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Prime Brokerage and counterparty credit risk for FX firms – What’s the current situation?

During recent years, obtaining credit from banks for the purposes of running an OTC derivatives trading firm has become very difficult indeed.

This is a matter which should be of prime consideration when establishing an FX company. The risk arising from the possibility that the counterparty may default on amounts owned on a derivative transaction has become a focal point for liquidity providers, prime brokerage, and even Tier 1 banks whose liquidity is aggregated by non-bank institutional providers which connect retail trading platforms via a single point connection.

This matter has become so vitally important that it is becoming increasingly difficult for OTC FX brokerages to secure relationships with prime brokers for providing FX (and other electronically traded asset classes) on an OTC basis to retail customers.

What is the main difficulty?

Just two years ago, a very large school of thought ammased which attributed the increasing difficulties in securing credit with banks to the Swiss National Bank’s decision to remove the 1.20 peg on the EURCHF pair in January 2015 which caused unprecedented market volatility, and exposed many retail and commercial brokerages
which process their order flow on an agency (Abook) basis to negative client balances, meaning that they owed the bank sums of capital that could not be repaid, and in some cases were forced out of business. This remains very much valid today.

The larger brokers survived, but were impacted heavily.

It is clear, however, that the Swiss National Bank’s decision was absolutely not the reason why credit is hard to obtain, nor was it a catalyst, as the banks which handle the majority of FX order flow were already looking closely at counterparty credit risk well before the ‘black swan’ event of January 2015, and in fact were doing so during a period of sustained low volatility.

On June 30, 2014, Citigroup, the world’s number one FX dealer by market share, handling 16.11% of the global interbank order flow in 2015, published a corporate document on advanced approaches and disclosures for the Basel III regulatory framework for banks which separated OTC derivatives business in terms of probability of default (PD) compared to many other aspects of business.

Bearing this in mind, banks were taking a very conservative approach to credit risk, even in market conditions which were in their favor. Indeed, as far back as 2010, the Federal Reserve Bank of New York produced a document about credit risk in FX, detailing its best practice guidelines which apply to banks giving credit to FX brokers and prime brokers on an OTC basis.

Within these guidelines were two important frameworks:

Netting agreements.

These are agreements that reduce the size of counterparty exposures by requiring the counterparties to offset trades so that only a net amount in each currency is settled and provide for a single net payment upon the closeout of all transactions in the event of a default or termination

Collateral arrangements.

These are arrangements in which one or both parties to a transaction agree to post collateral (usually cash or liquid securities) for the purpose of securing credit exposures that may arise from their financial transactions.

During 2010, the Dodd-Frank Wall Street Reform Act was sworn into US law by President Obama, an act which prescribed that all OTC retail FX firms should have a net capital adequacy for regulatory purposes of no less than $20 million.

Banks taking the cautious line Watch the percentages in the terms and conditions.

The New York Federal Reserve considers that much higher requirements are in place, even though it is widely recognized in the retail FX industry that the stipulations made by the US government are far in excess of those made anywhere else.

The central bank asked participants some 6 years ago to consider an example in which a client had a net positive mark-to-market exposure to Lehman Brothers of $50 million.

With an agreement by the International Swaps and Derivatives Association in place, the client was able to net the outstanding positions and was ensured that Lehman would be unable to “cherry pick” the winning trades from the losing trades.

However, without a CSA (credit support annex) in place and the associated placement of collateral, the client was still forced to replace the positions lost due to the bankruptcy, or the $50 million replacement cost, and wait for a number of years for some recovery on its $50 million claim in the bankruptcy.

A year later, banking giants HSBC and JPMorgan founded its FX prime brokerage businesses, and the liquidity from both institutions is now commonly present as part of aggregated feeds provided by broker technology firms and non-bank specialist liquidity providers to FX brokerages.

When examining the terms and conditions set out by JPMorgan’s prime brokerage division, it is clear that a very conservative approach was taken from the outset. Once bitten, twice shy is certainly part of the actuarial mantra.

In July 2012, the firm stated that the amounts which may be rehypothecated under a Prime Brokerage or margin account relationship are generally limited to 140% of the outstanding liability (or debit balance) to the Prime Broker or lender (or such other applicable legal limit).

For the purposes of the return of any collateral to customer, the account agreements provide for the return of obligations by delivering securities or other financial assets of the same issuer, class and quantity as the collateral initially transferred.

This combination of institutional ‘fear’ within the risk management and actuarial divisions of banks represents a tug of war, with banks realizing that retail business with its vast cost of real estate, bank branch operation and staff salaries which are required to deal with small value retail loans and bank accounts which hardly earn any interest is obsolete in its current form, whereas FX dealing requires one office (Canary Wharf) and generates vast revenues in an instant and very efficient manner.

There is some evidence of the sales divisions getting their way, with RBS (NatWest Markets) having recently explained to FinanceFeeds during a meeting at the company’s 250 Bishopsgate offices in London that they would, subject to very extensive due diligence, be happy to explore extending counterparty credit to smaller prime of prime brokerages once again.

London may well be the banking and interbank electronic trading capital of the world, but North America’s main financial centers of New York and Chicago have long been the investment banking powerhouses that specialize in hedge fund investment, proprietary trading and exchange listed futures via the giant listed derivatives exchanges.

The Dodd-Frank Wall Street Reform Act, which was sworn into federal law in 2010 by former President Barack Obama, one of America’s least business-orientated leaders in modern history, encompassed a number of obstacles and bureaucratic irrationalities that encumbered the institutional sector in the US, one being the Volcker Rule, which sought to prevent banks from trading on their own account, a core business activity of most investment banking divisions of financial institutions, which at that time were wounded from the financial crisis which was largely down to retail banking over exposure rather than electronic trading derivatives exposures.

Last year, there was some very quiet talk of a change in this becoming possible. In March 2017 President Donald Trump set about modernizing an old, post-depression law that would separate the investment banking businesses of major institutions from their retail and commercial divisions by reviving the Glass-Steagall Act. Whilst this is still very quiet indeed, progress on such matters would have to go through House and Senate, hence would take time but does represent some degree of government-led mindset in opening up the global non-bank markets – or at least increasing the availability of bank liquidity to non-bank participants.

If implemented, this could create a New York-based elite of massive, long-established Tier 1 banks that would concentrate solely on liquidity provision and investment banking activities without the shackles of retail banking around their corporate ankles,

The Glass–Steagall legislation describes four provisions of the U.S. Banking Act of 1933 separating commercial and investment banking.

The separation of commercial and investment banking prevented securities firms and investment banks from taking deposits, and commercial Federal Reserve member banks from:

  • dealing in non-governmental securities for customers
  • investing in non-investment grade securities for themselves
  • underwriting or distributing non-governmental securities
  • affiliating (or sharing employees) with companies involved in such activities

Starting in the early 1960s, federal banking regulators interpretations of the Act permitted commercial banks, and especially commercial bank affiliates, to engage in an expanding list and volume of securities activities. Congressional efforts to “repeal the Glass–Steagall Act”, referring to those four provisions (and then usually to only the two provisions that restricted affiliations between commercial banks and securities firms), culminated in the 1999 Gramm–Leach–Bliley Act (GLBA), which repealed the two provisions restricting affiliations between banks and securities firms.

By that time, many commentators argued Glass–Steagall was already “dead”. Most notably, Citibank, the world’s largest interbank FX dealer by volume with over 16% of the entire global market share, had a 1998 affiliation with Salomon Smith Barney, one of the largest US securities firms, and was permitted under the Federal Reserve Board’s then existing interpretation of the Glass–Steagall Act.  President Bill Clinton publicly declared “the Glass–Steagall law is no longer appropriate”.

By reviving the Glass-Steagall Act in today’s environment, the end result would be entirely different. Back in 1998, there was absolutely no developed global retail OTC FX or multi-asset OTC trading industry to speak of, and only a few firms with proprietary platforms such as Matchbook FX, GAIN Capital and FXCM were in their initial stages of development and were very new entities.

Now, in a very timely manner, we see IG Group taking its high quality and widely respected proprietary platform and its publicly listed commercial strength back to America.

Speaking in Chicago to a series of exchange and listed derivatives senior executives last month, FinanceFeeds was told “We welcome IG Group back to America with open arms.”

For banks that have centralized risk management centers that have been over generous when lending unsecured credit to unemployed or self-certifying retail customers which did not have the wherewithal (or intention) to repay the loans, as there were very few risks or consequences from the side of the customer, but plenty of risks from the retail banking side which ultimately resulted in large global banks needing to be bailed out by governments on both sides of the Atlantic and in some cases, such as that of Lehman Brothers, left to face their bankruptcies alone, the upshot has been a massive curtailing of the extension of credit to OTC derivatives entities, with Citigroup itself having generated a report last summer which stated that the company expects a 56% default ratio on OTC counterparty credit.

Should President Trump proceed with the separation of investment banking operations from commercial and retail divisions, it may well result in the US giants on their home territory being the places to go for prime brokerage agreements, as no overbearing risk managers that are used to dealing with traditional banking will be able to stand in the way of good business.

In many cases, corporate fecklessness has compounded the liquidity crunch that has begun to affect retail FX brokerages which now need to show a balance sheet in excess of $50 million in order to gain a prime brokerage agreement with a Tier 1 bank.

Deutsche Bank finalized a $7.2 billion payment with the US Department of Justice during the latter part of 2016 which was made up of a civil penalty of $3.1 billion and provide $4.1 billion in consumer relief for mis-selling mortgage-backed securities, having agreed the settlement in principle last December.

That is certainly not chump change and is a problem that faced one of the largest FX dealers which did not stem from its FX division, but it is not the crux of the main problem at all.

In October last year, during the myriad of woes that faced Deutsche Bank and long after German finance minister Wolfgang Schaueble attempted to deflect investor discourse from the firm’s worries by stating that there is pretty much nothing to see here (when he knew full well there was), Deutsche Bank’s Chief Risk Officer Stuart Lewis piped up, playing down the bank’s £41 trillion derivatives risk exposure.

Stuart Lewis, Deutsche Bank’s Chief Risk Officer was questioned about its derivatives exposure, his response having been to play down the estimates that have been made.

“The risks in our derivatives book are massively overestimated. The €46 trillion figure sounds gigantic, but it is completely misleading. The real risk is far lower,” he said.

Mr. Lewis spoke publicly on October 9 stating that the €46 trillion relates to the notional value of derivative contracts rather than the real exposure to the bank, which he maintains is closer to €41 trillion.

This type of lack of senior level acumen would be dramatically reduced if investment banking divisions were run separately, and thus operated entirely from top to bottom by professionals who understand this sector of the business correctly.

Andrew Saks-McLeod, Head of Research and Analysis, ETX Capital
Andrew Saks-McLeod, Head of Research and Analysis, ETX Capital
With 25 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.

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