Several meetings with senior Tier 1 bank executives and leaders of prime of prime brokerages in London recently have demonstrated that, as long as the criteria is met, the OTC FX industry is a vital business that the banks cannot afford to miss out on. Here are my findings thus far.
Here in Central London, something of a difficulty that has emanated from just one square mile of the world’s surface and created a liquidity crunch for the OTC derivatives industry globally has been omnipresent for approximately the last two years.
FX liquidity, which is the preserve of just a handful of large banks which maintain the largest market share – those being Citigroup, RBS, JPMorgan, Goldman Sachs, Deutsche Bank, HSBC, Credit Suisse and Societe Generale (not in any particular order except for Citigroup being the largest by far in terms of FX market share) – has become very scarce indeed and has created an environment in which a prime brokerage agreement has become an extremely difficult deal to close for many FX brokerages, large and small.
Not only that, but existing prime brokerage agreements are the subject of continual review by the banks, quite often because the audit and risk management departments of the Tier 1 dealers are always looking at how large a broker’s balance sheet is, $50 million to $100 million being usually the ballpark range that a brokerage or prime of prime brokerage needs to maintain in order to keep an existing prime brokerage relationship with a bank.
The report by Citigroup a year and a half ago which painted the grisly forecast that the extension of counterparty credit to OTC derivatives firms could present a potential default rate of 56% created a very harsh dialog between the banks and the non-bank liquidity takers, and resulted in just a handful of genuine prime of prime brokerages existing today.
Indeed, the word “prime” has become the latest buzzword for OTC companies with a B2B target audience, but FinanceFeeds research has proven that in many cases, the word prime does not always signify a genuine prime brokerage relationship but instead is in many cases a client onboarding avenue between brokerages.
Having spoken to senior executives within London’s Tier 1 banks in meetings in London over the past few weeks, it appears that there is light at the end of the tunnel and that some of them are beginning 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.
This is all well and good, however it does not make money.
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.
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.
I 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.
Another indicator of this is that today, here in Broadgate, as I write, a major interbank FX dealer that handles over 12% of the world’s FX order flow is hosting a round table to which I was invited, completely unprompted, as a key proponent of the OTC derivatives sector. This demonstrates further that the banks are holding their hand out once again. Of course, criteria will still remain strict, but the OTC business is something they want.
The largest British banks in terms of interbank FX order flow are Barclays (via the BARX platform), with 8.11% of the global market share, HSBC with 5.4%, RBS with 3.38% and Standard Chartered with 2.4%. OK, Standard Chartered is South African, but it is a completely British venture from historic times until now. If global banks are considered, Citigroup and Deutsche Bank are the largest, however they conduct their business also from London.
The British contingent are the very same banks that exposed themselves to vast unrepayable loans to retail customers, including credit cards, unsecured borrowing and perhaps even more remarkably, allowing retail customers to make their own declarations about their earnings and existing assets, which often were wildly exaggerated, meaning that mortgages were granted to those who could not afford to meet the commitments, ultimately contributing to the collapse and government acquisition of many major British banks.
Some 9 years have passed since the dark days of the bank runs and the credit crunch, however an investigation by FinanceFeeds demonstrates that the banks are shunning well capitalized FX brokerages and restricting prime of prime relationships even to firms with massive capital bases and highly complex risk management policies in place, yet the very same banks are making a return to offering 95% loan-to-value mortgages to retail consumers with no savings and no real proof of income or collateral to guarantee the repayment.
Added to this, the banks are not even profiting from this very much, as the interest rates are so low that they are almost negligible.
In the FX brokerage business, one of the most difficult professions is to head a division of a liquidity provider or prime brokerage in a capacity which requires forging and maintaining relationships with banks. The butting of heads over where to dispatch order flow plus the continual metaphorical grilling that the bank desks give prime brokerages with regard to which flow was offset against what, with a watchful eye on risk all the time.
Companies in London with capital bases of over $500 million and market capitalization figures running into the billions are the bete noire of banks, yet anybody can walk into a retail high street branch of the same bank and walk out with a mortgage secured on a house whose value may go down, not just up, having self-declared a fictitious income and having committed very little personal capital toward the transaction.
Local branches of HSBC and Barclays have set up stands in the front of their entrance halls, with a friendly and polite sales person proactively approaching retail customers who enter the branches to conduct counter transactions to see if they can sell them a mortgage with only 5% downpayment and no ‘bureaucracy.’
However, if you are the head of PB relationships at a large brokerage, you are likely to be butting heads with the risk management teams of the very same banks to get orders processed.
When viewed like this, it makes no sense to consider the FX industry as a high risk, when the retail banking businesses of most of the Tier 1 banks are far higher in terms of risk, whether from an exposure or operational perspective.
Last week, in a milestone dynamic for the OTC derivatives industry, even a senior figure at a central bank in one of the world’s most renowned financial centers joined one of the world’s most renowned prime of prime brokerages to discuss the FX Global Code, which is a very important aspect in itself.
Invast Global’s CEO Gavin White has been instrumental in endorsing the FX Global Code, and Dr Guy Debelle, Deputy Governor of the Reserve Bank of Australia and one of the FX Global Code’s key architects, joined Mr White and the Invast Global Prime Services division in hosting an event at O-Bar at level 47 of Australia Square in Sydney, in a coming together of minds between the OTC industry and the leaders of global banking institutions.
In 26 years in the institutional FX industry (admittedly mostly in technology projects), I have never known a senior figure at a central bank, or a Tier 1 institution, participate at that level within a symposium or dialog for the OTC derivatives industry.
This should be viewed as an absolute signal that the very finest and most well organized prime of prime brokerages, among them being Invast Global, Saxo Bank, Sucden Financial, ISPrime, Advanced Markets & Fortex (itself having an ownership stake by Australia’s Macquarie bank), Swissquote, CMC Markets, are actually gaining the pinnacle of respect by Tier 1 banks that realize that $7.5 trillion in retail volumes per month, dealt with by astute, risk-savvy and technologically advanced companies who understand the structure of the market properly, is too much to miss out on.
With MiFID II imminent, and allowing ‘systematic internalizers’ (b-book) brokerages to have their own remit to report exactly as that, banks have to realize that by pushing the majority of small to medium-sized brokerages onto b-book modus operandi, they are actually risking a massive revenue stream, and a revenue stream aided by companies that actually lead this industry in terms of trading infrastructure, knowledge and sophisticated liquidity management systems and order flow management, rather than concentrate on their archaic and unprofitable retail banking arms which cost a fortune in real estate, staff, and endless fines.
Let’s hope the other inhabitants of Canary Wharf and the Square Mile follow suit.
Recently, I discussed the ramifications of the prime brokerage relationship with banks – Here is the discussion: