OTC FX is King in China: Local banks have to risk $100 million to make $50 million in traditional investments – Investigation
Local exchanges in China will rush toward becoming OTC FX brokerages, using Chinese subsidiaries of well recognized Western prime brokerages. Whilst the West tightens, China expands in a very promising direction. Here is a full dialog and perspective from within
The only way to conduct research, and to gain a full and detailed understanding of how the Chinese FX industry works from the ground up, is to invest resources in spending time in China. Visit the various provinces and meet with industry figures who will demonstrate how everything is structured; from retail traders’ relationships with all-important introducing brokers, right through to how connectivity to the markets and liquidity is provided.
FinanceFeeds has extensively traveled throughout China, and has forged relationships with key entities in the country hence, at today’s FX industry conference, our opinion and perspective was proffered as a result of extensive and detailed research into the future direction of China’s retail FX business.
Last year was most certainly a year in which the entire prime brokerage sector was subject to a massive amount of evolution, largely due to the major Tier 1 banks having curtailed the extension of credit to OTC derivatives firms due to their extremely conservative approach to counterparty credit risk. On top of this we’ve seen increasing demand from brokerages for the best possible execution and access to the most accurate pricing and trade processing environment.
Indeed, Citigroup, the world’s largest Tier 1 FX dealer, with over 16% of FX order flow by market share, produced a report in the middle of last year that indicated that the firm expected a 56% potential default ratio on OTC derivatives credit. This resulted in the entire sector of interbank dealers deciding to raise their capital requirements for those brokers able (and allowed) to maintain prime brokerage agreements with them.
To put things in perspective, just five years ago, it was possible to obtain a prime brokerage agreement with a capital base of just $5 million, but now it is almost impossible with $50 million and, in some cases, no deal will be done unless $100 million is on the table.
This really matters for two important reasons when considering unlocking the massive potential of China’s retail business
Firstly, Britain’s large interbank dealers are weary. Their non-electronic trading divisions, such as mortgage and consumer credit lending entities, were battered by financial crises towards the end of the last decade, and have been subject to multi-million dollar fines for improper selling of payment protection insurance. Some have also been censured for benchmark rate corruption, and have lost billions in unpaid credit during the 2008 and 2009 credit crunch, which saw many of them having to be bailed out by the taxpayer.
Andrew Saks-McLeod examines the impending move toward domestic liquidity and IBs becoming brokers in their own right, in Shanghai, February 2017
This has created a situation in which the main Tier 1 banks are now ultra-conservative, are still licking their wounds by selling off retail divisions in their entirety, and are restricting how much risk they take on counterparty credit extension to retail brokerages.
Complexity due to lack of credit and massive capital requirements? No problem in China
Meanwhile, brokers still facing these counterparties have had to stump up massive capital bases to maintain those relationships and, then initiate relationships with non-bank electronic communications networks such as EBS, Currenex, Hotspot FX and FXall , in order to try to provide a more comprehensive liquidity solution to protect against the banks’ pulling the rug out from under everyone’s feet.
The same brokerages have been battling with this whilst focusing on mainland China, and its own restrictions toward allowing any transaction over $50,000 out of the country for the purposes of derivatives trading. These are minor considerations when looking at a very significant reason as to why liquid markets such as FX are preferred to traditional investments such as large scale property development, even by the Chinese banks.
China’s own banks, all of which are owned by the state, are massively well capitalized and have a very clever model indeed. They try to not expose themselves to undue risk, and have assets, (consisting of property, cash, investments in company stock, and indices) that are so enormous that they are hard to quantify. These banks, unlike the weary western banks, will extend counterparty credit to FX brokerages in China without the blink of an eye over risk.
Two weeks ago, in Hong Kong, FinanceFeeds met with senior executives of Prime of Prime brokerage, and brokerage technology provider, Advanced Markets & Fortex in order to discuss some of the important factors that have created a massive drive toward FX on the institutional desks of banks in the People’s Republic. These company executives are based both in their head office in the United States, and in mainland China.
Jake Zhi, Fortex’s VP of Institutional Sales in Shanghai, explained that there is some uncertainty with regard the banking environment in the US which differs tremendously from the commercial attitude to risk in China.
“It is clear that many people in China do not trust the banks, and those banks are often not held accountable. Even in Hong Kong, HSBC’s profits were down by 60% in its annual report last week” he said.
“There is also a lot of bureaucracy and regulations in the US. For example, the Volcker Rule drastically reduced the banks’ ability to conduct proprietary trading, stifling business but, recently, there is some hope that the new US administration may begin to reduce regulations and we may begin to see a more relaxed and free environment” said Mr. Zhi.
In China, the roles are reversed completely
“I have many friends who work in corporate departments of major banks, and, in order to make $100 million, those banks risk losing out on $50 million of corporate lending in mainland China so, really, they end up not having the security to lend.” – Jake Zhi, VP Institutional Sales, Fortex
Natallia Hunik, Global Head of Sales at Advanced Markets & Fortex then explained “In the West, particularly in North America, there are constraints that do not exist in China. The Dodd-Frank Act has ensured that banks really cannot do any speculative trading, and the liquidity has therefore dried up.”
“In China this week, there has been a lot of discussion among global senior executives about developing a genuine multi-product solution, offered to retail traders via one platform and, while CFDs are now facing regulatory pressure in Europe, and could be deleveraged, Chinese brokers are looking to circumvent this possibility by establishing offshore entities” said Ms Hunik.
Ms Hunik then explained the double-edged sword that currently aims itself toward many medium sized retail electronic brokerages. “Many retail brokerages do not have enough capital to be able to gain a prime brokerage agreement with a major Tier 1 bank (in many cases a minimum capital of between $50 million and $100 million has to be demonstrated to maintain a prime brokerage agreement) but on the other hand they cannot go upstream because they are unable to afford exchange clearing fees and membership. In China, some brokerages may go toward Bitcoin to diversify. There are currently 19 Bitcoin exchanges in China, and China is looking to regulate them.”
Mr. Zhi then added “The way Chinese brokerages are heading is toward, not only, providing to retail customers on a direct basis, but there are also many brokers that now want to become liquidity providers in their own right and offer liquidity in order to be able to play host to retail brokers in the domestic market. Many are angling themselves toward a B2B client base by increasing their marketing prowess, creating a good corporate image and concentrating on branding.”
The new law against regional exchanges opens the door to retail FX
During the iFX EXPO Asia 2017 last week in Hong Kong, produced by ConversionPros and industry news and research group Finance Magnates, many Chinese divisions of western institutional liquidity and technology providers demonstrated an opinion that, because of the new laws in China which will only allow one regional derivatives exchange per local vicinity (leading to the closure of many small exchanges across the country), these companies will look toward OTC electronic trading via international liquidity providers in order to retain their existing audience and branch out, whilst protecting themselves against closure.
This would mean the opening of prime brokerage accounts with global providers and using platforms hosted in mainland China, but developed and owned by global companies, in order to connect an existing Chinese client base to Chinese and international asset classes.
As far as moving this business onto a spot FX model, Mr. Zhi says that it is essential that global liquidity is sourced in order to operate a real or true market. “Chinese banks do not have the ability to open a channel for diversified liquidity pools outside the Yuan, therefore using an overseas PB is essential” he said.
“To be able to do this properly, an office in mainland China is essential, all banking facilities must be Chinese, and all infrastructure and hosting must be inside China, but operated by a western firm. Many companies look for an entity that is a wholly-owned subsidiary of a recognized western firm, with Chinese executives inside China, and the parent company being western” said Mr Zhi.
“Trust is a big issue in China, therefore it is very much a relationship business. It is essential to develop good relationships with vendors, partners and institutions to enter markets when others cannot” said Mr. Zhi.
“A good example of the dynamics behind this is that, while there are many technology providers with offices in China that does not necessarily mean that they will do well there. Communication back to the main office outside China is vital, as nobody can operate as an isolated Chinese center. The Chinese entity has to be part and parcel of the main company otherwise that division cannot supply the right information to customers and service them properly” explained Mr. Zhi.
In conclusion, this is very much in line with FinanceFeeds’ research recently in terms of the direction that Chinese firms may well go in that they are moving away from exchanges and going toward OTC global markets, despite it being via a forced circumstance.
With this comes a whole new need for trust, and therefore our conversation concluded on the potential damage to Chinese brokerages by the recent news of fines and bans imposed on FXCM due to the firm having traded against its customers for years when, all the while, maintaining publicly that it was an agency broker with no dealing desk. The penalties imposed by the CFTC cited that FXCM was taking rebates from a market maker that it had an undisclosed interest in, and was using that market maker to take the other side of client positions.
FXCM has a large presence in China, with large portfolio managers and introducing brokers having unfalteringly trusted FXCM for years. If it becomes common knowledge that the reason behind FXCM’s demise was that it was cheating its customers then that news, and the fact that we’re talking about a publicly listed, long established giant, may seriously damage the all-important trust of Chinese firms and their clients.
Mr. Zhi provided his opinion on this, by saying “The FXCM situation causes huge trust issues, so now we could see many IBs starting to open direct accounts with a liquidity provider in order to move away from being an IB because, that way, they can have control over their own funnel” he said.
“These firms will demand their own access to their own back end system to have transparency on trade execution and to verify everything. In China, the IB is a portfolio manager, and most of these are large, well organized and highly capitalized companies. Some OTC firms have resorted to attempting to aggressively poach FXCM IBs, but they will not be able to do so in China with the same recipe as was offered by FXCM, as the trust issue is now very prominent” concluded Mr. Zhi.