Evolution of prime of prime

As we are turning the corner of 10 years post 2008 financial crisis, I would like to reflect on my past 10 years in FX and how it has changed.
FX Prime Brokerage and FX Prime of Prime scenes have undergone dramatic changes.

In 2008, we have witnessed a take off of FX PB that used to be a prerogative of hedge funds as major banks expanded in the sector and started servicing various other participants with FX exposure like mutual funds, insurance companies, corporations and even retail FX brokers.Growth has been set on exponential trajectory and not until the swiss franc peg removal crisis that it started to take a major turnaround. In recent years, the Tier1 FXPB sector has been shrinking, with many major players reducing their exposure to FXPB and some exiting this business entirely. In this article, I will go through the origins of FXPB and Prime of Prime and dive deeper into how the sector has changed following major market events and industry re-shakes.

What is FX Prime Broker?

FX Prime brokerage allows FX market participants to source liquidity from multiple dealers but maintain a credit relationship with a single entity.
FX prime brokerage allows clients to trade with banking institutions using their prime broker’s credit profile and infrastructure. Clients signs a single legal agreement with Tier 1 Prime Broker, therefore eliminating the need for multiple legal and credit documents with each of their trading banks.

What is FX Prime of Prime?

The next level after Tier1 Prime Broker is “Prime of Prime”- in this scenario a Brokerage has an account with a Tier 1 Prime Broker and extends those services to other market participants such as retail FX brokerages, FX funds and other institutional players.
Prime of Prime’s role is to extend interbank market access to clients who do not have access to credit. To put it another way, it helps create direct market access for those clients who do not meet the stringent collateral and credit criteria that’s needed in order for them to establish their own, direct, prime broker relationship with a bank. The main value that a real Prime of Prime delivers is non-latent access to institutional trading, in a secure and regulated environment.
Prime of Primes are bridging the gap between the institutional and retail FX markets by offering faster onboarding processes, access to interbank liquidity and the latest in technology advances all bundled into a single offering.

Prime of Primes will generally offer higher leverage than a Tier 1 PB as well as plug and play integration into a single aggregated feed via industry-standard FIX API or standard adaptors/connectors to other trading platforms.

In order to mitigate reputational and transactional risk, true Prime of Primes will typically not work directly with retail fx clients unless PoP services are a part of its overall business. They will also have higher account opening standards, more in-depth due diligence as compared to a retail FX broker and higher deposit requirements.

By working with a Prime of Prime, institutional FX market participants gain the following benefits:

Access to Interbank Liquidity and Non bank Liquidity
FX Prime of Prime brokerage allows clients to trade with a large number of institutions round the clock and third tier banks, and banks specializing in exotic currencies. In years post SNB crisis, non bank liquidity providers (hedge funds and others) are striving and gaining a stronger footing as liquidity providers.
Many of them will not work on margin and prime of prime has become a unique gateway to access these unique pricing from non-bank vendors.
Faster time to market
Prime of Prime typically offers pre-aggregated liquidity package that is already up and running and doesn’t require any certification process and/or technology onboarding and integration, mapping setups with give-up networks etc.
Therefore, Prime of Prime’s clients reap the benefit of shorter lead time (2-3 weeks compared to 6-12 months).
Higher leverage
Prime of Prime adds value by leveraging its balance sheet and extends even greater value to its clients in a form increased leverage.
Significant technology costs savings
By working with a Prime of Prime, market players are able to tap into savings by accessing already working setup that doesn’t require any hefty entry fees or technology maintenance fees. Prime of Prime are able to significantly lower technology fee barrier by taking advantage of the scale.
Full netting capability
All the trades executed are ‘given up’ to the FX Tier 1 prime broker, which assumes the Prime of Prime’s credit risk and that of their counterparties. The FX prime broker then consolidates the trades and Prime of Prime calculates a single margin payment for the client that will cover all their trades.
Reduced Margin Requirements
By consolidating trade exposure into one net account, FX prime of prime brokers can reduce the amount of collateral that their clients need to post to execute their FX trades.

Why are once burgeoning FXPB and FX Prime of Prime sectors shrinking?

The growth in the FXPB industry in 2008-2015 has been driven by the expansion in high frequency algorithmic trading, retail FX trading, and the growing popularity of FX as an asset class (a trend that has led to a marked increase in the number of currency managers and currency-orientated hedge funds).
The dramatic price moves in the wake of the Swiss National Bank’s removal of the Swiss franc’s peg against the euro on 15 January 2015 sent shockwaves through the FX industry, causing Tier 1prime brokers to raise fees and cut clients. This has reduced participation by hedge funds and other leveraged players in FX markets, as they have already been experiencing low returns.(1)
Some banks also cut their business exposures to retail margin brokerage, which affected market access for retail aggregators.
A number of major prime brokers raised capital requirements, introduced tighter onboarding procedures and raised clearing fees.
As a result, Tier 1prime brokers have focused on retaining large-volume clients, such as large trading firms engaged in market making, while shedding retail aggregators, smaller hedge funds and some high-frequency trading firms.
In order to access interbank FX liquidity, many players shifted towards prime of primes that were able to source the same liquidity at the preferential conditions. As this sector started to boom in 2015, many has shifted to the prime of prime model, some from the retail aggregator space. The term has started to be mis-used and retail brands, without a Tier 1 bank prime broker relationships, were creating “Prime” brands in an attempt to capture some of the more sophisticated clients. Retail market makers also started to take advantage of the trend, named themselves Primes and were actively taking risk as opposed to passing it on to the interbank.
Fast forward to 2019, and prime (real and quasi) are shrinking following record low volatility that heavily impacts funds’ strategies, capital intensive nature of the business and tightening margins. Retail aggregators are increasingly looking to either take more risk on their own books or pass it on to an aggressive market maker that is able to provide rebate or share profit on it.Handful of true prime of primes are offering genuine services to market participants who are looking to access interbank market, get better fills, deep liquidity and seeking for better protection of their trading funds.

What is Margin aggregation?

This article would not be complete without mentioning of such a phenomenon as margin aggregation. It became omnipresent amongst retail aggregators in recent years as access to credit has dried up due to reasons outlined earlier in this article.

FX Margin aggregation is a way of pulling together FX price feeds (typically using best bid/best offer logic) from Prime of Primes, the “institutional” divisions of retail FX brokers, and from retail FX market makers. Unlike in the purely institutional trading environment, where a Prime Broker would handle the settlement of transactions with the banks and ECNs, with FX Margin Aggregation there is no such a clearer, and the retail FX broker is solely responsible for all trade reconciliation.

However, there are a significant number of cons associated with the model. While improved spreads are great, paying double spreads with your counterparties is not so great. There are also inefficiencies in margin management, over-paying swaps and issue of double-hits.Despite the shortfalls, margin aggregation is uniquotus these days as many players are now at arm’s length from the original sources of FX liquidity.

Conclusion

When the Prime of prime industry began circa 2008, the FX market was given an impetus by the world’s global financial crisis.
Today, it is a global industry servicing FX needs of organizations all over the world. The innovative solutions that prime of primes have delivered to its clients and the skill sets which prime of prime experts employ are well suited to the changing global marketplace.
While there were a few setbacks for the FX industry as a whole recently, I think the growth for prime of primes is set to continue, making prime of prime an integral component of the overall FX market.

Sources:
https://www.newyorkfed.org/medialibrary/microsites/fxc/files/2005/fxc051219a.pdfhttps://www.bis.org/publ/qtrpdf/r_qt1612e.htm#Graph-2