Prime of prime, or not prime at all? The triumph of marketing over substance

“If a prime of prime focuses heavily on marketing their product as a “prime” service, rather than a service which specialises in providing bespoke pricing, clearing and (critically) execution services, then they are advertising themselves as a simple credit intermediary, and are pretty clearly advertising that they are not adding any value to the transaction process at all.” – Jonathan Brewer, Managing Partner, IS Prime

If there has ever been a time at which it could even be remotely appropriate to misuse the word ‘prime’, or create intentional ambiguity with regard to how institutional liquidity is provided to retail FX brokerages, then this year most certainly is not it.

Over the course of the last two years, there has been tremendous discourse among industry participants globally with regard to how the order flow of their clients’ trades is being handled by their institutional liquidity provider, and whether genuine aggregated liquidity is being delivered via correct and proper prime brokerage relationships with Tier 1 banks.

This has been accompanied by a noticeable retraction of counterparty credit facility extension to OTC derivatives firms by Tier 1 banks whose own internal tug of war has brought about a situation in which Citigroup, the largest interbank FX dealer by market share for an uninterrupted 15 years until 2015, considers that a potential default rate of 57% when providing counterparty facilities to OTC brokerages is entirely possible, yet realizes, along with the other major interbank FX participants, that highly liquid foreign currency market making is a very efficient core business activity.

Citigroup and HSBC, two of the largest interbank FX dealers in the world, are apparently ridding themselves of a sizable proportion of their retail customers and closing down high street branches, with Citigroup having intentionally waved goodbye to 69 million customers on its retail side since 2007.

Britain’s financial giant HSBC removed 1,600 U.S. locations, including its subprime-lending business, and closed more than 500 branches in the United Kingdom, and Citigroup has sold or shut more than 1,300 U.S. branches in the past decade, including its consumer-lending network, to concentrate on major cities.

Jonathan Brewer, Managing Partner, IS Prime

What is difficult to comprehend here is not the actual figures involved or the corporate decision to reduce the number of retail outlets, downsize human resources, and move the focus away from resource and service-hungry retail banking but why this is being regarded as a negative matter.

This clearly shows that major banks understand that there is more profit (despite the risk) in making FX markets on a global scale from just one Canary Wharf or Square Mile-based headquarters rather than having real estate, human resources and operational expenditure relating to thousands of retail outlets handling tiny domestic loans and small, low interest bank accounts.

Retail banking in its traditional format, via branches, is expensive and somewhat obsolete. It costs a fortune to rent or purchase premises, is time consuming and human-resource hungry and when considering the core business which is taking deposits from customers to lend out to other retail customers at small amounts and low interest, is a very marginal business indeed.

Compare that to the interbank electronic trading which is conducted by the same firms – both leaders in this industry, with number 1 FX dealer Citigroup processing 16.3% of all global FX electronic order flow for the entire world from one office in Canary Wharf, with no network of branches needed for this activity, and HSBC being the largest corporate FX dealer in the world, and its overall market share being 5.4% making it the 7th largest handler of FX order flow in the world, all conducted from its Canary Wharf site.

Between the two banks, over a fifth of the daily $5.5 trillion notional volume is being handled and processed.

This is the real core business of these banks, not retail banking with physical branches, which has become a dinosaur.

In 2015, Citigroup had just 812 operational branches, whereas in pre-financial crisis 2007, the firm had 2,183 branches operational.

Therefore, despite the very rigorous due diligence and actuarial procedure, the banks understand the reliance on OTC derivatives, especially OTC FX, via relationships with non-bank prime of prime brokerages.

Indeed, by last summer, various meetings with senior executives of London’s Tier 1 banks by FinanceFeeds showed that some of them had begun to court the FX and OTC derivatives sector once again.

Clearly, risk management – namely the possibility of ‘going upside down’ on large prime brokerage accounts due to extending counterparty credit to spot FX companies that are placing trades in a highly liquid and volatile market – is one factor that has given the banks a reason to retract recently, but the other is compliance. If banks give counterparty agreements to all brokerages, they would be responsible for “Know Your Client” and “Anti Money Laundering” reporting to the prudential regulator and probably the non-bank regulator on the brokerage side.

Perhaps the banks have realized that missing out on such a huge part of their revenue stream is simply not commercially sensible, and are coming back to a now very well organized FX business in order to gain from it.This is all well and good, however it does not make money.

Meeting with RBS last week in the Square Mile, it was clear that the company is absolutely willing to do business with OTC prime of prime brokerages.

The executives that I met with at the company’s head office, along with its NatWest Markets division, show a very distinct interest in fostering prime of prime relationships with non-bank entities, as long as the relevant (and extensive!) due diligence is completed.

FinanceFeeds followed this up with some London-based prime of prime brokerages, and it appears that most certainly, RBS has the lowest entry barriers and is actually willing to do business as a Tier 1 counterparty. The bank realizes that London’s prime of prime sector is very well organized and is operated by large, well-backed corporations and in some cases hedge funds, and that the rules are followed diligently, hence its willingness to open its doors once again.

This is all well and good, and means that such relationships can be maintained, however when looking one level underneath this, it is critical to consider which entities actually face the banks and how they are structured.

The differential between the genuine prime of prime and the non-genuine has recently made itself evident in some very high profile commercial demises, some intentional and some the result of the provider having not actually been processing trades to a live market, but instead operating a profit sharing model, which is akin to the HYIPs that existed en masse at the turn of this century.

Recent examples include the recent bankruptcy of Galant Capital Markets, which has had an enormous knock-on effect, creating deficits for many retail firms and also for other institutional providers that held capital with Gallant – that in itself being a red flag, in that liquidity providers do not hold capital with other liquidity providers if they are genuine prime of prime brokers, and, according to substantial research by FinanceFeeds, has brought to the surface several deficiencies in a few firms globally that have purported to offer genuine liquidity via Tier 1 feed aggregation.

Indeed, the profit sharing model that was utilized by the so-called Prime of Prime in this circumstance contributed, according to the trustee of Gallant Capital Markets bankruptcy, to the firm’s demise, thus demonstrating that said “prime of prime” was not a prime of prime at all.

There is no doubt that the execution model at institutional level is under the spotlight – not from regulators, as they do not understand its component structure correctly in most jurisdictions.

If one could imagine going to CySec or any other European regional regulator and explaining to a beige-suited civil servant how to place capital with eFX desks at Tier 1 banks in Canary Wharf, and then electronically aggregating a price feed, before routing it via a liquidity management and order matching system from their single-dealer interbank platforms collectively, via an MT4 bridge to a retail trading platform.

Said civil servant will have headed for the Werthers Originals and poured his Ovaltine into his CSMA mug long before a chance to explain this in anything more than very brief form would present itself.

In other B2B markets, especially Asia, the misuse of the term Prime of Prime is even more prevalent, and was documented in detail by FinanceFeeds last year whilst conducting research in Guangzhou, China.

Today in London, FinanceFeeds spoke to Jonathan Brewer, Managing Partner of IS Prime, one of London’s prime of prime brokerages which is under the prestigious ISAM hedge fund umbrella, led by Lord Stanley Fink.

Mr Brewer explained ““When looking for liquidity, there are a few things that a broker should look out for.  Many “Prime of Primes” market their services in at best a misleading way. ”

A good example would be some of our peers, who market that they are offering genuine prime services, when all they are doing is offering PoP services, and disclosing the LP names.  This is a ruse to make a client think that they are getting something different from a standard prime of prime aggregation service, which is misleading.  Often the provider will offer uncompetitive initial margins alongside this service, to preserve the masquerade of being a “prime broker”. – Jonathan Brewer, Managing Partner, IS Prime

“Other prime of primes market the fact that they have added value services, or unique liquidity.  Again, this is often not the case at all, as most providers are simply white labels of third party technology providers, who don’t really contribute anything other than balance sheet” said Mr Brewer.

Mr Brewer concluded “If a prime of prime focuses heavily on marketing their product as a “prime” service, rather than a service which specialises in providing bespoke pricing, clearing and (critically) execution services, then they are advertising themselves as a simple credit intermediary, and are pretty clearly advertising that they are not adding any value to the transaction process at all.”

FinanceFeeds then raised the subject of the fact that it is becoming harder to become a prime of prime, the banks require far higher capital bases. Just a few years ago, $5 million would have got a prime brokerage relationship with a bank, now it is between $50 million to $100 million, and in many cases despite the capital being high enough, banks will still not provide credit.

This lack of access to traditional prime brokers has led to a prime of prime explosion over recent times, giving rise to the use of the word ‘prime’ by some offshore entities, or smaller retail brokers selling their B-book feed to other brokerages on the premise that it is genuine liquidity.

It is possible to count the number of genuine prime of primes that exist in today’s market on two hands. Maintaining a clear path to genuine market access therefore is the privilege of the many and has never been more accessible, but is truly the preserve of the few.

It always pays to check carefully.

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