Consolidation among sell-side providers of FX prime brokerage (FX PB) is worrying hedge funds, as they face the risk of reduced access to liquidity and operational disruption from moving to a new provider, a new report by Acuiti has found.
The Rising Risk of FX Prime Brokerage Consolidation, which was commissioned by Standard Chartered and is based on a survey or interviews with senior operations executives at 57 hedge funds, found that 39% of firms had reduced the number of FX PB relationships over the past three years.
While the most common reason for the reduction in relationships was an internal decision to consolidate, of those that had reduced FX PB providers, a third had done so because their existing provider withdrew from the market and 24% were offboarded by a provider.
On why so many sell-side providers are consolidating or withdrawing from the market, Acuiti founder Will Mitting told BEST EXECUTION there are a variety of factors behind it.
“Overall the risk/return profile of serving hedge funds has shifted for some banks as they experienced high profile blow ups in that market. At the same time, capital charges have increased the costs of providing leverage and associated services such as clearing. This has changed the economics of offering Prime Brokerage to hedge funds and as a result some banks are seeking to focus on larger hedge funds that can also access other services across the bank.
“This has happened against a backdrop of consolidation across the banking sector, most recently with the merger of Credit Suisse and UBS which has reduced the number of players in the market.”
On what can be done to drive diversity and combat the effects of consolidation on the market, Mitting said there is an opportunity for smaller banks to expand their offerings in FX PB and associated services.
“Our survey found that firms are looking to reduce their reliance on a small number of providers and the risk associated with that but also that they are seeking new and unique opportunities in frontier and emerging markets. This presents a significant opportunity for sell-side firms with a strong presence in emerging and frontier markets to expand their services to hedge funds,” Mitting added.
Hedge funds that were offboarded or saw their provider withdraw from the market reported reduced access to liquidity, the costs of onboarding and integrating with a new PB and increased operational and settlement risk as the results of a reduction in providers.
FX PB as a business line for the sell-side has come under scrutiny over the past five years in the wake of several high-profile losses and the Archegos Capital Management collapse which, while the troubles the fund faced stemmed from equity derivatives, it caused a re-evaluation of hedge fund risk at banks.
At the same time, the commercial and risk profile of providing FX PB to hedge funds is leading to increases in minimum monthly commissions and offboarding of smaller firms or funds that provide lower flows to their providers.
This is creating a two-tier market in which smaller hedge funds, particularly those with an Asset Under Management (AUM) of below US$1bn, risk facing incomplete offerings with a limited number of providers, the study found.
This divergence was perceptible in hedge funds’ satisfaction levels with the number of FX prime brokers available to them.
Roughly the same proportion of respondents were very satisfied but smaller firms were significantly more likely to be unhappy with their FX PB options – 43% of firms with an AUM of less than $1bn were either quite (30%) or very (13%) unsatisfied, compared with 12% and 8% respectively among firms with an AUM of over $5bn.
Overall, 53% of respondents were quite concerned and 16% very concerned about the impact on their business that the withdrawal of one of their FX PB providers would have, and over a third did not have an executable back up plan if they were offboarded by their core FX PB provider.
Significantly, levels of concern were highest among hedge funds that had been offboarded or experienced a provider withdraw from the market. These firms have experienced the disruption and do not want to do so again.
The study also found that hedge funds are looking to increase FX PB providers, primarily to access unique opportunities in the international FX market. This will prove challenging if the market continues to consolidate.
“Hedge funds are highly reliant on their FX PB providers and it is no surprise that levels of concern are high across the market,” says Ross Lancaster, head of research at Acuiti.
“There is an opportunity for expansion among the sell-side to meet the demand from hedge funds both to access unique trading opportunities in emerging and frontier markets but also to reduce operational risk associated with the dependence on specific providers.”
Andy Ross, Global Head, Prime & Financing, Financing & Securities Services, Standard Chartered said “The survey shows that hedge funds are encountering an increasing challenge in finding a Prime Broker for FX PB and firms have no executable back up plans in the event of services being withdrawn by their core provider.
“At the same time, with ongoing growth in the global market place, hedge funds from across the world are looking for a partner that can provide access to a broad spectrum of currencies to optimise their trading strategies. Standard Chartered is well placed to meet that growing demand.”
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