Will the b-book ever die? FX counterparty risk is once again on the agenda

Counterparty credit risk was never much of a consideration within the FX industry until around seven years ago.

Back in the early days of retail OTC electronic trading, it was very easy to establish and maintain a relationship with a Tier 1 FX counterparty, largely because very few retail brokers had such a thing back then, and the new influx of MetaTrader brokers could not do so as the MetaTrader 4 platform in its original guise back in the mid-2000s was designed specifically to act as a closed system for market makers only.

Thus, banks did not consider the retail FX industry to be much of a risk, nor a large part of their core business, so they extended OTC counterparty credit agreements to professional and corporate liquidity takers willy nilly, and added a handful of retail FX brokers which had their own platforms and had been established for many years to their liquidity provision client list without much concern.

It wasn’t until 2015 when Citigroup, the largest FX interbank dealer by market share at the time which had held that top spot for 17 years, issued a report stating that it considered the retail OTC derivatives sector to be a large credit risk, indicating that it expected OTC counterparties to be responsible for a potential 57% default rate going forward.

This generated a culture of fear within other Tier 1 banks, who began retracting their counterparty credit agreements to FX brokers, and stipulating that any liquidity taker of any kind would need to demonstrate balance sheets of between $50 million and $100 million in order to establish and maintain an agreement with a Tier 1 bank.

Indeed, in some cases, banks withdrew counterparty credit agreements that they had worked with for a long time from some prime of primes at the time who had never defaulted, so fear-driven was the kneejerk reaction.

Thus, to this day, many firms that use the word “prime” are doing so in name only, and are really operating a b-book. There are only a handful of genuine prime of prime brokerages that exist today, the main ones being IS Prime, Swissquote, Advanced Markets, INVAST Global, Saxo Bank, and Sucden Financial.

Perhaps more gloom on this subject has come to light recently, in the form of a report provided to FinanceFeeds which demonstrates more deterioration than improvement in credit risk for financial counterparts.

This week Credit Benchmark released a report which was provided to FinanceFeeds along with information on the latest Financial Counterparts Monitor report. The credit risk analytics firm has provided this report to demonstrate the changing creditworthiness of different groups of financial counterparts.

The report, which covers banks, intermediaries, buy-side managers, and buy-side owners, summarizes the changes in credit consensus of each group as well as their current credit distribution and count of entities that have migrated from Investment Grade to High Yield.

The data, which is based on the credit risk views of Credit Benchmark’s contributing financial institutions, is also available at the legal entity level. Users of the data can monitor and be alerted to the changing credit consensus of their financial counterparts.

The report, which covers banks, intermediaries, buy-side managers, and buy-side owners, summarizes the changes in credit consensus of each group as well as their current credit distribution and count of entities that have migrated from investment-grade to high-yield.

There are a few different metrics used in the report, including the ratio, which shows improvements vs. deterioration (upgrades vs. downgrades) for different types of firms. A larger number indicates more deterioration than improvement.

In the latest update, there’s been more deterioration than improvement (higher ratios) in most categories. The ratio for Banks – Global is 1.2, while the ratios for Banks – North America, CCPs, and Prime Brokers are 1.7, 2.0, and 3.0, respectively.

Among the types of financial counterparts seeing improvements in credit (lower ratios) are G-SIBS at 0.7 and Broker Dealers at 0.9.

It is FinanceFeeds perspective that the risk arising from the possibility that the counterparty may default on amounts owned on a derivative transaction has become a focal point for liquidity providers, prime brokerage, and even Tier 1 banks whose liquidity is aggregated by non-bank institutional providers which connect retail trading platforms via a single point connection.

This matter has become so vitally important that it is becoming increasingly difficult for OTC FX brokerages to secure relationships with prime brokers for providing FX (and other electronically traded asset classes) on an OTC basis to retail customers.

Bearing this in mind, banks were taking a very conservative approach to credit risk, even in market conditions which were in their favor.

Let’s look at the history – FinanceFeeds reasearch.

Indeed, as far back as 2010, the Federal Reserve Bank of New York produced a document about credit risk in FX, detailing its best practice guidelines which apply to banks giving credit to FX brokers and prime brokers on an OTC basis.

Within these guidelines were two important frameworks:

Netting agreements

These are agreements that reduce the size of counterparty exposures by requiring the counterparties to offset trades so that only a net amount in each currency is settled and provide for a single net payment upon the closeout of all transactions in the event of a default or termination event.

Collateral arrangements

These are arrangements in which one or both parties to a transaction agree to post collateral (usually cash or liquid securities) for the purpose of securing credit exposures that may arise from their financial transactions.

During 2010, the Dodd-Frank Wall Street Reform Act was sworn into US law by President Obama, an act which prescribed that all OTC retail FX firms should have a net capital adequacy for regulatory purposes of no less than $20 million.

Banks taking the cautious line – Watch the percentages in the terms and conditions

The New York Federal Reserve considers that much higher requirements are in place, even though it is widely recognized in the retail FX industry that the stipulations made by the US government are far in excess of those made anywhere else.

The central bank asked participants some 6 years ago to consider an example in which a client had a net positive mark-to-market exposure to Lehman Brothers of $50 million.

With an agreement by the International Swaps and Derivatives Association in place, the client was able to net the outstanding positions and was ensured that Lehman would be unable to “cherry pick” the winning trades from the losing trades.

However, without a CSA (credit support annex) in place and the associated placement of collateral, the client was still forced to replace the positions lost due to the bankruptcy, or the $50 million replacement cost, and wait for a number of years for some recovery on its $50 million claim in the bankruptcy.

A year later, banking giants HSBC and JPMorgan founded FX prime brokerage businesses, and the liquidity from both institutions is now commonly present as part of aggregated feeds provided by broker technology firms and non-bank specialist liquidity providers to FX brokerages.

When examining the terms and conditions set out by JPMorgan’s prime brokerage division, it is clear that a very conservative approach was taken from the outset.

In July 2012, the firm stated that the amounts which may be rehypothecated under a Prime Brokerage or margin account relationship are generally limited to 140% of the outstanding liability (or debit balance) to the Prime Broker or lender (or such other applicable legal limit).

For the purposes of the return of any collateral to customer, the account agreements provide for the return of obligations by delivering securities or other financial assets of the same issuer, class and quantity as the collateral initially transferred.

How much do I need to operate directly with a Tier 1 bank? – I find out….

Research that I conducted with regard to opening a client deposit account for FX brokerages demonstrated not only the variation between large, Tier 1 banks and their criteria, but also the commercial attitude toward retail FX brokerages.

NatWest, part of the RBS group, as well as RBS’ corporate division itself, stipulate no minimum deposit and no required minimum daily balance for client money holding accounts, however when I enquired as to whether this service was available for small retail FX brokerages, the answer was a resounding no. Law firms and insurance agents, yes, but FX companies serving retail clients, no.

Chase Private Client, the client money holding account offered by Chase, will accept certain FX brokerages according to very stringent conditions but expects a $250,000 average ledger balance to be maintained at all times (made up of either cash or qualifying deposits and investments linked with the account – ie collateral) and a minimum daily balance of $15,000 or more.

Bearing in mind that this is a separate matter from operating capital requirements and operating costs, and a separate matter from regulatory capital requirements, it is clear that banks have a strict risk management profile.

How brokers are looking to mitigate risk, yet offer modern and attractive services

Smaller brokerages which transfer their entire order flow to their liquidity providers, and white label partners of retail brokerages should bear in mind that if they are operating a pure A-book (which is very very rare) the chances of being outside these parameters is high, and therefore at the end of the liquidity chain, the banks will intervene, ultimately limiting the activities of smaller, less capitalized firms.

It is possible for all brokerages to assess this carefully by using online services such as the S&P Global Market Intelligence Platform, which is designed to help firms measure and manage their credit risk exposure by screening benchmark relative financial and credit metrics.

Companies such as Traiana, which is the post-trade clearing, risk management and settlement division of British interdealer brokerage ICAP, provide services including automated post-trade processing for give-ups, allocations and clearing of CFDs, which have become very popular since the Swiss National Bank event in January 2015 as a form of OTC futures contract which many brokerages are viewing as a means of lowering the risk of negative balance exposure which may ensue from high volatility.

Britain’s electronic trading sector has, for many years, been centered on CFD trading and spread betting, necessitating the development and maintenance of proprietary platforms by London’s long-established retail FX giants.

During the last four years, there has been a distinct drive toward taking the CFD product to an international audience, and some very significant mergers and acquisitions have come about as a result, a notable example being the purchase of City Index by GAIN Capital for a sum that was at the time reported to be $118 million in October 2014.

Subsequently, it emerged that the net purchase price was actually $82 million, which included $36 million in cash. That aggressive switch toward CFDs subsequently resulted in a regulatory backlash which we are now seeing in major markets such as Australia, Britain and Europe.

The drive toward adding CFDs to global product ranges was relatively short lived, and has now become a very quiet and somewhat distant dynamic. It may well be that the reason for this is the inability to clear currency-based CFDs, despite certain services being available to clear equity CFDs as per the Traiana Harmony network, and also the very wide spreads which can ensue due to the OTC nature of a futures contract being intrinsically difficult to assess from a buy-side perspective.

Chart Source: Credit Benchmark