FX CREDIT GAP – TIME TO ACT.

Tighter regulation, reduced risk appetite and the decline in the number of prime brokers (PBs) has affected an estimated 25% of global FX volume, according to ADS Securities. The loss of available trading lines is leading to reduced trading, wider spreads, higher prices and increased foreign currency exposure for many participants, as Marco Baggioli, COO at ADS Securities, explains.

Eighteen months ago there were over a dozen FX prime brokers and now we are down to six main specialist players – BNP Paribas, Citibank, JPMorgan, RBS, UBS and Deutsche Bank. The others are no longer committed to providing a full-service FX offering and if they stayed in the business, they now have a much narrower focus on specific multi-asset-class clients. They have decided that the risk vs. returns make this area of business unprofitable for them and have transferred resources – mainly capital – to other areas that have less risk and greater potential returns.

The remaining PBs have also adapted their business models to the changed world we operate in. More and more they are only looking to work with tier one clients by introducing higher capital and entry requirements as well as minimum fees to satisfy a much reduced credit and risk appetite and higher costs. It may feel as though it is a distant memory but in fact less than two years ago PBs would compete to provide their services. Brokerages from the small to the large would expect to be offered a PB option by at least two or more different banks. For most of these firms those days have gone.

Two years ago an agency broker with US$5million in paid in capital might have been able to access even the largest FXPBs. But today the same PBs will expect to see capital of around US$50-75 million before they engage in any conversation, which is why there is such a shortage of credit in the market. Some smaller firms may be able to trade bilaterally with each liquidity provider and post margin accordingly, but this approach has a lot of limitations, including netting of risk inefficient margin requirements and operational costs. So, at the moment the situation is unworkable for start-up hedge funds or those whose assets under management or capital do not make the cut with the FXPBs.

The change in the markets can be traced back to the Swiss National Bank de-pegging of the CHF from the euro on the 15th January 2015. This day will be remembered by all FX traders. The SNB may have been the trigger, but the reality is that the change was going to happen regardless and the SNB possibly accelerated the pace. The FX market is extremely large and is now based around very high tech sophisticated trading algorithms and because of this any significant market events cause rapid and uncontrollable changes to prices. This opens PBs up to extremely high levels of risk – risk which in the climate of increased controls and greater regulation, they cannot take on, especially when they only receive a few dollars per million traded.

So what needs to happen, what is the answer? We see the solution coming from within the industry. The FX market evolves very quickly. We have seen the development of very fast, low latency machines, we then moved to the development of sophisticated liquidity aggregation platforms, which use both bank and non-bank flows. But none of these solutions is, or can be, effective if the necessary credit lines to back the trading are not in place. Our view is that some of the immediate issues can be addressed by a true prime-of-prime model.

Prime-of-Prime is effectively a credit intermediation service mirroring what the traditional PBs offer to their selective client base. There are a number of brokerages which already provide a principal trading product. A principal trading account has a lot of benefits for clients who do not have an FXPB and need additional credit lines to access liquidity. The account means that they can trade bilaterally without PB fees, even placing small ticket sizes, which a PB would not want to handle and with no minimum monthly fees. The limitation is that you can only trade on the undisclosed liquidity provided by the brokerage offering the principal trading facility. At ADS Securities we offer undisclosed access to the top LPs and best liquidity through NY4, LD4 and TY3, but many clients want to trade using their own disclosed liquidity and relationships.

For these clients our prime-of-prime (PoP) is the perfect solution. They can execute anywhere in the market using their external liquidity. Our PoP clients – typically hedge funds, banks, family offices or brokerages – can access the credit lines and liquidity they need and maintain direct relationships with their providers. We provide them with the credit backing and all back end processing, including risk netting and margin optimisation.

So, this is our selling point. ADS Securities can offer a true PB service under a PoP set up because we are very well capitalised and have access to some of the largest NOP lines in the brokerage industry. Our track record and history with the PBs allows us to act as a true credit intermediary in the market. We sit between the PB and the trades and take on the counterparty risk. As more brokerages like us offer this level of service some of the credit gap will be filled.

Even before the SNB event it was clear that PBs were taking on risk and not being paid for the credit they were providing. This scenario always had to change if, as we estimate, there has been a reduction in available credit affecting up to of US$1.3tn in daily volume.

However, if large and well-capitalised brokerages are willing to take on some of this risk and sit between the clients and the PBs, this is a very good way of increasing available credit. Large brokerages help smaller market participants and support the work of the FX-prime brokers. There are also additional benefits in that the sign-up process for PoP is a lot quicker than getting PB agreements in place with larger banks.

We do believe this is one way that the decline in credit lines and volumes can be reversed and the industry can work together to grow the market. Prime-of-Prime may not be a new concept but it is now a product which is becoming an essential component of the global FX market.

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