Historically the prime of prime (PoP) business model evolved from clients, most typically retail brokers, requiring access to multiple single dealer liquidity providers (LPs) but without sufficient capital to secure a tier one bank prime broker. The PoP model places better capitalised firms between a tier one bank PB who provides the PoP credit access to LPs and the PoP which faces the end client via a credit/margin relationship. A PoP typically uses third party technology to connect to the LPs then aggregates and distributes liquidity to the end user as a single stream of prices.
At its inception the PoP offering was largely a one size fits all solution often inhibited by the limited features of the LP eFX streams. However, with advances in technology competition from non-bank market makers, LPs now offer multiple streams. These factor in differences in client demands such as tight prices with a small top of book for retail flow or full amount streams suitable for single ticket execution, in addition to legacy sweepable streams.
Drivers towards the PoP model
Recent market events such as the SNB removal of the EURCHF floor caused many prime brokers (PBs) to reassess their capital requirements for clients. It meant many clients were forced to seek alternative solutions for liquidity and credit provision, with many landing at the doorstep of top tier PoP providers. Additionally, many PBs such as Rabobank pulled out of the FXPB sector completely, thus compounding the drive towards the PoP model. Many of the clients seeking alternative liquidity and credit solutions were small hedge funds or proprietary trading firms. Both have very different liquidity requirements to the traditional retail FX client base, forcing major PoP providers to offer far more bespoke credit and liquidity solutions. This evolution in PoP services has in turn attracted more institutional clients to the PoP sector.
As mentioned, not all clients in any given sector have the same liquidity requirements and flow profile. However, it is worth discussing some of the common requirements and associated PoP bespoke solutions available.
As volatility continues to remain at historically low levels and taking into account the fact that spot FX remains a very low yielding product, many firms are expanding their currency trading universe to include more exotic currencies such as TRY/RUB/ZAR/CEE. The role of the liquidity manager at PoP firms has become far more key to providing customised solutions. LPs are now able to provide PoP firms with multiple streams which will often include features such as EMFX and inventory skew. Therefore, the skill of the liquidity manager is creating a bespoke stream which most suits the client’s requirements. The PoP/client relationship has become a much stronger consultative one. As tier one Bank PBs withdraw the availability of credit, especially in local markets, the role of the alternative liquidity provider has become more important in recent years. It is worth repeating that flow from a specific client sector, for example retail flow may differ greatly from client to client, therefore the old solution of one size fits all no longer exists. Factors such as average ticket size, round trip requirements, regional currency and third-party costs all define the mix of LPs available to a client’s bespoke pool of liquidity.
Many clients forced to exit tier one bank PBs initially struggled with the transition from their own direct disclosed access to LPs with a single stream of aggregated liquidity. However once the value of alternative liquidity providers was understood, many firms large enough to secure a tier one PB now actively choose to outsource some, if not all of their liquidity management requirements to non-bank liquidity providers.
Given the proliferation of non-bank liquidity providers seemingly offering similar services, how does a client navigate the wide choice to find the most suitable fit? For larger firms able to secure a tier one PB, the first choice is whether to face a non-bank liquidity provider via a give up agreement or whether they wish to enter a direct credit relationship. In either event, clients should look to choose the best in class, taking into account liquidity management experience and technology providers. Choosing industry leading technology is a key component to building a viable and sustainable eFX business. Credit worthiness and balance sheet is also a key consideration for clients wishing to face their liquidity provider, especially when placing collateral or client money as initial margin.
One of the most significant technology developments in recent years has been the availability of post trade data analytics tools, which help providers identify the balance point between their commercial interests and those of their counterparties. Relationship-based trading is emphatically not a zero-sum game, it is entirely possible for both taker and maker to win (and for both to lose). New technology exists to help firms such as Sucden Financial to identify mutual opportunities so that they can all ensure their businesses are commercially sustainable in the long term.
Here at Sucden Financial we made an active choice to partner with an independent and innovative firm – FairXchange. Their Horizon product greatly enhances the liquidity manager’s role and provides a holistic view across our entire business in terms of both clients and our valued liquidity providers. This is particularly important when flow is routed over multiple channels (e.g. Integral and SmartTrade) – we require a normalised view of everything, as opposed to having to compare two systems with completely different formats.
Because our clients – the ultimate originators of the trades -are not in direct contact with the liquidity providers, it is incumbent on intermediary firms such as Sucden Financial that sit in the middle to provide the necessary feedback to them on the flow they execute. Competitive liquidity is not a given, to earn and retain it takers must understand their responsibilities for trading in a responsible fashion. The data provided in Horizon helps those individuals managing client relationships to craft a narrative to share with their customers on how their LPs may be faring with their flow. This also helps salespeople respond to client feedback – which until recently may have forced them onto the back foot and feel obliged to make changes that undermine their own revenue. If a client’s liquidity has changed (increased rejection rate for instance) we can now often tell clients why.
Forward-looking firms like ours are also using this information to gain a competitive advantage pitching for new business in the PoP space, by showing there is a data-driven process underpinning their liquidity management. Until relatively recently, data-driven decision making has been the province of a small number of highly qualified individuals (i.e. quants) within a firm. There is now broad recognition that data forms a fundamental part of everyone’s day job. If it is to be used by everyone, this means that the data needs to be presented in as accessible a fashion as possible. Too often quantitative analysis is overly intimidating to people who don’t have mathematics degrees – FairXchange has spent a lot of time researching the science of data visualisation to make sure anyone who needs to work with the data provided, is able to make sense of what they are looking at, with the minimum of effort. Thus, provide tangible feedback to their clients.
It is important for clients to consider the independence of their PoP’s choice of data analytical provider and if that provider is now owned or paid for by the end LPs – this is key to providing a completely impartial view. Independent data is our most valuable asset, and the right choice of technology partner is the key to supporting our drive to optimise client liquidity.
Filling the void
Earlier I discussed how tier one banks and prime brokers are withdrawing credit intermediation facilities to tier 2 and 3 banks, thus leaving traditional institutional clients searching for alternative providers such as Sucden Financial. Clients are also telling me that tier one banks are limiting OTC products to spot only, or at the most short-dated swaps in majors, thus leaving a void for clients seeking EM or NDF currencies and swaps and OTC FX options. This has provided non-bank liquidity providers the opportunity to fill the gap in bank product offerings with streaming NDFs and aggregated OTC FX option services. Lastly many clients require full financial settlement of their FX trades due to commercial requirements, however more and more banks are reluctant to extend sufficient daily settlement limits. Institutional clients are left searching for bespoke aggregated deliverable liquidity with the flexibility of same day settlement out to multi-year tenors.
So in summary there are factors pushing and pulling institutional clients away from traditional tier one banks and prime brokers and seeking the bespoke aggregation and liquidity services of non-bank liquidity providers. Clients should interrogate a provider’s skill at selecting best-in-class third party aggregation and distribution technology, plus innovative post trade data analytics tools to support the continued curation of bespoke liquidity. Lastly financial security is a major consideration when choosing an alternative liquidity provider.