It is the opinion of many Swiss banking executives that I have spoken to this week that compliance, and not just balance sheet size, is a major, and unwritten consideration for Tier 1 banks when extending counterparty credit to the OTC sector. Here is my opinion
It is most certainly the case that, since I read Citigroup’s dystopian report last summer which was sent to me in well organized, fifty page format, detailing the bank’s comprehensive policy with regard to extending counterparty credit to OTC derivatives firms, the curtailing of said credit has blighted the liquidity provision sector considerably.
The report documented many factors that Citigroup demonstrated concerns over, with one particular projected statistic having stood out like Ruby Wax’s voice in a public library, that being the bank’s prediction that in the years ahead, OTC firms present a 56% default risk.
Citigroup, being the largest interbank FX dealer by volume and market share (16.9% of the entire global interbank FX market) instilled the fear factor into other Tier 1 banks, which have, albeit very quietly and without such reports and statistics having been published, followed suit.
The result is that it is either impossible, or at best very difficult indeed to continue to maintain a prime brokerage relationship with any of the small number of Tier 1 banks that make up the entirety of the interbank FX liquidity structure.
49% of all interbank FX trading is conducted from within just five banks, all sharing the same space along East London’s docklands at Canary Wharf, those being the banks that the entire institutional division, and some of the retail division of the FX industry depend on for live market pricing and institutional liquidity to be able to execute orders for their customers.
It has certainly become evident to me over the past year that, whilst banks will rarely discuss this criteria with anyone, the collateral available or numbers on the balance sheet are today’s credit-scoring factors.
It is nigh on impossible for newcomers to the liquidity provision sector to gain a prime brokerage relationship directly with a bank, even if they are well funded. There have been recently several examples of companies establishing themselves as a ‘prime’ and using the word prime in their name, however the reality is that they do not have the capital credentials to gain a prime brokerage relationship with the banks, hence the reality is that such companies simply use this as an onboarding method and provide a separate retail price feed to the brokers that take their liquidity, hence it is a retail feed, not a prime.
This has prevailed for quite some time, and indeed during the curtailing of credit by the banks, many new non-bank liquidity providers came to market, the majority of which are not offering a prime of prime service, prime of prime being the status of a company which aggregates prime brokerage liquidity via direct relationships with Tier 1 banks and provides it to retail brokerages.
A significant elephant in the room has been not only the emergence of retail brands that are using the word ‘prime’ to distinguish their B2B feed from the standard direct retail price feed, despite it being one and the same source, is that existing, well respected prime of primes have, in some cases, found great difficulty in maintaining their own prime brokerage relationships, demonstrating that banks are actually removing the facility from firms with which they have had a long relationship with.
It is therefore entirely possible to count the number of genuine prime of primes on one hand these days. Genuine prime of primes, with real, direct relationships include Saxo Bank, ISPrime, Sucden Financial, Invast Global, Dukascopy Bank, CMC Markets, Swissquote, and Advanced Markets. These companies have longstanding relationships with Tier 1 banks and are able to meet the capitalization requirements as well as the customer onboarding requirements from their side.
During meetings this week in Switzerland with senior prime brokerage specialists that have banking careers dating back to the late 80s at Swiss Banking Corporation and now operate within OTC prime of prime liquidity provision, another matter was raised which may be an equal contributing factor in the curtailment of counterparty credit, that being the nervousness by banks to expose themselves to the enormous rigmarole of having to conduct due diligence on every single brokerage which takes liquidity further down the line.
AML (Anti Money Laundering) and KYC (Know Your Client) rules apply not just to retail brokerages onboarding retail clients, but also to banks onboarding brokerages.
It was mentioned to me several times during meetings last week that in many cases, the compliance divisions of Tier 1 banks do not want to take the risk, or commit the expense, toward having to conduct KYC inspections on every single brokerage that is one step down the line from the prime of prime that they have an immediate relationship with.
The rulings set forth by the vast majority of established financial markets regulators stipulate that KYC due diligence must be carried out only between the client, in this case the prime of prime that takes liquidity directly from the bank, and the bank itself. Simply, it is a two way street.
The brokers that are being provided with liquidity would be subject to KYC due diligence from the prime of prime, and the end user clients would be subject to KYC due diligence from the retail broker.
In short, KYC responsibilities extend just one level down.
It was suggested to me this week that should counterparty credit be extended to all and sundry, not only would there be a massive credit risk aspect, but the banks would be inundated with compliance requirements and in some cases may be able to onboard a brokerage, but subsequently be exposed to compliance issues if said brokerage transgresses or ends up owing the bank money and contributing to more shareholder discourse or KYC-related regulatory fines, thus it would be risky and hard to manage even for large banks.
According to FinanceFeeds research, there are 1231 active MetaTrader 4 brokerages (comprising of actual brokerages, white labels and partners) globally, hence the increasingly ultra-conservative major banks would have to oversee the activities of all of them, that being not only an expensive task, but a potentially damaging one.
Banks, unlike very small brokerages with light regulatory licensing in offshore jurisdictions, no capital and a $5000 white label MT4 license, are gigantic, have public responsibilities and are always in the spotlight of the mainstream news and political agendas. Small offshore retail brokerages are very rarely subjected to any consequence even for relatively large transgressions, whereas banks are censured immediately for making faux pas such as taking too much risk.
Therefore, a simple transgression of compliance by a small unaccountable MT4 broker offshore could generate a PR and compliance nightmare for banks, with the return not being worth the reputational damage.
For this reason, it is the opinion of many Swiss executives that banks prefer to stick with the few extremely trusted and long established companies with unfaltering prime brokerage relationships than to extend themselves past that and into the mainstream.
Thus, it is the sensible approach for brokerages to take liquidity from the trusted and long standing prime of primes.
Quod erat demonstrandum