Single bank platforms are giving way to London’s FX giants. CMC Markets perspective on Prime of Prime relationships

“A mid market gap there is, outside the US, which is on the other side of the wall as a result of Dodd Frank, and it would be two separate matters in terms of the other companies that would be well positioned. There are many participants in Europe but they are reliant on London firms to provide liquidity” says Richard Elston as we discuss in great detail the means by which liquidity is provided these days

A great degree of innovation and development has now become the focus of prime of prime brokerages and institutional liquidity providers in an era in which Tier 1 banks are restricting the credit that they are providing to OTC derivatives companies, especially those which provide electronic trading to retail customers.

London is very much the epicenter of prime brokerage these days, with the world’s largest interbank dealers adorning the waterside at Canary Wharf’s docklands, where just six banks account for 49% of all global FX order flow.

One such bank, Citigroup, this year estimated that the default risk when extending counterparty credit to OTC derivatives firms globally is a staggering 56%, thus reluctance to provide services such as this to what is a core business sector has come about.

Indeed, the execution models among retail brokerages vary. Some obtain a price feed only, thus they can internalize trades but execute them in accordance with a correct pricing tariff, according to the aggregated price feed provided by a series of Tier 1 banks via a prime aggregator, yet not transfer risk.

Others combine agency and b-book execution and follow the price feeds accordingly, whereas those wishing to maintain a very strong relationship with the banks and transfer as much order flow as possible have to bear in mind the enormity of the capitalization required these days, plus the banks’ ultra-cautious attitude toward filling orders and taking last look action.

Today, FinanceFeeds spoke to Richard Elston, Head of Institutional at CMC Markets in London, in order to discuss this in detail.

Mr. Elston is a highly experienced institutional FX industry professional, whose understanding of the structured relationships that must be maintained is comprehensive to say the least.

“The way I read this is that the emphasis is on capitalization” explained Mr. Elston.

richard elston
Richard Elston, Head of Institutional, CMC Markets

“While I wholeheartedly agree with that, there is a symbiosis that exists with regard to three aspects. The first is indeed capitalization, which in my mind has slight precedence over the other two. You have mentioned trade execution before, that therefore is the second aspect, especially with regard to how much can be lodged, and the third aspect is having the right technology to be able to to the job.”

Orwellian equality

“It is a bit Orwellian” said Mr. Elston. “Everyone is equal but some are more equal than others. Technology must be right in order to serve the purpose and achieve the job in hand, but technology can be relatively easily available. Assuming that you have the right funds you can go out and purchase that off the shelf. Anyone can do that as long as they have the money to buy it but it has to be implemented correctly and structured accordingly.”

“With regard to trade execution, we are told that our execution is comparatively optimal versus some of the incumbents in the relationships we have had” said Mr. Elston.

We hear this often with our CFD API, for example. Trade execution is a byproduct of being able to access the right liquidity, and of course companies need the right relationships to be able to obtain the right liquidity in the first place” – Richard Elston, Head of Institutional, CMC Markets.

Citing the Swiss National Bank’s removal of the 1.20 peg on the EURCHF pair in January 2015 as a major event that affects liquidity, Mr. Elston explained “Events such as the Swiss National Bank’s move to remove its peg with the Franc against the Euro dry up liquidity, dry up will, and also dry up enthusiasm.”

“Then you have an event such as Brexit in which everyone tries to manage their book during such a time, and sees the event coming but there are still low liquidty moments. To be able to obtain the right liquidity, companies need to have decent relationships, which can really be maintained by firstly having the right capitalization, and secondly to show the banks enough flow to make it worthwhile” – Richard Elston, Head of Institutional, CMCMarkets

“That doesn’t mean a firm has to give all business away” said Mr. Elston. Once you have the pricing you can then aggregate it to provide it through to the firms that take it” he explained.

“The richer a company is, the easier it becomes. The dice is loaded, and that’s the way it is. We can walk into a sales scenario and look at this. For example we could say a lot about whether technology is optimal to the client, but ultimately, with us it is tansparency that is a major factor. We are a listed entity with over 20 years in this market, and that is what people want” said Mr. Elston.

The three tenets of Chinese liquidity provision

Concurring with this, FinanceFeeds understands that three particular tenets that are imperative when establishing relationships at both institutional level as well as partnership level are indeed length of time in business, regulatory jurisdiction and public listing.

Speaking to a Chinese portfolio manager in the second-tier development town of Zhengzhou last year, FinanceFeeds understood that major Chinese firms looking to place order flow with retail brokers that cater for high volume and can place it with the banks indeed view these three criteria as the make or break factors of any deal.

These are firms that operate from plate glass establishments, have over 100 staff and produce over 90,000 lots per month in managed volume, thus are brokerages in their own right, it is just the actual execution and client funds that are being managed outside, thus publicly listed, FCA regulated firms are preferred.

Mr. Elston shares this view, stating that in the Chinese market, many introducing brokers which work on that basis are smaler in terms of assets under management than other firms but there are a great deal of companies that really care about stability.

“Whilst stability is vital for those larger companies such as the one you describe, I have heard on a number of occasions that while stability is vital, many smaller operators in China only care only about price” he said.

“It is about prestige to the right people, those within the money management sector who want to be able to demonstrate to their underlying client that their funds are in the right place with a solid entity, however where I have heard the pricing argument is usually among the cheaper MT4 firms that just want to gain quick business” explained Mr. Elston.

Overall, we both concur that firms providing services to such companies need to show stabilizing characteristics.

Taking a good last look at last look!

In terms of providing bank-sourced liquidity, a polarizing factor is the use of last look privileges by banks, when no other entity apart from the banks are allowed to pick and choose which orders to execute and which to reject.

“There is definitely demand among consumers to operate on a no last look basis, however I am not sure what the reality is about last look” said Mr. Elston.

“If you re going to have no last look, then the technology needs to be able to exceute correctly with no movement in the market place” – Richard Elston, Head of Institutional, CMC Markets

“I think there are other ways of building last look into the scenario” said Mr. Elston. I almost don’t beleive in a no last look world. If you look at those who don’t do last look, let’s check their spreads” he said.

“Of course the non-bank providers are probably far better at producing any no last look liquiity feeds but is there really a true no last look scenario? In any trading relationship there has to be some kind of give or take, thus to proivde a true no last look is foolhardy perhaps” he explained.

If you are attempting to trade on a published price, then one would hope that would be filled, but there is a lot of infrasturcuture required. There is some good will that means a firm may take the trade on board for the sake of the relationships, then in the end it could be unprofitable” – Richard Elston, Head of Institutional, CMC Markets

“You have to be ultra confident that you’ll be able to make money out of a scenario in every case. For example we had a scenario which went on till midnight on Thurday night when the pound flash crash happened” he said.

“We want to try to provide the client with sensible execution, and some of Thursday’s events included in some cases zero liquidity, thus it would be very difficult to offer no last look execution in such a scenario” said Mr. Elston.

“How can no last look be offered? The liquidity providers have grown up enough to realize that this is the way the market is, and such is the ebb and flow. Looking at where FX firms have been filling clients, we are very happy where we are with this” he said.

“As that particular market event happened at that time of night, there were pros and cons. For example, not many people were caught up in it, but liquidity was so thin that anything drastic would move the market even further” explained Mr. Elston.

Mid-market prime brokerage gap – London is the place!

“Filling that gap between traditional Tier 1 prime brokerages that are attempting to extract business from clients that are too small has become an interesting situation, therefore it has created a mid market gap where companies such as ourselves can fill this very well. We want to be sure that the Tier 1s have a different scale to ours” said Mr. Elston.

FinanceFeeds understands how London-centric this has become, and thus discussed this matter with Mr. Elston.

“Traditionally, the US is where this prime brokerage model originated, and in Europe, there were always far less firms providing it than in the US, but now there are companies with decent balance sheets that are offering this.”

“A few years ago there were firms with very poor balance sheets offering agency style execution. Are tehre any left, or have they all started becoming counterparty to the trade? Its not just about execution and access, its all about credit intermediation in this market without question” said Mr. Elston.

He is indeed absolutely right.

“There are large entities around Europe, but I’m not sure how geared up they are. Some have extremely expensive pricing but also I would be fairly sure that in addition to the pricing differential,the only liquidity they are offering is their own, and in many cases the technology will be archaic” said Mr. Elston.

“What London is going to be, is a sophisticated center in which good firms can fill the mid-market gap comprehensively. Because we are very aware of the online trading world, and a company like us which is born out of the retail market and therefore the technology has been tested by the masses, this is a very big positive” – Richard Elston, Head of Institutional, CMC Markets

“If we can combine all this with our balance sheet then we can do a better job of lesser known, more regional efforts that come from Europe, therefore London is a damn good place to be” said Mr. Elston enthusiastically.

“A mid market gap there is, outside the US, which is on the other side of the wall as a result of Dodd Frank, and it would be two separate matters in terms of the other companies that would be well positioned. There are many participants in Europe but they are reliant on London firms to provide liquidity” he concluded.

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