiency when dealing with more than one counterparty,” he explains.

Given this general unfamiliarity with the non-bank FXPB world, how would he recommend firms evaluate potential partners? “Low latency price formation in OTC products is very much a base requirement,” Alexander says. “With more processing of quotes and orders comes more load and a highly resilient/redundant set-up has never been more critical.”

“The level of effort and investment that is applied to ensuring maximum resiliency continues to rise. As an example, for the ingestion of market data, 26 Degrees deploys multiple data vendors, each cross-connected in multiple locations providing hot-hot backup capacity to all clients across our server network in NY4, LD4, and TY3,” explains Alexander.

“In turn, each of these pricing/trading servers is backed-up hot-hot with real-time replication from full spec servers in a separate data centre.”

Ayres also strikes a note of caution. “The pace of innovation in Prime Brokerage has left the door open to some rogue operators who are doing little more than recycling liquidity from multiple existing pools,” he says. “That’s problematic when it comes to mitigating market impact or avoiding contention especially in fast moving, less liquid currencies.”

He says looking beyond headlines and ensuring awareness of price construction beyond the underlying market and keeping an eye on transaction cost analysis are essential. “Ultimately this remains a highly commoditised space,” he says, “so the ability to work profitably will always lie with a counterparty’s ability to bring something unique to the table, rather than simply repackaging what is already out there.” 

StoneX’s Melia adds, “With the right partner, clients can avoid the significant costs of managing multiple PBs and liquidity providers, as well as the necessity of employing FX Operatives to manage their exposure and curate liquidity.”

“The savings for clients can be significant,” he continues. “Clients don’t need to constantly analyse the FX market to identify trends in technology and liquidity – this service is provided by a capable prime broker.”

Melia says scrutinising the service provider’s balance sheet, regulatory framework, reputation, global footprint, and multi-asset capabilities is critical.

Dewdney notes that evaluating an FXPB has always been a critical task. “The focus should be to ‘do it once and do it right’,” he says. “This should not be underestimated for smaller firms whose limited headcounts wear many different hats simultaneously.”

“Performing the required DD/KYC/AML to onboard and thereafter integrate new processes, API’s, EoD files, user accesses, and test the different flows is a lengthy process.”

How can clients go about evaluating all of this though? “I would urge clients to scrutinise the technology, business processes, available products, regulatory status, and credit profile,” he says.

“I would also suggest considering the roadmap and checking if that prime broker can cater to your growth trajectory. It’s also worth understanding what the client service looks and feels like – where are they based, what are their coverage hours, etc.”

Dewdney adds that these assessments should be viewed from a value perspective, not just costs. “If a single counterparty solution for multi-asset trading and custody improves operational performance, it will be worth more in the long run than a convoluted arrangement of slightly cheaper alternatives,” he says.

Automation in Prime Brokerage is set to increase

How will FXPB evolve?

Given the volume of changes FXPB has experienced over the past few years, market participants can expect even more changes and Tier 1 consolidation to occur. From an APAC perspective, Alexander believes the reduction in US settlement cycles is a positive step forward. 

“More broadly, this reduction in settlement risk should see pressure on margin requirements ease. As a non-bank PB, we can offer our clients synthetic, non-deliverable spot FX where positions are auto-rolled daily, meaning our clients can hold spot FX and Metals positions indefinitely with daily Credits or Debits posted in lieu of swap rates,” he says.

Ayres pinpoints one key issue he believes will shape the path of FXPB. “The ability to track, in an accurate and timely manner, the fast evolving shape of credit and concentration risk,” he says. “This is exacerbated by market fragmentations as the global weight between US, Asia, and now MENA shifts.”

“Being able to work with some of the specialist technology vendors in the market that are addressing this area is going to be critical for primes as they scale their businesses globally,” he states.

Dewdney thinks automation is set to increase, given the pace of technological development. “A key area where we see this happening is for liquidity management and flow segmentation,” he says. “Understanding trading behaviours in real-time will allow brokers to better understand their clients, and help their clients understand their own business even better.”

Melia says the number of non-bank PBs is set to increase. And that this increase is unlikely to harm the quality of services on offer. “The market has long been dominated by banks, but we’re seeing a significant increase in the number of non-bank financial institutions with strong balance sheets and high-quality liquidity servicing this sector far more effectively than the traditional prime brokers,” he says.

Change is constant in the FXPB world. However, clearly, not every change is bad news.