Foreign Exchange Prime Brokerage

A quiet revolution

Originally published in the May 2007 issue

To some the existence of currency exposure is an irritation to be dealt with and accounted for by someone else. For others it is their livelihood. Foreign exchange means many things to different people but few are not impacted by it in some form or other. For those considering a more active participation in the FX markets it is important to understand the current trends and drivers of the market place.

In the last few years the FX Market has been going through a quiet revolution. For those close to the action, it is an intense place to be. The pace of change has increased rapidly since eCommerce in FX moved from information delivery to being transactional in nature. Today the FX Market is mostly electronic with a small percentage of trades initiated by phone.

Growth of FX markets

Foreign Exchange Prime Brokerage, traditionally a clearing and operating efficiency structure for currency managers has, in combination with eCommerce dealing, contributed directly to the recent growth of the FX Markets. In essence, FX prime brokers acting as credit intermediators provide access to all available prices. Separating the link between executing agents and settlement agents provides a highly efficient OTC clearing platform. Apart from access to best price it also provides collateral and operational efficiencies.

This is best demonstrated in electronic market places such as LavaFX, Hotspot, FXAll etc where clients are able to deal on all available prices by virtue of their FXPB. In a number of these portals, trading is completely anonymous, where prime broker names are substituted for client names. This sounds just like an exchange but we are still talking about an OTC market, where ‘clearers’ are able to compete on pricing and services. To make things more interesting there are numerous pools of liquidity. Active FX clients can choose to deal directly with the banks provided by their FXPB or on ECNs such as those mentioned already and even platforms that were once the backbone of the interbank market such as EBS and Reuters.

What has been an interesting development is the emergence of FX prime brokers that are essentially singularly focused on a specific strategy, that of providing to the program trading community. This is more or less driven by their relative strengths and weaknesses, since to be a full service FXPB requires that you have the global presence and FX pricing capabilities of a major FX institution. The main reason being that clients benefit from a zero fee structure when dealing direct with their prime broker. FXPB institutions that have poor or no FX liquidity are merely leveraging their operational infrastructure and charging fees on ECN business where trading is anonymous and fees are leveraged on every trade.

“In the last few years the FX Market has been going through a quiet revolution.”

The greater transparency in pricing in various pools of liquidity; the electronic delivery of that pricing and the competitive nature of the market-making institutions has meant that there are very realistic opportunities for the growth of high velocity program trading. Many of the new entrants are coming from the equity markets where their experience of this type of trading is far more advanced in comparison to most traditional FX players.It is also interesting to note that a great many program traders come with little or no experience in trading FX, nor any in depth understanding of the FX market participants and the underlying nature of the market itself. For them, it is simply a mathematical exercise in which they can potentially make returns. So far there is evidence that this works in the current environment. On the back of the surge in FX program trading comes what is already well understood in equity circles, namely, algorithms to smooth execution without moving market prices. Electronic FX tends to suffer from what some call the liquidity mirage, where liquidity appears deep in multiple pools but invariably comes from a limited number of price providers. Algorithmic execution is essential and very much a talking point in FX circles. It is clear that this is a significant target for technology investment.

Execution costs and technology

Within the program trading community, profit margins are finely tuned and as such, cost of execution is an integral part of the program itself. The knock on effect of all this competition is that banks are now turning to address their processing cost bases. Traditional FX Operational structures are creaking under the weight of ticket volumes and therefore technology is once more required to solve the issue. Netting services to reduce tickets numbers sent to operating systems are being employed to reduce overhead and operating friction. This is in its infancy, so there is still some way to go, however firms such as Traiana and EBS ICAP have developed this capability and the CLS Bank, (clearing mechanism for interbank settlements), are reportedly working toward a netting solution. The impact will be enormous in terms of operating costs and risk.

Competition among FX prime brokers to secure the highest volume program traders is intense such that fees have plummeted for this particular client segment. In simple terms, the FX market is much more accessible and spreads are tighter than ever. This is great news for the currency manager or program trader that is highly specialised and singularly focused on a particular segment. Most other managers however run complicated businesses and therefore require greater levels of service. As most full service prime brokers know, you need to be able to service the client at multiple levels. That means satisfying everyone from the CEO to the IT department, even down to the client administrators. Everyone within the client organisation has a say in whether the prime broker is delivering a top level service.

All things to all people

So what does it mean to be all things to all people? Not all clients are cross-product in nature, so first of all it is essential to be best in class in each product discipline. For my part I have to be the number 1 service provider of FX prime brokerage services. Equally, a cross-product prime broker is only as good as it’s weakest individual performer, so it behoves each contributor not only to be highly active and creative in each discipline but also second to none in terms of service, cost and investment. Whilst not all hedge fund mangers have cross-product needs it is reasonable to say that the very largest hedge funds are almost always cross-product.

For the prime broker, being able to co-ordinate a cross product vehicle within an organisation that depends on silos for economies of scale is no mean feat. It is, however, achievable and this is typically down to the flexibility and skill of the prime broker management to deliver what is essentially to each client a tailored solution. What is certainly expected is standardised technology interfaces, single access internet portals, a single account structure and real cross product margining. The final essential ingredient is down to the people who manage and run the service. Within that service, foreign exchange needs to be available in whatever form the client requires it. That could be simply the efficient conversion of currency balances from dividend payments or it couldbe FX risk management solutions and ECN access. There should be no cause for concern, whatever your requirements. Essentially, it is still a very straight forward product.