Don’t end up in the hedge! – Op Ed

If anything has demonstrated the cracks… or rather gaping holes.. in the risk management procedures of the Tier 1 FX interbank dealers recently, it has been the debacle surrounding the now notorious Archegos hedge fund.

By Andrew Saks, Head of Research and Analysis, ETX Capital

The forlorn-looking executives at Nomura and Credit Suisse may well make voyeuristic lunchtime reading for non-bank OTC derivatives and FX brokerages who shudder at the thought of it yet thank their lucky stars that the buck didn’t stop with them as it does with the rash and easily tempted Tier 1 market makers.

Being dazzled by the prospect of bringing onboard a large hedge fund and chomping at the bit rather than taking a step back and looking at the potential pitfalls has had adverse effects on the capital position of banks many times over recent years, and in some cases landed them in a Lake Geneva-sized amount of hot water.

Now is the time to use the Archegos hedge fund incident as an example of how inept risk management from Tier 1 institutions can lead to problems of which certain areas of the FX industry which are completely unassociated with the banks that created the problem could have to bear the brunt.

Using turnkey solutions for starting an FX brokerage with a regulated umbrella is commonplace in the retail FX sector, and has been for some time with specialist technology, law and corporation establishment companies very much part of the landscape in popular areas for large retail FX brokerage to establish.

The combination of the near-identical structure of many MT4 brokers and the lack of ability to provide a diversified product range to increasingly discerning traders as they do not have their own trading infrastructure has led a number of institutional FX liquidity providers to look toward onboarding hedge funds instead of retail clients, as they could not make enough commission revenue by providing price feeds to MetaTrader 4-based white labels in obscure jurisdictions with small ticket client bases.

Now the OTC derivatives world faces another potential curtailment, as hedge funds may have been the darling of the institutional vendors just four months ago, but it is very likely that the impending kneejerk reaction from the men in grey suits with accountancy qualifications will put paid to that.

Yes, FX hedge funds would have in theory bolstered the margin capital base of the FX prime brokerage world, which would have gone some way toward quelling the nervousness that has existed for over 10 years within the Tier 1 banks who have been making it almost impossible to maintain a counterparty credit agreement for OTC derivatives trading without a balance sheet of over $50 million, however that was before the eyes-wide-open approach of a series of Tier 1 interbank dealers led to a sharp slap in the face by the Archegos hedge fund-related mess.

It would not take much guessing to draw the conclusion that the banks may unleash the risk managers and accountants who will likely not only chastise the traders and relationship managers for having eyes bigger than their wallets when onboarding the Archegos hedge fund as a counterparty, and rib them for chasing a huge potential trading revenue whilst ignoring exactly what banks have been so cautious of recently – credit default risk.

Brokers need to look toward diversifying their asset class base, being more masters of their own destiny by investing in the development of their own multi-asset platforms and being less reliant on Tier 1 bank counterparty credit. The same banks that demand over $50 million balance sheet proof before extending an OTC prime brokerage account to an OTC counterparty don’t use the same caution when they onboard hedge funds that can decimate them.

Credit Suisse may well have its own capital position decimated by this rashness. By operating a shrewd in-house risk management strategy, having a competent proprietary platform and offering a multi-asset environment where traders can execute across venues in all parts of the capital markets economy is the way forward.

We as leaders of the electronic trading industry have a huge amount to be proud of. Our sector is innovative and has created an enviable environment that suits retail traders so well in terms of fast execution, solid risk management and an emulation of the institutional trading sector at a fraction of the price which enables traders to access multi-asset global markets from any living room anywhere in the world to the point at which the listed derivatives industry which is far longer established and very highly capitalized has spent the last 30 years losing its retail client base to the OTC world and having to engage in high-value M&A deals by buying OTC derivatives entities to get their client base back, but on an OTC basis.

We have the astute leadership and comprehensive industry knowledge to learn from the Archegos debacle and not to follow the banks down the same path.

Andrew Saks Head of Research and Analysis at ETX Capital

With 29 years of experience in the financial technology sector, Andrew is a prominent international figure within the FX industry.

His detailed research in editorial and televised form is often the central point of information for executives within all sectors of the global FX business.

 

The subject matter and the content of this article are solely the views of the author. FinanceFeeds does not bear any legal responsibility for the content of this article and they do not reflect the viewpoint of FinanceFeeds or its editorial staff.

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