FX trading is often seen as the poor cousin of equities when it comes to establishing and retaining a relationship with prime brokers (PBs); yet FX traders need access to services and liquidity just the same. One way for funds to access these requirements is the prime of prime model.
PARTNER FEATURE
FX trading is often seen as the poor cousin of equities when it comes to establishing and retaining a relationship with prime brokers (PBs); yet FX traders need access to services and liquidity just the same. One way for funds to access these requirements is the prime of prime model.
A challenging market
In the past 12-18 months, the FX market has been a challenging space, seeming to experience a split between larger existing players and new market entrants.
Sam Bratchie, Managing Director and Founder of fund administrator Ifina, comments: “From a start-up perspective, there has been a massive increase in enquiries, especially from traders who are looking to get into an institutional environment and can’t do it. Market volatility and getting no interest on your money in the bank means that people are looking for alternatives and this is encouraging new entrants to the hedge funds arena.”
Money managers and proprietary trading firms are also realising that they need more of a regulatory framework in order to carry out their trading activities, secure and raise capital investment and in turn grow revenues.
In the last few years with heightened global regulation from ESMA, CYSEC, FCA, ASIC etc., the retail FX brokerage segment has somewhat contracted and consolidated, leading a number of traders and firms turning to the hedge fund space as they look for more consistent, performance-based revenue streams. Additionally, proprietary, or buyside trading has increased due to the ease of access to API connectivity and algorithmic trading in recent years.
In contrast to Bratchie’s experience with start-ups, however, Philippe Bonnefoy, Founder of quant macro specialist, Eleuthera capital AG, has seen a marked drop in FX profitability. “This has been the most barren period in years,” he states. “Unless you are doing super-exotic stuff, volatility and intraday price dispersion has been killed by quantitative easing (QE).”
However, Bonnefoy does note that as QE ends the FX markets may be entering the most fruitful period of the cycle – if firms are already placed to take advantage of it. “It takes years for funds to get a track record, so they could miss a fabulous three years of trading,” he says.
Size and scale
This track record and the frequently associated size of the firm seems to be at issue in funds’ relationships with prime brokers too. Many prime brokers have not had an easy time over the last few years, with a notable downsizing taking place, which has impacted on their risk appetite and their costs.
One of the reasons for this is a shift in the regulatory environment. Adrian Marcu, Head of Investment Solutions at the multi-family office Belvoir Capital AG, comments: “There are regulatory requirements per liquidity provider and prime broker to do their reporting and checks per client, which has elevated the threshold of business that you have to provide per name. This raises the costs of the sell-side and the buy-side.”
Indeed, as prime brokerage becomes more capital intensive, the market is becoming increasingly segmented, creating a split between big, profitable clients and FX flow traders who are not providing the banks with enough income.
Jonathan Brewer, Commercial Director at ISAM Capital Markets, comments: “FX prime brokerage is a pretty low-yield business for banks. It is becoming more capital intensive so they need much more revenue from each client.”
He adds: “Barriers to entry to tier 1 PBs are significantly higher in terms of capital on account and fees to pay. Even after the initial threshold, there are significant amounts for funds to pay every year.”
And this is not the only risk when appointing a tier 1 PB: as Bratchie points out, prime brokers are liable to drop clients who do not provide sufficient income in what Brewer also terms “a regular cull”.
A new model
One option for smaller funds or new entrants to the market is the prime of prime model. Some such firms seek to offer a true prime broker service while others, such as IS Prime, offer clients access to credit, greater leverage, more understanding of flows, and the ability to curate liquidity appropriate to the trading style of each individual client.
Bratchie comments: “Clients starting with USD3, 5, or even 10 million are always going to struggle when PBs want guaranteed commission. Even if they start well and values then drop, they will still be turned off by a tier 1 PB. But prime of primes can offer them an institutional account and the ability to protect their alpha as flows are anonymised.
“Cost is paramount, too, as annual operational cost impacts severely on their NAV while their performance is audited. Start-ups don’t want a minimum monthly fee,” he adds.
Small firms also run into the issue of spreads: if they don’t have sufficient scale of flow, they can’t interest enough liquidity providers to compete for their flows to such an extent that they will receive good spreads.
“Clients can license a prime of prime’s spreads, buying power with the street, and scale of good quality flows,” Brewer says.
Funds also need to ensure they can cover the operational aspects of trading. Bonnefoy comments: “If you have an active market backdrop, that’s great, but if the market goes quiet you have to craft your own liquidity, and that sounds good until you have to manage it yourself which takes a lot of time and resource. There are a lot of mechanics behind the scenes and that’s where prime of primes come in.”
There can be a further issue for even larger or more established funds to contend with if choosing a tier 1 PB: that of internal structure and politics. “If you are trading multi-asset funds, it can feel like you are doing a ton of business with a firm, but FX is the little brother of equities and internal politics and P&L often don’t travel across departments,” Bonnefoy says.
“If you have 60 per cent of the equities book and 10 per cent of FX, you won’t get a really good deal on FX,” Bratchie adds.
The view of the allocators
One of the caveats to choosing a prime of prime rather than a Tier 1 PB might be the requirements of your allocators. End investors have traditionally liked the association with tier 1 banks, so how do they feel about this approach?
According to Brewer, it depends on the investors. “If you have certain names on the paperwork going out to investors, that will be the rubber-stamp you need in some cases. But those sorts of investors won’t invest anyway unless a fund has a critical mass of USD200-300 million.”
It may also be the case that funds are using a prime of prime for FX but a tier one PB for equities, which could allay those investors to whom a big name matters. However, Bratchie adds: “The investor base for small entrants isn’t looking for a KPMG or a Goldman Sachs. They want to know that the fund, the managers, the brokers are all regulated. They also need handholding. They don’t know the funds arena and they just want to get on with trading,” he concludes.
Long-term relationship
For some clients, however, a big name really does matter and, once they reach critical mass, they may wish to transfer business from a prime of prime to a tier 1 PB. But many funds either choose to stay with their prime of prime or to continue to maintain a liquidity relationship.
Bonnefoy says: “Price movement creates opportunity, and if not much is happening, it might require a shift of how people are pricing you. It helps if someone more liquid than you is aggregating the flow of many clients and doing it full-time – another utility that comes into play. That’s where the added value of an intermediary comes in.”
“There is the added benefit of the anonymity of using a prime of prime, especially when markets or thinner or you are trading something you don’t usually trade,” Mancu adds.
The next step
As the markets continue to move on from the uncertainties of Covid, Bratchie predicts that the slew of new entrants will continue, particularly in FX and crypto, with new funds and start-ups acquiring funding from family and friends. Prime of primes will therefore also be looking to move, or move further, into these spaces.
The issue of technology may also be a mover. “Prime brokers take a long time to get things going, so tech can be a costly problem,” says Mancu.
Bonnefoy agrees: “To the uninitiated technology stability appears completely unimportant, that is until it doesn’t work. You take it for granted until you can’t get into or out of a trade.”
With so many drivers for change and new market entrants looking for services they can no longer get from prime brokers, it looks like the prime of prime model is here to stay, in FX and beyond.
Replay the Hedgeweek webinar – FX Funds: Is the traditional prime broker model of accessing liquidity still relevant and what are the alternatives? – produced in conjunction with IS Prime.
