FX prime brokerage is a mysterious financial service. Natasha de Terán talks to experts in the field to clarify exactly what it is, its place within a bank's portfolio, and what it can offer clients.

Prime brokerage is one of those strange functions within the banking world that is in a constant state of flux. Each bank seems to describe it differently, include different functions within it, and attribute greater or lesser importance to it. As such, prime brokerage persistently defies definition and prime brokerage groups escape easy comparisons with their competitors.

Even against this backdrop, FX prime brokerage is a particularly tough conundrum. Although it is the lifeblood of many a leading FX franchise - and an increasingly important component of the prime brokerage offering - it is all but ignored in most discussions about prime brokerage, and by and large excluded by the most widely followed industry surveys. It is also little known in the wider marketplace.

Defying definition

Why this should be so is unclear, although Ed Pla, head of fixed-income, currencies and commodities (FICC) clearing services at UBS, attributes it to the fact that the number of dedicated FX funds is quite small compared to the number of equity-related funds.

Marty Malloy, head of prime brokerage at Barclays Capital, believes it can also be explained by the fact that the traditional equity and fixed-income prime brokerage business is materially larger than FX prime brokerage in revenue terms.

Chris Hansen, head of global macro services and clearing at Deutsche Bank, believes it can be put down to the way in which the service has evolved. He dates the emergence of FX prime brokerage to the late 1990s when Bankers Trust (which Deutsche Bank later acquired) spearheaded its development as a sales-related tool.

"Initially it was designed to assist the bank's hedge fund clients trading FX on the one hand, and to attract more business into the bank's FX franchise on the other. In other words, it was first devised as more of an add-on, complementary service to the bank's main FX business, as opposed to equity prime brokerage, which was devised as a standalone explicit revenue-generating business from the very start," he says.

In the following years, many other banks followed by setting up their own FX prime brokerage groups, but Mr Hansen says it wasn't until 2006 or so that banks began realising that FX prime brokerage wasn't only franchise-enhancing. Owing to the growth in e-trading, the resulting rise in volumes and the entrance of new players into the market, such as the high-frequency and algorithmic trading communities, it could also be revenue-generative in its own right as business. In other words, FX was a late starter in the prime brokerage mix, its bottom line contributions ignored and it has long remained divorced from most banks' main prime brokerage groups.

The final two reasons behind the elusiveness of the FX prime brokerage definition might lie in diverging viewpoints over its scope and situation.

Soliciting an explanation of exactly what FX prime brokerage is delivers little consensus. For Jonathan Cantouris, deputy head of business development and products in the prime brokerage group at French broker Newedge, it is a "highly competitive, fully automated, highly industrialised, credit-intensive business". For Mr Hansen, however, FX prime brokerage is about clearing - as opposed to equity prime brokerage, which is mostly about financing. Andrew Coyne, head of FX prime brokerage at Citigroup, meanwhile has a third definition: "Traditional prime brokerage is mostly about the custody and asset sourcing and financing function; FX prime brokerage is about access to marketplaces and credit lines and operational efficiencies."

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Ed Pla, head of fixed-income, currencies and commodities (FICC) clearing services at UBS

The Banks' view

Situating the FX prime brokerage business within banks is no easier. At UBS, FX prime brokerage sits within the wider FICC clearing services business, which includes rates, swaps and credit. Mr Pla believes this makes sense from several standpoints, not least of which is the fact that an increasing number of clients are choosing to trade across the FICC spectrum. "The advent of CDS [credit default swap] clearing and the expansion of swaps clearing to include customer clearing will only accelerate this trend," he adds.

At Newedge, the FX prime brokerage service is integrated within a wider prime brokerage group. Mr Cantouris believes that this way his firm can better ensure it offers a comprehensive industrialised offering, as well as delivering to its customers all the possible cross-product netting benefits.

Meanwhile, Deutsche Bank has taken a different view by tying its FX prime brokerage and e-commerce businesses with futures clearing and DB Select, the bank's managed accounts platform. Mr Hansen explains that FX prime brokerage groups need most of all to be in a position to scale the infrastructure to clear all products in the most capital and margin-efficient way possible and to be able to quickly respond to and solve clients' problems.

Mr Hansen says: "It also means that we are expertly equipped to face the changing dynamics - whether these see the emergence of cleared FX facilities, more exchange-traded FX products, or greater demand for managed account investments from traditional managers."

Finally, Morgan Stanley has gone down yet another route. Long in the top tier of traditional prime brokerage operators, the bank is expanding and re-locating its FX prime brokerage offering. Until recently, it sat within the bank's market-leading equity prime brokerage business. However, earlier this year, the bank changed track. Its FXEM group (the result of a merger between its FX and fixed income emerging markets groups) decided to make FX prime brokerage offering a strategic priority and annexed the business. Since then, the bank has made a number of high-profile hires from rival firms, including Martine Bond, the bank's new global head of foreign exchange prime brokerage hired from JPMorgan, whose mandate it is to build a prime brokerage service that will be core to the broader FXEM offering.

Ms Bond says that the idea behind this model is to build the service out as a standalone business to attract the sort of funds that are that not predominantly equity focused. "It is logical to do this because the services are really quite different; equity prime brokerage is very much about the financing side of the business, while FX prime brokerage is more about credit intermediation. Furthermore, the number of hedge funds and other clients trading FX - which might include other broker dealers as well as traditional asset managers - has grown enormously," she says.

Justifying the investment

Widely ignored, unplaceable and indefinable as it may be, FX prime brokerage heads are in little doubt about the value they add to the banking mix. Mr Pla of UBS says: "Having a strong prime brokerage capability is an important complement to the rest of our FX business. As a prime broker we are able to develop a much deeper understanding of a client's needs. This allows us to tailor our approach to those needs for maximum mutual benefit."

Mr Malloy of BarCap admits that there is still a good amount of debate as to whether FX prime brokerage is a main driver for the prime brokerage business or for the FX business, but says that at Barclays they have resoundingly concluded that it benefits both. "Here FX prime brokerage is a priority business, for two reasons: for the prime brokerage side of Barclays Capital's activity, it is an excellent cross-sell with clients. We can service the FX-related activity of our existing clients' trading of fixed income, futures or equity and because they are increasing investing across asset classes, it is a nice way to ensure that our business is properly aligned with their own. Second, on the FX side, where we are a market leader, our FX prime brokerage business is hugely complementary. Not only does it help generate additional revenues, but it largely relies on the same platforms and infrastructure, reporting and risk management mechanisms that we already have in place."

Mr Hansen, meanwhile, believes that Deutsche Bank is a test case example of what a good prime brokerage franchise can bring to the FX top table. "Ten years ago, the bank was ranked in the top 20 FX providers globally, while by 2005 we were ranked in first position. Our ascent up the rankings is directly correlated to the growth of our prime brokerage business."

Finally, and for those in any doubt as to whether ambitions in the FX world will be better supported by developing a strong prime brokerage function or not, Stephen Li, head of FX and derivatives prime brokerage products at Barclays Capital, concludes: "You can argue around the degree to which an FX player needs to have a strong FX prime brokerage capability, but at the end of the day all the top ranked firms in the FX business have solid FX prime brokerages."

What clients need

Reasons enough then to develop the facility - but why should clients want to use an FX prime broker? Ms Bond has three key reasons: first, access to liquidity. A prime brokerage client of Morgan Stanley would, she says, have access to all its liquidity pools, potentially being able to trade with as many as 70 counterparties through the International Swaps and Derivatives Association agreements it has in place, as well as on multiple electronic communication networks (ECNs), on Reuters and electronic broking services. The client would also be able to trade in all the standard currency crosses, as well as in emerging market currencies, and be able to use the spot, forward, options or futures markets.

The second reason is around margin efficiency - Morgan Stanley (and many other prime brokers) are able to recognise portfolio benefits, giving clients margin offsets not only across currencies and currency products, but also across other linked portfolios.

The third reason is about operational and settlement efficiency. "Prime brokers should be able to receive trades in whatever format the client wishes to send them; be able to settle hundreds of thousands of tickets with full STP [straight-through processing] support and generate reports on request and in the format required," says Ms Bond.

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Marty Malloy, head of prime brokerage, Barclays Capital

Standing out from the crowd

With just about every bank nurturing ambitions in the FX world and the compelling logic behind developing supporting FX prime brokerage offerings, the competitive landscape is hardly a welcoming one. The requisites for such a business are no easy call either.

Mr Coyne at Citi says that firms need first of all to have good credit and be able to facilitate customers with access to a wide range of credit lines. "That said, good credit is not sufficient in and of itself to succeed in this business - you also need a strong FX market activity with global presence, excellent risk management, very good connectivity and robust, scalable operational capabilities. We have to be able to service a wide range of clients, including those that might typically trade 100 tickets a day, as well as systematic accounts that will book tens of thousands of tickets on any given day. Capacity and technology is fundamental and critical to being a good FX prime broker."

Philippe Teilhard de Chardin, global head of the prime brokerage group at Newedge, says that to operate in the FX prime brokerage business a firm has to have 100% STP and be connected to all the various trading platforms, confirmation systems and networks such as Continuous Linked Settlement (CLS) and Swift. He therefore believes there is no real way firms can distinguish themselves on the technology front.

Mr Teilhard de Chardin's viewpoint is, however, an isolated one. Ms Bond believes that although technology is an imperative, it is still an area in which Morgan Stanley can distinguish itself. "We have a very aggressive technology agenda and are very focused on building out the best client tools and technology that we can - for instance, we aim to be one of the leaders in the pre-netting aggregation service being rolled out by Traiana and CLS. This, combined with our focus on the product side and our investment in people, will ensure we are at the leading edge of the market, and aggressive in our pricing," she says.

At UBS, technology is again a differentiator - albeit one that it combines with client service. "In both cases there is a big difference between understanding client needs and successfully developing, then implementing, solutions," says Mr Pla. "We believe we have an edge through the way we have organised ourselves, the depth of our resources and strength of our collective experience. On the technology side, we have a dedicated team supporting us and have very good internally developed technology. Building all our own technology gives us flexibility and allows us to be responsive to client demands and changing trading practices."

For Mr Coyne at Citi, the differentiators are technology and staff. On the technology side, he believes that it is not just about having a better, quicker piece of kit, but rather about creativity and response times. "We have our own technology team within FX prime brokerage at Citi, which means we can be more intuitive than others, respond very, very quickly to client interests and are able to expand our offering on demand."

On the staffing side, he takes pride in the bank's "mixed DNA". "Our client-facing team includes a range of experts ranging from ex-sell-side traders and former buy-side investors, to former operational staff and risk controllers. Between them they have a very solid, wide range of experience which we believe makes a real difference," he says.

Hedging bets

Mr Teilhard de Chardin - constant with his belief that there is no means by which a firm can distinguish itself on the technology front - has meanwhile pursued an altogether different avenue. Because Newedge entered the prime brokerage business relatively late, he undertook a broad market study before starting it up, to map out what the ideal prime broker might look like. The study findings led him to believe that one of the main issues hedge funds struggled with was the potential for conflicts, and therefore from the outset he has worked hard to ensure his group is devoid of all these.

He says: "We are completely agnostic as to where they execute their trades and who with - as long as it is with counterparties of good standing - and we have been very clear from the very beginning about what we do and what we charge what amount for. In turn, this means there are no pressures, no unclear waters and no compromises.

"The key differentiator between Newedge and most of our competitors therefore lies in the fact that we are totally agnostic. We can commit to a total segregation of interests - there is none of the cosy, symbiotic relationship between sales, trading and the funds and its related conflicts or risk pollution that might arise within an investment bank."

Contrary to this, however, Mr Coyne insists that when investors choose a prime broker, they should instead deliberately try and select one that they expect to deal with a lot, as those banks typically wave their prime brokerage fees on trades struck with the house.

The credit question

No discussion of prime brokerage could ignore the credit factor. Although the leverage ratios and credit exposures within the FX area are typically substantially lower than in the other prime brokerage business, it is still a significant factor.

Unsurprisingly, both Mr Li and Mr Hansen observe that hedge funds and other customers have become much more wary about their prime brokers' credit. Mr Hansen says: "They are a lot more selective about who they do business with, rather than choosing between one prime broker and another. This has forced several players with weaker credit profiles out of the market, but played to our strengths."

Mr Li adds: "Even big funds are now willing to post some level of margin. At the same time clients are also now becoming much more careful about their counterparts, which in certain instances has been a greater concern than the strength of a broker's platform."

Being by no means immune to counterparty risk themselves, the prime brokers have also become much more onerous in their requirements. According to Mr Hansen, credit was previously provided by prime brokers almost free of charge - but is now being priced into the service systematically. Another credit-related trend - which Mr Li says has begun reversing since mid-2009 - is that most prime brokers retrenched quite a lot from the less liquid currencies and the forward-forward market.

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Andrew Coyne, head of FX prime brokerage, Citigroup

Future trends

If the FX prime brokerage business is beset by divergent viewpoints and appears to be in constant flux as it seeks to adapt to changing market dynamics, emergent opportunities and customer demands - it also appears to be in pretty good health.

According to Mr Li, a lot of smaller banks have recently been entering the business, while others that retrenched have re-entered it. He also notes that - in addition to the Morgan Stanley initiative - there have also been a lot of personnel moves around the FX prime brokerage world, all of which he is confident signifies a renewed focus on the business and a growing recognition of its importance.

Mr Coyne is equally bullish on the business's future as a growing number of funds are now trading FX in greater size, and he expects more to enter the market. He also believes there is also some room to extend FX prime brokerage services to other non-typical customers - for instance, to selected corporates and traditional managers.

Mr Coyne says: "It is true that few corporates do the sort of volumes that would merit a prime brokerage relationship and in any event, most of them tend to trade bilaterally with their preferred bank or banks, but larger corporates more active in the FX markets, particularly those trading on ECNs, would benefit from prime brokerage relations.

He adds: "Similarly, and depending on their size and the scale of their FX activity, some traditional asset managers could benefit from using a prime broker, owing to the huge operational efficiencies we can offer."

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