With the larger foreign exchange prime brokerage houses restructuring and new entrants offering new types of services, Frances Faulds asks whether regulatory changes have contributed to the demise of the industry or simply to its reinvention.


There have been a number of high-profile exits from the foreign exchange (FX) prime brokerage market of late, including Morgan Stanley's withdrawal in 2013 and Rabobank's this year, as well as SEB’s announcement that it would not take on any new customers. But, at the same time, several noteworthy entrants have come to the fore, including Danish investment bank Saxo Bank, London brokerage firm CFH Clearing and UK-based FX trading firm Forex Capital Markets.

Overall, there have been more entries than exits, but the traditional model is changing so dramatically that it is not the case that the FX prime brokerage market is fragmenting, rather it is polarising.

Aside from regulatory changes, FX is a very competitive product and margins have shrunk to levels that make it hard for small players to compete. The rising cost of FX prime brokerage services has meant that it has become a game of scale, not just for the providers but also for the clients. The bulk of volumes go through the largest 200 clients, who can more easily maximise the benefits of the multi-asset platforms they are being offered.

As the large prime brokers broaden their offerings amid the rise of the ‘prime of prime’ model – which involves micro contract trades, often with greater leverage – the so-called ‘mini prime’ and cloud providers are filling the void with specialised offerings for smaller hedge funds and asset managers. As a result, the growth in the market is coming from a new breed of prime of primes and, in some cases, providers looking to reinvent the traditional FX prime brokerage model.


Consolidating early

While many of the changes to the market began in 2008, following the regulatory requirements for over-the-counter (OTC) products, one established player, JPMorgan, took the lead and consolidated OTC products into its listed derivatives clearing business during 2007 and 2008, before the new regulatory regime took hold. The restructured JPMorgan team, now part of the firm’s investor services arm, integrates pre- and post-trade services by bringing together the bank’s agency clearing, collateral management and execution services, agency lending, custody and fund services, prime brokerage and financing. Investor services sales teams are now aligned to customer segments rather than asset classes.

Andrés Choussy, head of derivatives clearing in the Americas for JPMorgan, says: “This provided our clients with a single platform across all of the products that they traded, and a single standard of service. We decided to leverage our service across multiple products, get away from the siloed approach and look at the client holistically.”

For Mr Choussy, even before the regulatory requirements added a new layer of cost and complexity, the cost of doing business in the highly competitive FX market was already going up, and, with it, the cost of servicing prime brokerage clients. By consolidating its product lines early on, JPMorgan has been able to achieve economies of scale by diluting these costs across a broad number of products.

“We anticipated where the market was going even though a lot of the regulation, particularly the clearing mandate, had still not even hit FX yet,” he says. “We started trying to achieve cost efficiencies and savings by consolidating functions that were common across multiple product lines, which then allowed us to serve clients in the best possible way by giving them as much product coverage as we could.

“The value-add of a prime broker really comes down to operational and capital efficiency. A smaller FX trading firm with fewer counterparties is not going to get much operational efficiency from an FX prime brokerage set up. Initial margin savings will also be smaller as the benefits from a portfolio margining-type of platform are limited.”

JPMorgan investor services already provides cross-margining between bilaterally traded FX cash products and futures products by margining based on a holistic risk profile of the client. When FX clearing of non-deliverable forwards and FX OTC options becomes a reality, Mr Choussy believes that the infrastructure that the bank has built will allow it to provide an integrated cross-margining platform.


Fewer silos

Although an established player of 10 years, Newedge came to FX prime brokerage from the listed derivatives market, so at first its clients were largely commodity trading advisors acting on behalf of other clients, and then global macro funds, and now are full-service prime brokerage clients. As the biggest listed derivatives house, Newedge knows centrally cleared technology well and, in a sense, the FX market is coming towards Newedge.

“We have been fortunate in that our model was less siloed than that of a traditional investment bank, which might have put together a prime brokerage business from equity, fixed-income and FX businesses,” says Andrew Waterworth, head of FX prime brokerage at Newedge. “We have offered FX clearing and FX prime brokerage as part of our core offering to the global macro players for some years. Because we were a little later to the game compared with some of our competitors, we were able to build [our offering] on an integrated platform, and have had a single client-facing platform from day one and have not had to re-engineer our platform greatly since.”

Newedge’s prime clearing services cover equity, fixed-income and FX prime brokerage, as well as commodities. FX prime brokerage can be offered as a standalone service but Mr Waterworth says Newedge aims to cross-sell and cross-margin the execution and clearing offerings to maximise the benefits to both the client and the broker.

He says that new regulatory requirements have come at a time when there is almost a perfect storm in FX – fees, regulatory capital and the cost of business are going up amid decreasing volumes. “This is why we are seeing a re-pricing in the market anyway. Mandatory clearing is just one strand of the changes facing the market.”

Mr Waterworth believes that cherry-picking of clients is simply a consequence of this, and one that is perhaps driving smaller investors to non-traditional and niche prime brokers, or ‘mini-prime’ providers that are not taking the full, multi-asset approach. He believes the biggest casualties of the retrenchment of prime brokers from the wholesale market in the past 12 to 18 months have been institutions using white-labelled services from the larger prime brokers.

For Mr Waterworth, FX prime brokerage is already part of a cross-asset offering and this will strengthen, which is why Newedge has invested significantly in its full-service (execution, clearing and prime brokerage), multi-asset platform in the past five years.


Prime of prime step in

There is little doubt that the tightening up of credit allocation by prime brokers has enabled the prime of primes to grow their market share by providing credit services to smaller firms, a trend that was only enhanced by the spate of recent exits from the market.

Saxo Bank built its FX prime brokerage business 18 months ago. As a bank, it entered the market as one of the biggest ‘prime of prime’ FX brokerages, with a strong balance sheet and track record in both FX and technology provision. Peter Plester, head of FX prime brokerage, who recently joined Saxo Bank from Rabobank, says the decision was made to enter the market because it had evolved and the days of a single liquidity provider have gone. “FX prime brokerage has grown out of the need to clear trades from multiple sources of liquidity and it was a natural step for Saxo Bank as FX is such a big part of its business,” he says.

Mr Plester says that this specialisation in FX has led Saxo to develop a unique prime of prime model. Once an account is opened, the client can choose to use Saxo as a liquidity provider, a clearer of single bank liquidity providers or electronic communication networks, or use the Saxo account to cross-margin against options, contracts for difference (CFDs) or commodities. “We can offer other instruments from which the client will benefit from cross-margining in the single Saxo account,” says Mr Plester. “Doing FX clearing with one provider, futures with another and CFDs with another would be very margin inefficient.”

With the larger FX prime brokers raising the bar to entry, and smaller market participants searching for brokerage services, Mr Plester believes that the growth in the market will come from the prime of prime model. “All these customers need to go somewhere and whereas previously they may have been able to choose from a list of five main FX prime brokers and 10 prime of prime providers, today they may only be able to choose from the prime of prime providers,” he says.

“Furthermore, for these prime of primes, FX is their main business, and often their specialisation, unlike the larger [prime brokers, for which] FX is a relatively small part of [their overall] business. This lends itself to a more tailored and personalised service and one more like a private banking service.”


Technology race

With its strong focus on technology, Lars Holst, co-founder and chief executive of CFH Clearing, says that CFH re-launched a year ago to emphasise its prime of prime and clearing services. “Prime brokerage is a combination of good credit lines and good technology,” he says. “We might not have the balance sheet of some of the large prime brokers but we have unrivalled technology. Just having the balance sheet can only take you so far, but to have scale in your business you need the technology as well.”

CFH Clearing builds trading infrastructure for banks and brokers, and emphasises that it can give access to any liquidity source and any prime broker, clearing tickets from the interbank market and connecting the primary market to the institutions. “We appeal to the smaller hedge funds as well as those that do not want to join the onboarding queue of three to six months for the major prime brokers. Also, as we have the economies of scale we can price very competitively,” says Mr Holst.

While CFH Clearing is seeing new entrants that want to get to market faster, Mr Holst says the prime of prime offering is also picking up business from prime brokers exiting the market or tightening up their on-boarding requirements. As CFH Clearing operates fully automated no-touch systems, it is less concerned with the number of tickets a new customer is expected to clear daily than some prime brokers might be. Already this year, CFH Clearing has cleared the same volume that it handled throughout 2013.

Mr Holst says: “The market has changed dramatically. It is no longer enough to have a strong balance sheet – it is about technology and scale. It is now a technology race and the nimble players that can adapt to changing market circumstances and cater for a different profile of clients [are the ones] that will win.”


Goodbye legacy model

A wholly new approach to the provision of prime brokerage has come from Liquid Holdings Group, a cloud technology and services company for alternative asset managers. It provides fund managers the independence and autonomy to park assets with multiple prime brokers. Driven by the need for streamlined processes to address transparency and reporting post-2008, Liquid was developed in 2012 and went live in July 2013 with a single platform that handles orders, execution and risk management (OERMs), as well as reporting in real time. It had approximately 130 clients as of June 2014.

Robert O’Boyle, director of sales and marketing at Liquid, says: “The majority of hedge fund capital comes from institutional investors, such as pensions and endowments, with insurance companies now following suit. This segment of investors requires quality infrastructure, which today we provide to fund managers of all sizes. We work with our clients to understand the exact front-office controls and services required to run their business – whether that includes a single OERM for our smaller managers, or a full-on OERM, backed by an outsourced middle office for our larger managers.

“Our model eclipses the legacy way of doing business, which resulted in small and medium-sized funds relying on a single prime for services as well as less than adequate technology limited to the market expertise of that particular prime.”

Liquid’s platform eliminates those restrictions by providing connectivity to all prime brokers. It also tries to make it simple for hedge funds to manage different strategies and different fund structures, while leveraging any prime broker or execution channel in a way that was not possible before, at a significantly lower cost.

Larger hedge funds would most likely use several prime brokers for a number of reasons, including diversification and risk mitigation and to have execution flexibility in different asset classes. But this is expensive for the smaller hedge funds. Liquid makes it less so, while lowering technology and operational risks and costs. Mr O’Boyle says: “Liquid levels the playing field for hedge funds, providing the necessary front-office controls and middle-office services to manage the business. We are helping hedge funds succeed more efficiently and at a lower cost.”

The use of cloud technology is enabling hedge funds to continue to adopt the multi-prime brokerage model for FX, once tipped for growth but which is now in danger of extinction amid the rising costs of prime brokerage and the development of multi-asset class models by the larger players.

Rabobank was one of the last of the larger entrants to the market. Its exit – it offered direct credit lines to the interbank FX market that serviced lower capitalised firms – has provided an opportunity for prime of primes to gain additional clients, even if it does create a void of lower end primary bank offerings.