Charalambos Psimolophitis

Prime-of-prime is the new Prime

Our industry has proven itself to be exceptionally resilient, especially after the global crisis of 2008 and through the periods of low volatility that have ensued. If anything, the intervening years have seen an industry rapidly coming of age. Our traders have experienced increasing transparency as well as improvements in liquidity and technology that have led to better prices and faster execution times. The trend, as I have observed in previous articles, has been for a gradual levelling of the playing field.

In the midst of the collapse of Lehman Brothers one hedge fund consultant likened the situation to a game of musical chairs. Clients of the prime broker had the assets they posted as collateral lent out, or rehypothecated, to multiple parties who then also had a claim on them. When the music finally stopped there weren’t enough chairs to go around.

As the credit lines tightened following the crisis it became increasingly difficult for new clients to unlock top-tier liquidity. What’s more, the growing sense of risk-aversion went both ways. The hedge funds that had previously been by far the largest and most lucrative prime brokerage clients were also more wary; counterparty risk became the buzzword and many smaller primes sprung up to enable these funds to diversify the risk of tying their assets up with a single prime broker. Funds that previously had little choice but to accept the terms of their prime brokerage agreement now recognised the peril in putting all their eggs in one basket.

A study conducted by Tabb Group showed that before the crisis hedge funds with more than $3 billion is assets typically only used one prime broker. In 2009 this went up to 4.8 prime brokers per fund. Even so, as the costs mounted and investor confidence continued to wane this process of disaggregation began to reverse and the old monopolies started to reassert themselves. The study found the above figure dropping to 3.9 prime brokers per hedge fund in 2010, down to 2.9 in 2011.

As was the case after the tech bubble burst almost a decade earlier, FX emerged out of the chaos as a more than just a necessary component of, say, an international equities transaction, or a corporate forward contract, but rather as an asset class in its own right that could prove to be a valuable source of alpha in a world of diminishing yields and increasingly correlated securities. This is evidenced in the rise of the currency overlay manager as well as the number of hedge funds now specialising in FX. It is also plain to see in the explosion of FX prime-of-prime brokerage services that we have been observing for a number of years now. To call this growth exponential is not to exaggerate.

FX is an entirely different animal to traditional asset classes and this is largely why FX prime-of-prime continues to grow where other primes have struggled. In today’s global reality it’s becoming harder and harder to find organisations that do not have some kind of FX strategy. Today brokers, portfolio managers, CTAs, hedge funds, mutual funds, pension funds, sovereign wealth funds, insurance companies and corporates all require different solutions to specific FX problems. Our $5 trillion per day market has more than enough head room for many more players to enter the space and offer their liquidity relationships and expertise.

Expertise is really the main driver here, it’s the reason for the explosion in boutique prime brokers and why they are so competitive. There’s so much more on offer now in terms of service than just credit and clearing; from post-trade risk management and full trade reporting, to 24-hour support and assistance in a variety of areas including: business strategy, marketing and technology.

It’s also the reason that we have elected to enter the market after our acquisition of FX aggregator and bridge provider Quotix. By leveraging the credit relationships we have built over the years, as well as our industry experience and the technology we now have at our disposal, we feel we are able to offer genuine value in this space. FxPro Prime clients can now access liquidity from a variety of top-tier institutions, as well as other specialist liquidity providers such as those dealing in exotic pairs, all through a single margin account. We are able to offer up our sources of liquidity with far lower collateral requirements than traditional prime brokers, and we also provide our clients with a number of advantages in terms of risk reduction. In entering into an agreement with us FxPro Prime clients are not exposed to the credit risk of any of our end-dealing partners, while our advanced order-matching and execution technologies also mitigate their operational risk.

We regard this as a continuation of the trend discussed in the opening paragraph, of better services and higher quality liquidity that inevitably ends up benefitting individual retail clients. If the brief history of FX prime-of-prime brokerage is anything to go by, we anticipate a great deal more competition in this space. This will inevitably lead to vastly improved liquidity and more competition in the retail space. Specialisation is the key here, it’s the reason we’re seeing a new generation of nimble and adaptable firms that can harness their expertise to provide a completely tailored service to their clients. In our view long may it continue, ultimately it’s the end trader who benefits.