When a prime of prime goes belly up – Op Ed
The demise of Galant Capital Markets has opened up a massive question. Do NOT work with a prime of prime unless you are certain that it is an actual prime of prime and operates according to correct liquidity management principles. Here is a detailed overview
Prime of prime brokerage is a term that has become increasingly used at the very forefront of the non-bank electronic derivatives business over recent years.
It is quite possibly the most central and integral part of the retail FX and multi-asset trading ecosystem, bearing in mind that no other method of facilitating live, real time and completely liquid access to global markets where any asset whatsoever can be traded, priced immediately with millimetric precision and offered to a retail audience at a very low price, exists.
Prime of prime brokerage has elevated the non-bank electronic trading sector to such levels that London’s transformation from a stock and equities mainstay in the 1980s has completely given way to it prominence as the world’s largest institutional and interbank FX center, with 49% of all interbank order flow going through Canary Wharf’s Tier 1 banks, and whose electronic communication networks (FXall and Currenex have vast business in London) nestle among giant commodities brokers and non bank prime of prime liquidity providers, all of which bear no relation whatsoever with – and conduct absolutely no business with – any listed derivatives exchange.
This enormous and finely honed market is the darling of retail electronic trading customers and institutional prop desks globally, its connectivity via ultra-efficient hosting centers in New York, London (Well, Slough!), Tokyo and Hong Kong processing tens of thousands of spot trades per minute with complete accuracy and knocking the clunking abilities of the exchanges, which are unable to match the efficiency of the OTC market but are also vastly expensive in terms of clearing fees and membership cost.
Whilst global traders access on and off exchange multi-asset trading environments via the ubiquitous MetaTrader 4 platform thanks to continually innovating liquidity management systems from specialists such as Gold-i, PrimeXM and oneZero, connecting the retail traders of the world to several hundred asset classes which are aggregated in price streams by prime of prime brokerages and delivered to and from market instantly for just a few dollars per million traded, those which did not adopt this method are left behind.
Toronto, North America’s third largest financial center, retains its equities and stock trading past, the pin-stripe suits and briefcases of yore ambling along Yonge Street, whilst New York, London, Hong Kong, Sydney and Singapore rocket into the future with volumes and dedicated retail customers with large portfolios to show for it.
The level of expertise in this particular sector is also of the very highest in the entire financial sector.
Meeting with Saxo Bank’s Head of API Business at the company’s Canary Wharf office in London late last year, FinanceFeeds discussed how prime of prime relationships should be structured.
Beginning the discussion by focusing on new types of service that are beginning to be offered in London, Mr. Lauerman had been very keen to point out “the liquidity and collateral issues are arising from the use of prime or prime providers or brokers at the same time.”
“The rationale for using two prime of primes makes sense as a contingency, when one of those is a primary provider and the other one is a secondary provider. However, the reason for using a single prime broker at any given time is to consolidate positions in one place for more efficient use of collateral” said Mr. Lauerman.
Important operational matters to consider
Mr. Lauerman stated “If you lodge $5 million in total, use 5 prime of primes, put $1 million at each prime and then are long at number 1, and then short at number 2, then long at number 3, you will lose out on netting benefit regarding your use of collateral, and have a complex issue to manage with regard to ensuring you minimize your funding costs.”
In terms of explaining how Saxo Bank conducts its bank relationships, Mr. Lauerman explained “Because of our balance sheet and our status as a regulated bank, we have stable, decades long relationships with the largest liquidity providers in the market, and are able to effectively evaluate the new entrants to the market. This is a major differentiator.”
He is indeed correct.
The subject of order fills is also vital. So competitive is execution time these days that non-bank prime brokerages and market makers such as XTX and Citadel Securities are attempting to beat the banks. There are schools of thought that would consider these to offer very fast execution, but to be less effective at filling a high percentage of orders than the Tier 1 banks.
These are just some important matters that form the planning and consideration when establishing prime of prime relationships for retail brokerages to ensure that they access live markets with aplomb, relying on the expertise of some of the most experienced senior executives in the industry.
But what happens when it is not structured properly?
For the most part, today’s prime of prime sector is so vast and has such a significant market share that it is a major concern for the exchange listed derivatives sector which has resorted to a sort of perceived lobbying attempt in order to effect a vain attempt at regaining the vast retail business that it lost over the last two decades to the far more efficient OTC sector.
However, there have been some flies in the ointment, one of which was the demise of Emirati firm Fortress Prime just over a year ago which struck relationships with brokerages on the premise that they would be provided with a prime of prime liquidity feed, when actually there were no price feeds and a profit / loss sharing model was in place, meaning that the end result heralded a blot on the copybook of the retail sector where the firm ran away with the money of its brokerages and their customers.
Appalling? Yes. Surprising? No. Anything can be done about it? Not really.
Any firm that places its funds with an unregulated firm in the United Arab Emirates takes its chances. In that region, contracts count for nothing and paper and procedure is worth less than the fountain pen that was used to write it. In the Arabian Peninsula, suitcases with cash, a look in the eye and a handshake is everything. Contracts, regulation and Western-style organized bureaucracy simply does not exist.
In short, Fortress Prime was at liberty to do whatever it liked to its customers, corporate or retail.
Small brokerage tempted by extremely keen terms and low prices, with almost no cost per million and a helping hand to get going in the form of generous bonuses and zero commission. Whilst this may appear very attractive to small brokerages whose balance sheets are not favorable to London. Sydney and New York’s prime of primes, the reality is that such offers have as much appeal as an all inclusive package vacation in Mogadishu.
On April 15 this year, another dark tale emerged, this time in the form of the demise of Galant Capital Markets, filed for bankruptcy protection at the US Bankruptcy Court for the Eastern District of New York. The firm, although filing for bankruptcy in the United States, was regulated by the British Virgin Islands Financial Services Commission… if you can call that regulation.
On the retail side, this is not a new scenario. Market events can occasionally cause retail brokerages to go West, such as the Swiss National Bank’s decision in January 2015 which saw the end of Alpari UK and caused Liquid Markets to become, well, illiquid.
When a firm that offers supposed prime of prime services goes bankrupt, however, serious questions must be answered.
….and serious questions there most certainly have been.
It has come to the attention of FinanceFeeds over the past few weeks that in some cases firms purporting to be offering prime of prime services to retail brokerages have been operating a profit and loss model, basically engaging brokerages on a profit sharing basis rather than providing an aggregated price feed.
Several actual brokerages have approached FinanceFeeds and explained that there have been losses sustained to them as a result of the Galant Capital Markets insolvency. Whether this is able to be substantiated or not is really a matter for debate as there is no reporting system in place for trades that do not approach a live market (this will change in January 2018 when all systematic internalizers will have to report their trades publicly according to MiFID II).
The current status quo is somewhat problematic because prime of primes which conduct their business properly and are actually displaying their balance sheets to Tier 1 banks in order to obtain prime brokerage relationships and offer a genuine aggregated liquidity feed to brokerages have been under the cosh as far as the curtailing of counterparty credit to OTC derivatives firms by the Tier 1 institutions’ eFX divisions is concerned and have had to resort to extremely detailed operational reform and technological innovation in order to remain competitive, especially when passing the costs of operation onto often unwilling clients, whereas those tempted to operate their business on a profit sharing basis – deeply frowned upon by ALL regulatory authorities – get away with offering very attractive terms and having very little censuring when it goes wrong.
One particular executive in the prime brokerage sector of the banking industry in North America recently explained to FinanceFeeds “Wholesale or institutional clients are not protected by any jurisdiction. Perhaps BaFIN in Germany is the only exception, but a misunderstanding of licenses is still out there.”
He continued “Several times per week I am approached by clients that have been mislead by liquidity providers, which is something they do not believe could actually happen until they run into a liquidity provider bankruptcy case.”
In the case of Galant Capital Markets, Jiri Kubicek, the beneficial owner of WSM Invest/WSM Investments, has been detained by the National Headquarters against organized crime in Prague, Czech Republic.
Mr. Kubicek also owned Gallant Capital Markets, that recently filed for Chapter 11 bankruptcy in a United States court.
According to the Prague-based media reports, Mr. Kubicek’s residence was raided by the police in March, but was not charged with any crime.
However, it has been confirmed that the police has now officially arrested Mr. Kubicek on the charges of financial fraud and international money laundering.
The Czech police has made a statement that the losses incurred by Mr Kubicek’s fraudulent schemes exceed $40 million, impacting tens of thousands of people in Czech Republic, Slovakia, Poland, Russia and Hungary.
WSM Investments was started five years ago by Mr. Kubicek, in order to sell automated forex trading software, that later converted itself to a forex trading management fund that promised double-digit returns to its investors.
According to the police, Mr. Kubicek was involved in many other types of pyramid schemes, in addition to his forex scam. The proceeds of the fraud were mainly invested in buying expensive real-estate properties at various locations around the world.
Whichever way this can be viewed, orchestrators of pyramid schemes are people who know very well how to orchestrate a profit/loss model and get the smaller brokers working for them. This is a sort of pyramid scheme in a way. I can remember approximately ten years ago, when MetaTrader 4 was first released, many firms with malintent were established and the senior executives either came from the affiliate marketing and lead buying background, or from selling MLM schemes such as Herbalife.
These unsavory characters have now shuffled off the FX coil, taking millions in client funds with them.
When looking for a prime of prime brokerage, it is imperative to check the provenance and pedigree of its senior management. If they have substantial experience in global electronic financial markets at senior level and have a proven and publicized career path, then that will work. If they are based outside the major electronic trading centers of Switzerland, Britain, North America, Australia, Singapore, Hong Kong or Cyprus, run a mile.
In the case of Galant Capital Markets, the British Virgin Islands registration should be the very first sign not to establish any B2B relationship.
FinanceFeeds is aware that there have been allegations leveled at Galant for keeping capital at a liquidity provider which was licensed by the FCA.
A senior industry executive in New York explained his perspective to FinanceFeeds on this matter this week. “It’s odd that GCM would keep so much capital with a liquidity provider” he said.
He continued “By so much capital, I mean enough that it has to file for bankruptcy, and if it were a liquidity provider with an FCA license, there is legal action that would be taken. I’m not an expert on how the law works in these cases but it seems some action would be taken to return the funds as it falls under FCA guidelines. The original story about WSM seems at complete odds with these allegations relating to a liquidity provider being invovled, namely that the owner got in trouble and perhaps had his assets frozen so business stopped. I’m purely speculating but from my perspective the liquidity provider as the culprit doesn’t match everything I’ve read.”
As far as our information is concerned, the demise of Galant Capital Markets is just the beginning as many firms were involved in this and are now struggling to pay withdrawals or meet their PB requirements.
As this continues to unfold, there will be substantial fallout for certain firms, and the New York official bankruptcy report, when published, will be the revealing publication.