The Last Look…
Posted by Colin Lambert. Last updated: July 12, 2022
A few readers were in touch about last week’s column to suggest that I under-played the role of prime brokers in the decline of the non-bank market making industry, and perhaps I did. That said, I would argue that the prime brokerage industry is probably doing as much as it always did for these firms – it’s the business model of some of the latter that is broken, as I argued last week, not their access to market.
A sub-theme in the comments was a sense that, as one correspondent put it, “FXPB isn’t what it was”, mainly because of what was seen as a decline in interest on the part of the major banks. I respectfully disagree. I fully accept that FX prime brokerage has become a little harder for the banks thanks to the changing regulatory landscape, but with most FXPBs offering access to clearing, it’s just OTC is, at some houses, a smaller part of the business than it was.
I sense that the dominant position of one player in the recent past coloured our view of FXPB and when that player decided, over a course of time, that it wanted to reduce its FXPB operations, for whatever reason, there was a general sense that decline was widespread. I am not convinced it was, or is.
Plenty of firms I talk to in this space are still getting PB-ed, it may be costing a little more but especially as markets become more volatile and access important, it is still an affordable and invaluable service. Some in the hedge fund and prop trading space have been forced to the prime-of-prime market, but even here the sense is these firms were always likely to be pushed in that direction due to their size.
Personally, and here I am judging people much smarter than me (not for the first or last time of course), I think it was a mistake by some of the PBs to kick off the guaranteed and steady income from non-bank market makers in favour of firms trading “more meaningful” derivatives. I am sure the fees were higher, but the regulatory cost – which has been known for some years now – was always going to rise, and hurt.
Of course, it can be argued, with some justification, that many of the non-bank firms would have drifted away from FXPB as they did the FX market more generally, but then not only have some of these firms been replaced, as I argued last week, by others that are maybe not as active and are more directional traders, but the operational concerns – which clearly influenced the decisions to get rid of the non-bank market makers – would have been mitigated.
The question of prime brokers when dealing with high volume clients is primarily around tech spend. Some argue, however, it is about the levels of risk being taken on and the regulatory cost, but in FX at least, how risky is a high volume trading client that, by its very nature, is taking on very short term risk (measured in seconds – I’m old-fashioned). These firms have built their (largely successful) business on being technologically efficient and resilient – down time is a serious dent to the bottom line, so why would we think they are risks to the system? I would argue that the top non-bank firms have better, more resilient and robust technology than most, if not all, of the industry giants.
We (and I include myself here) sometimes become too obsessed with the actions of one or two players or influence of one or two factors, when the bigger picture would tell us something different.
If a PB has the right technology stack in place – and it does need scale and room for spikes in activity of course – then I would have thought the non-bank firms would have been lower risk than a hedge fund for example punting away in the three months. The latter is using the PB’s suddenly expensive balance sheet and, due to the lack of real insight into the firm’s overall positions, is a much bigger blow-up risk.
The longer-term trading firms are clearly more valuable to the overall FX business, especially if they trade with the PB’s (separated) trading desks, but it would be an interesting insight to see exactly how much value this flow brings when placed against the increasingly capital costs.
I digress, as always, however, and to go back to the theme of this column, I see FXPB as being a long way from a business in terminal decline, as some have suggested over the past week. Yes, the regulatory costs are high, but then more capital cost mitigation tools are available through compression, novation and netting at industry level.
FX is still not really pushing in the direction of becoming a listed market – CME’s FX Link will be a valuable part of the industry going forward, but it will be just one of several tools used by major players to reduce their regulatory costs. Client still want access to the OTC FX market beyond their one or two banking relationships, and that means prime brokerage still has a lot to offer.
We (and I include myself here) sometimes become too obsessed with the actions of one or two players or influence of one or two factors, when the bigger picture would tell us something different.
Like so much else in the FX industry, FXPB is not going away – it’s just operating differently. The bar to entry has always been pretty high and it remains so, but as volatility and a trend sustain, execution quality and slippage become more important, which means clients want market access.
One or two firms may have made what could be seen as mistakes in their strategy, and others have genuinely pulled back as part of a retreat from FX in general. As a whole, however, the FXPB industry still looks healthy enough to me – and interestingly, I don’t hear as many complaints from customers as I used to!
@ColinlambertFX