Prime brokerage scaremongering: Cliff-hangers are not new, but hedge fund pretenders are!

The bias toward hedge funds and trad prime brokerages is not new. It is resurfacing though, as the listed derivatives lobby once again puts its 2 cents in…. Or should that be $50 million?

Prime of prime relationships and the future

Remember the days when a meeting with the eFX division of a Tier 1 bank over an artisan-style arrangement of lemon-infused asparagus served on a roof tile atop a lit-within table in an overstyled plate glass restaurant in Cabot Square would result in a prime brokerage relationship having been easily established?

Only five years ago, when the standard, grade A, mark one dinner plate was giving way to the obscure use of construction materials in the culinary world’s quest for attention, said overpriced winter vegetable would have been the more interesting point of discussion during said meeting, the prime brokerage criteria occupying a few minutes at the end with a quick glance at the seven figure balance sheet of the brokerage followed by a quiet and confident nod of the head.

Unfortunately the days of establishing such a relationship are long gone, and equally unfortunately the roof tiles remain. Wish it was the other way around? Certainly.

The culinary equivalent to today’s banks capital stipulations. It is not a plate, but costs far more to do a similar job in a worse fashion

Today, the cursory glance at a seven figure balance sheet would simply never happen. Instead, before even answering an email inquiry, a prime brokerage division of any Tier 1 bank would be on the defensive, thinking more like an accountant or asset stripper than a top level liquidity provider, wondering if the brokerage has not just seven figures on the balance sheet, but over $100 million in many cases, and even then, caution is the absolute mantra.

Last year, industry discussions among senior executives from North America to Britain, and from Singapore to Australia focused on how the difficulties arising from curtailing of counterparty credit are giving rise to the need to innovate and change the entire structure by which non-bank prime brokerage operates, fostering better relationships outside the Tier 1 banking sector in order to make for the best level of execution at retail brokerage level despite the bank-imposed restrictions.

Sudden shock? Not really….

So developed and multi-faceted has the retail OTC derivatives industry become over the last decade that the prime brokerage element is considered a tour de force, and has been for quite some time. Last year, as the claws of the Tier 1 interbank risk managers began to sink in, many new Prime Brokerage divisions of existing firms, and newly established entrants peppered the FX industry centers of London, New York and Cyprus, aiming to generate a non-bank ecosystem, combined with the integration specialists that provide market liquidity globally.

Citigroup’s unpleasant report last summer stated that its risk managers consider OTC derivative counterparty credit to be a 56% potential default risk, which resounded across the entire interbank sector, Citigroup being the largest FX dealer by volume with 16% of the entire global order flow going through its books.

GAIN Capital CEO Glenn Stevens and GAIN GTX senior executive William Klippel enthuse about modern prime brokerage with Andrew Saks-McLeod

The discussions and concerns may have come to a head over the past year, but these same credentials and reasons for constraints are not new.

As far back as 2008, a widely held view was that custodian banks had long sought a foothold in the lucrative prime brokerage market, but most had struggled to compete with the large balance sheets, breadth of services and access to liquidity investment banks can draw on.

Indeed, just that same year, many investment banks with prime brokerage divisions went to the wall, Lehman Brothers being a case in point.

The prime brokerage landscape has dramatically changed since the collapse of Lehman Brothers in September 2008. Hedge funds which received margin financing from Lehman Brothers could not withdraw their collateral when Lehman Brothers filed for Chapter 11 bankruptcy protection due to a lack of asset protection rules (such as 15c3 in the United States) in the United Kingdom. This was one of many factors that led to the massive deleveraging of capital markets during the Financial Crisis of 2008.

Upon Lehman Brothers’ collapse, investors realized that no prime broker was too big to fail and spread their counterparty risk across several prime brokerages, especially those with strong capital reserves. This trend towards multi-prime brokerage is also not without its problems.

From an operational standpoint, it is adding some complexity and hedge funds have to invest in technologies and extra resources to manage the different relationships. Also, from the investors’ point of view, the multi-prime brokerage is adding some complexity to the due diligence as it becomes very complicated to perform proper assets reconciliation between the fund’s administrator and its counterparties.

That was almost ten years ago, so why the sudden panic now? 

Quite simply, the reason is that the banks and the exchange listed derivatives sectors are squeezing the market in order to attempt to regain some of the fast, liquid global business that spot FX has taken.

It is clear that Tier 1 banks offer the best execution, yet are being very sparing with extension of counterparty credit. This is the desirability of it vs the unattainability.

Natallia Hunik, Advanced Markets & Fortex

Natallia Hunik, Global Head of Sales at Advanced Markets & Fortex explained to FinanceFeeds at a meeting in Boston, Massachusetts in December last year For retail users, the best order execution is by banks with fill rates close to 100%. Compare that to Tier 2 or 3 providers where, from my experience, the typical fill rate is around 60%. Some are better, some are worse, I’ve seen 30% in some cases so they vary but they cannot compete on execution with the banks” said Ms. Hunik.

“A prime of prime has to give each counterparty enough business so that they value the business and provide a deal that is relationship based and, for that reason, a prime of prime that works with a finite number of the world’s best bank providers is typically able to obtain better pricing” she said.

Advanced Markets’ business model is different from most other firms in that all orders are routed directly through to the Tier 1 banks / liquidity providers for execution. No risk is taken in-house.

“I have experience with aggregators that have used both banks and Tier 2 or 3 providers in the past, and at end of month, the prime of prime looks at the analysis and compares execution statistics. Many of the Tier 2 execution statistics were not shining. Yes, in terms of spread, they were outstanding, but that means nothing when they could only execute approximately 60% of all orders”

“Most of the Tier 2 providers’ prices are algo-driven and, when dealing with the retail market, if one of these pulls their price during a market event, retail users will simply not understand why the trade is being rejected – Natallia Hunik, Global Head of Sales, Advanced Markets & Fortex.

This type of difficulty can be mitigated quite easily if a firm which has the relationship with the Tier 1 bank is a powerhouse.

GAIN Capital has had the GAIN GTX Direct prime brokerage service for professional traders available for almost six years. Meeting with William Klippel, ‎Director of Sales & Operations at GTX Direct at the FinanceFeeds New York Cup in Manhattan in December demonstrated a very relaxed and calm Mr. Klippel, who, along with GAIN Capital CEO Glenn Stevens, discussed the entire prime brokerage topography with FinanceFeeds with the unruffled aplomb of confidence that only a firm with that level of experience and a market capitalization of $362 million would be able to do.

With 10 prime brokerage relationships, GAIN GTX is a fully independent FX ECN which, similarly to that of Saxo Bank, combines bank and non-bank pricing via its credit engine. The technology allows users to trade with all GTX participants, not just the traditional liquidity providers, thus has client-to-client capabilities.

Thus, systems such as GTX or a prime relationship with Saxo Bank are here to stay and have absolutely weathered the OTC credit storm with no such impact on execution of retail orders.

In London in November, Saxo Bank’s Head of FX Prime Brokerage Plester explained “If a client was to develop the tools required to be able to provide effective aggregated liquidity internally, there would be a lot of cost and resources and the client would spend a lot of time talking to several liquidity providers. By outsourcing that to us, we save them time and money.”

“Because clients were used to having direct relationships with liquidity providers they could have lost a lot of feedback and data but they still get it because we do it for them whereas if a broker went to a prime of prime that didn’t provide that, it may be that the broker begins to feel devoid of information” – Peter Plester, Head of FX Prime Brokerage, Saxo Bank

Mr. Plester explained that there is ambiguity among many brokerage firms about how this relationship is supposed to be structured. “We have been providing this specific prime of prime service for 4 years now” he said.

This is an example of how the astute knowledge of experts in this industry has given rise to an entire methodology that navigates the banks’ increasingly harsh stipulations.

Saxo Bank’s Head of FX Prime Brokerage Peter Plester is an expert on transparency and efficient execution

It is absolutely abhorrent that banks with large FX dealing market share are allowed to continue to behave in the manner which has created the need for such innovation in the OTC markets.

Standard Chartered, just to name one of the villains of the peace, is the twelfth largest interbank FX dealer by market share, sitting between Societe Generale and Morgan Stanley, with 2.4% of the entire global market.

Last year, Standard Chartered met all its hurdle rates in the Bank of England’s stress test but failed to reach the minimum capital requirement.

What would happen to an OTC prime of prime that had a relationship with Standard Chartered if it even so much as dipped below the contractual capital requirements, let alone those stipulated by any regulatory authority?

The bank would cut the liquidity feed, that’s what.

Bearing in mind that just five years ago, it was possible to maintain a prime brokerage relationship with most Tier 1 banks in London with a capitalization of $5 million, however nowadays it has risen to between $50 and $100 million, hence if an auditor from a bank makes a visit to an OTC derivatives institutional provider’s premises and checks the balance sheets, finds there is less than what it considers to be an acceptable amount of net capital, the bank would remove the relationship or place strict restrictions on how many trades could be processed and at what value.

Perhaps rather an added potential moot point is that from 2012, Standard Chartered has applied a liquidity charge in which the bank applies a levy if tehre is a margin shortfall.

Standard Chartered states in its terms and conditions that it may be required to fund a margin requirement shortfall in circumstances where there is insufficient client-funded collateral available at the time the CCP requires a margin requirement to be met.

The bank may apply a liquidity charge in respect of the margin shortfall paid by Standard Chartered to a central counterparty, which would accrue at a rate that is the aggregate of Standard Chartered’s cost of funds plus 200 basis points (or such lower rate as the parties may agree). The bank’s terms also highlight that it may charge a capital charge reflecting its costs of funds for the capital requirement of a client’s clearing account.


Certainly this represents one rule for one, and another rule for another. This week, the preference and bias toward hedge funds and the exchange-traded derivatives sector grew further.

Lightspeed Trading, which has an agency trading desk and technology service is expanding into the institutional sector and has launched a prime brokerage division.

Andrew Saks-McLeod reveals CBOE LIVEVOL’s new Data Shop for retail audience using Amazon model, with Catherine Clay in Chicago

Just another new entry into the prime brokerage sector? No. This time, Lightspeed Institutional, as the new division is called, is headed up by a series of exchange-listed derivatives veterans including Craig Aronoff as Executive Vice President of Prime Brokerage Services.

Mr. Aronoff began his career at Shearson Lehman Brothers as a financial consultant. Most recently he founded Victor Securities, a firm providing technology-driven brokerage solutions to professional traders.

In addition, Joe Minton has joined Lightspeed from Livevol Securities to manage its agency trading desk. Mr Minton began his derivatives career in 1998 as an equity option market maker and volatility trader, and given CBOE LIVEVOL’s introduction of an Amazon-style new website for news and analytics completely directed at the retail trader, it can be an easy guess that CBOE, like many listed venues, has its eyes on the retail trader, hence with this structure, Lightspeed’s institutional division echoes the old school tie network of the hedge funds of the early Millennial years and is likely to be welcomed into the boardrooms of banks.

Thus, if any guesses can be made as to why CFH Group sold its entire operations to Playtech (!!) at the end of last year, it is likely that it required a capital injection in order to not only establish new prime brokerage relationships, but keep its existing one. Banks these days have been known to withdraw existing prime brokerage agreements if a balance sheet dips below $50 million.

Thus, our estimate is that the total of $45 million that will be paid to CFH Group by Playtech once the entirety of the deal is finalized will be enough to maintain its lifeblood, and its lifeblood only.

Go figure. Literally.


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