The foreign exchange prime brokerage (FXPB) market has undergone significant change since the financial crisis. Increased capital costs, changing regulatory requirements and an aversion to risk has seen the top tier FXPBs retreat from the market and retain only the most profitable parts of their client base. In their place has emerged the Prime of Primes (PoPs) which through a more inventive use of technology and a leaner organisational structure have picked up all those FX market participants let go by their tier one PBs.
As the PoP market matures, its principal providers are now seeking to differentiate themselves through various means. For some, it is all about the use of technology and its ability to make pre-trade risk management and post-trade reconciliations as painless as possible for clients; for others, the emphasis is on creating access to a bespoke and diverse pool of liquidity.
There are also divergent views among the various providers as to what defines a PoP – is it the operating model (clearing services and agency brokerage or execution and liquidity services), is it the target market, is it the size of the balance sheet, or is it a mix of all the above? And how sustainable is the PoP market given its opportunistic beginnings? How can the providers evolve beyond a status of second-tier stopgaps and become long-term partners for their clients?
Broader than broadway
Some will argue that the PoPs have always offered services above and beyond the PBs. “The offering of the average PoP has always been broader than the service provided by the traditional FXPBs,” says Jonathan Brewer, managing partner of IS Prime, a UK-based PoP that launched in January 2015. “An FXPB offers a clearing only service, whereas PoPs typically offer liquidity, execution and clearing services in a single ‘one stop shop’ package. In this respect, the market hasn’t materially changed.”
Where the PoP market has changed, says Brewer, is that more sophisticated, technology driven players are entering the space. “There are now really two types of PoP. There are those like IS Prime who offer a sophisticated, bespoke offering underpinned by proprietary technology, whereas the majority are essentially simply white labels of ECNs such as Integral or Currenex.”
One would think that as the PoP market grew in terms of new entrants and target market, and once the competition intensified, that there would be a greater emphasis on creating a more tailored approach to liquidity and thereby appealing to a wider set of participants. But Brewer believes that the opposite scenario is true. “I feel that many PoP offerings are becoming increasingly standardised, rather than more bespoke.” New and flexible technology facilitates this bespoke approach and enables IS Prime to white label its infrastructure so that clients can offer high end institutional brokerage services to their B2B clients.
This ability has been a key in enabling clients to significantly scale their volumes, says Brewer. It is also evidence that flexible technology is more important than a large balance sheet in the PoP world. “Size of balance sheet is an interesting topic, and some participants have been trumpeting their ‘financial strength’ heavily since the SNB episode at the start of last year. This in many cases is misleading, because the financial institutions that have failed in the recent past have done so as a result of either poor risk management, having an excessively leveraged balance sheet or a combination of both.”
The PoPs have enjoyed an opportunistic rise in prominence, given that market conditions forced the larger and incumbent FXPBs to jettison so many of their clients, into the arms of grateful PoPs. So do the PoPs have a foreboding sense that the current conditions are temporary and that once the FXPBs are fully restored, their clients will come running back?
“The financial markets are always cyclical, and therefore it is definitely possible that the needle may shift back in the direction of FXPBs to some extent,” says Brewer. “What the market is realising now however is that it is not mandatory for a participant to access the wholesale markets via a primary PB in order to be competitive, in fact, the operational and resource benefits of using a PoP rather than a primary FXPB are often very compelling. In the case of a retail broker for example, if they have a good PoP who takes care of trading and clearing in an efficient and cost effective manner, it frees them up to focus exclusively on acquiring clients and generating flow, which is typically their major forte.”
The changes in the FXPB market have accelerated in the last 12 months as global regulatory reforms like Basel III designed to contain the ‘too big to fail’ banks have started to bite, says Gavin White, CEO of multi-asset prime services firm, Invast. Different activities and asset classes were ranked according to an assessed risk weighting and capital requirements were prescribed accordingly. FX and Metals were two asset classes which were quite severely dealt with, making activities in these asset classes, such as Prime Services, very expensive for banks to engage in. “It has taken some time to happen, but banks have gone through their books and run a ruler over each client. They are turning away new clients and even existing ones that don’t create enough revenue,” states White.
The change has been on a sliding scale, a gradual contraction of the market that has intensified following the SNB event in January 2015. “The contraction accelerated after the SNB crisis, as FX suddenly became a much riskier and therefore more expensive asset class. Small and mid-tier clients were left looking for alternatives. Since this is being driven by significant global regulatory reform, it is not a temporary phenomenon. It is a generational change, the biggest one I’ve ever seen. It will ebb and flow but overall I think it is a long-term change,” says White.
The shortages being experienced in the Prime Services market have been exacerbated by the fact that FX and Metals have been discovered as a new asset class by the middle classes across the globe. Consequently, there is a growth in the number of consumers at exactly the same time as there is a contraction in the provision. This has opened the way for the PoPs to come in and fill the gap.
Invast has stepped up its PoP offering in the last six months, using its balance sheet and the significant volumes generated by a large Japanese client base to target institutional players who are unable to sign a bank prime broker. Invast has primarily focused on small and mid-tier investors and brokers – from hedge funds to high frequency traders, through to retail brokers. As the PoP market develops, competition intensifies and balance sheets increase in size, more innovative approaches and offerings will appear, says White.
PoPs are more flexible and more able to design their offerings around their clients’ needs, much more so than the global investment banks. For instance, providing collateral alternatives, such as accepting bank guarantees rather than cash, which is one of the innovative ways Invast satisfies the needs of smaller funds. The very large global investment banks can’t do that.
But is there any concern that some of the PoPs will over-extend themselves in terms of credit or collateral, as we saw with the SNB event? “The regulatory trajectory is focused on improving the collateral rules and I don’t think any broker trying to push that line will be successful,” says White. “The innovations we’ve seen in the PoP space provide more security for brokers and clients. There is less naked credit extended and more pre-trade risk management.”
One of the ways PoPs are looking to innovate is by tailoring liquidity to meet the bespoke requirements of a wider range of FX market participants. “Generally, the needs of different FX market participants are similar - credit, a trading platform, expertise and liquidity access - but as you go down the chain, the liquidity needs are very different” says White. “Hedge Funds tend to require thicker, deep liquidity, so that they can transact in large amounts without market impact, whereas HFT firms and retail brokers generally prefer a tight top-of-book. There is also very strong demand for multi-asset PoPs. In the end, PoP is all about credit and access to bespoke liquidity.”
White believes there is a huge opportunity for PoPs to develop into something between a private bank, or boutique for high net worth investors, and an investment bank. “I think there will be a dozen or so firms that will really benefit from this opportunity and in five or six years’ time, they could be really large players. But in order to take that opportunity, these PoPs will have to be diversified across multiple asset classes because very few of these small and medium clients are focused on single asset classes.”
The PoPs will also have to invest heavily, and wisely, in technology and administrative support, says White. Not only do they need cutting edge and low latency technology at the front end, they need to invest in their back office to meet new regulatory requirements around trade reporting, for example. “Those committed to the industry will be the ones that survive.”
Only a handful of PoPs will make the jump into the multi-asset world, says White. “It is all about access to capital. It is a very capital-intensive-business to support a big prime service. You have to apportion credit and capital to clients as you see appropriate. But for those that are able to meet these capital demands, they could triple in size very quickly. This will stretch the market and there will be another tier of PoPs focused on even smaller clients below them. The landscape is changing and it is a very exciting time in the industry.”
Filling the gaps
Divisa Capital is one of a number of firms that have emerged in recent years to fill the gap in the market created by the partial withdrawal of prime brokers from all but their most profitable clients. Divisa began as a purely FX prime of prime (PoP) but has since expanded to cover multiple asset classes and to provide what it terms as ‘bespoke liquidity’ to institutional and professional traders. It has since expanded further by launching an institutional trading venue, otcXchange, designed for larger clients with their own prime broker that are looking for an alternative pool of liquidity.
According to Divisa Capital’s CEO, Mushegh Tovmasyan, there has been a reversal in market conditions that have made the emergence and expansion of the PoPs possible. “A few years ago the biggest cost in FX was technology while there was a flood cheap credit. Now the opposite is true. Credit has become much more expensive while the technology is increasingly affordable and accessible. This has created a bottleneck for the tier one participants and also an opportunity for firms like us. There has been a shift downward and those that were previously well served by the prime brokers are now being serviced by PoPs.”
Tovmasyan describes Divisa Capital as a specialised PoP in that it focuses purely on professional and institutional traders and does not dilute its service by engaging with retail traders. This approach is in contrast to others that have grown from a retail broker to become PoPs. “I think that model can be problematic. Firstly, the retail market is very time consuming and costly to service, secondly, retail brokers tend to prioritise their retail flow above their B2B offering which causes trust issues.”
Divisa Capital also focuses on providing more tailored liquidity for individual clients, says Tovmasyan. “Typically in the PoP space, there is one pool of liquidity made available to several clients at different cost structures. Before, the technology wasn’t flexible enough; the ECNs would curate the liquidity and brokers would then sell that on to different types of clients. We tailor it more to the client’s needs – localised liquidity, technology agnostic with good spreads that can be monitored by the liquidity providers using anonymous client identifiers.”
Divisa Capital uses three matching engines in New York, Tokyo and London with more than 20 liquidity providers in each location providing tailored liquidity. “We have had to find a balance between the liquidity providers and liquidity takers and to make the whole process more efficient, from client on-boarding to pre-trade risk monitoring. The key to being more efficient is to change from being reactive to proactive and to do more of the work beforehand to eliminate the amount of work and how the client is interacting with the liquidity,” states Tovmasyan. “We have introduced a new P2P trading network where we act as the prime broker for multiple price takers and makers. Our job is to essentially try and simplify the trading process for participants. We want to make the pre-trade check more linear and easier to understand, we want to segment credit and increase our customers’ purchasing power accordingly. Our goal is to make our platform as accessible as possible.”
Technology and networks
In the last few years, the cost of technology has come down in the FXPB industry, just as it has elsewhere. Processing power has increased, cross-connecting has become more affordable and bandwidth has broadened. These days getting a decent technology stack is not going to ruin you.
And technology will be the key to addressing the areas where the PoP process could be further improved, says Tovmasyan. For example, pre-credit checks could be more efficient through the use of peer-to-peer technology, such as the distributed ledger technology commonly known as blockchain or other technology that enables peer-to-peer clearing.
In addition to the application of new technology, Tovmasyan says that risk will be the key influence on the evolution of the FXPB market. “The trading chain works because someone creates a risk-based price and someone takes that risk. But it is no longer just credit risk. There is operational risk and regulatory risk. In the current market and following the SNB event, we are operating in a risk-averse environment. The top tier banks have lost their risk appetite and the cost of credit has gone up. The management of risk will be something that strongly influences how this market will evolve.”
But just how permanent are the current market conditions? Is there any concern that once risk appetite returns to the big banks they will claim back their former clients and leave the new breed of PoPs without a sustainable business?
Divisa’s Capital’s latest offering, otcXchange, targets those larger firms that already have an existing prime broker and are looking for an alternative liquidity pool. For Divisa Capital, these new clients will not be in need of capital, unlike the PoP clients that piggyback the credit lines of the PB. “If you look at the financial services industry, the large financial institutions are never the innovators that change the industry,” says Tovmasyan . “They can always undercut the likes of us with prices but they are never aggressive in terms of innovation. That is our domain. It is a natural way for the market to operate.”
The targeting of more institutional FX traders is increasingly commonplace among the PoPs, especially for those looking to place large orders. There is also a feeling among some brokers that not all retail clients understand the different ways in which to access liquidity and what may work best for them.
“If you are looking for a low cost brokerage, efficient execution and a technology which is top notch, then PoP is the answer for you,” says Naeem Aslam, analyst at ThinkMarkets, a leading Australian-based online FX broker. “In order to survive in this competitive industry, and most importantly provide what investors really want, PoP providers are continuously looking for ways to improve their products. PoP directly target client needs and their emphasis is to improve the liquidity. We have seen massive improvement in this space and a more tailored approach is constantly attracting new clients,” he concludes.