Shifting Priorities

The changing landscape of foreign exchange

Originally published in the August 2017 issue

Before buying any product or service, consumers will typically run through a list of key criteria. A car, for example, needs to be affordable, reliable, safe and easy to drive, but changing circumstances may alter the importance of those factors. New driving regulations might make speed controls more important, while a rise in road traffic accidents could shift the focus on to safety features.

Foreign exchange prime brokerage has been through a similar renaissance in recent years. The combined effects of post-crisis banking reforms and the fall-out from the Swiss National Bank (SNB) de-pegging of the Swiss franc in 2015 have driven major shifts in focus on the part of prime brokerage providers and their institutional clients.

One of the first considerations for clients should be the creditworthiness of the prime broker, as there is a significant range of entities offering the service, from the largest investment banks to smaller boutique providers. In the wake of the SNB decision, when many institutions lost money on the sudden one-way currency move, safety of funds has become ever more important. Firms now recognise that they need to scrutinise the balance sheet and capital base of their chosen counterparties to make sure they have the necessary resources to withstand future market stresses.

Credit quality follows close behind, as the provision of credit lies at the core of the prime brokerage business model. If a prime broker is dealing with a large number of trading platforms, liquidity providers and clients, it needs a strong and plentiful supply of credit. Before entering into a new relationship with a prime broker, clients need to be sure that credit will be available when they need it.

The rise of the Prime of Prime model requires clients to assess the individual prime brokers being used by their chosen provider. This necessitates an additional level of disclosure on the part of the Prime of Prime, but it is important if the client is to avoid extra cost and risk. Institutions must be sure, for example, that the prime brokers being used are connected to NetLink, the industry standard post-trade solution, or else they stand to incur higher processing costs.

Following creditworthiness and credit quality, liquidity has become a growing concern for all market participants, and firms need a proper understanding of the liquidity provision their prime brokers can facilitate. How many platforms are they connected to? Are aggregated pricing streams being accessed as well as ECNs? Does the prime broker source liquidity from non-banks as well as banks? These are the kinds of questions that should be asked of every prime broker.

While a number of prime brokers are not yet tapping non-bank liquidity providers, this may soon render them uncompetitive, as prudential regulation is making it harder for banks to hold risk, and non-banks with greater risk-taking capacity are increasingly stepping up to plug the gap. If the balance continues to shift towards non-bank liquidity provision, connectivity to those firms may become a necessity.

Managing a diverse array of liquidity providers and trading platforms also requires heightened risk awareness, including pre-trade risk controls to set and maintain allocation limits on individual venues. Such controls are critical for prime brokers to ensure that credit is not over-extended and clients’ net open positions in particular liquidity pools do not exceed approved levels.

In order to access the credit and liquidity they need as quickly and efficiently as possible, institutions also need their prime brokers to have the right technology and connectivity in place. Prime brokers with a presence in the three main regional data centres will have a natural advantage in connecting their clients to liquidity in their own region with very low latency.

Meanwhile on a post-trade basis, buy-side firms face a growing number of clearing and reporting requirements arising from new market regulations. If they can rely on the prime broker to manage these obligations, they will save themselves significant resources. Assessing a prime broker’s reporting capabilities and connectivity to relevant market infrastructures must therefore be part of the standard due diligence process.

The prime brokerage landscape is increasingly complex and challenging to navigate, but the one constant is the ongoing importance of strong relationships. While credit, liquidity and technology may have risen up the agenda, service provision and reliability are just as important today as they always were.

This wide-ranging set of selection criteria means that the most eligible prime brokers may not always be the largest and most well-known institutions on the street. If a boutique provider can combine an attractive product offering with strong credit, technology and customer service, it may be able to wield an advantage over its larger competitors in the years to come.