FX: Prime Brokerage


By Gordon Platt

Trade between emerging market countries is driving a campaign for a new currency order.

Future growth of the foreign exchange prime brokerage industry will come from asset managers that are entering the foreign exchange market from equities and futures, and that are empowered with algorithmic trading tools. This will generate volume for the big banks that support cross-asset trading, analysts say.

Additional growth will come from asset managers entering the emerging markets in Asia, according to Celent, a Boston-based financial consulting firm. “A large number of traditional asset managers who already have relationships with the large banks will easily adopt prime brokerage services if the right kind of team is put in place,” it says in a recent report. Foreign exchange prime brokerage (FXPB) has emerged as a very lucrative mainstream business, Celent says. “Top players like Citi have 50% of their FX turnover by ticket numbers coming from prime brokerage,” it says.

FXPB enables hedge funds, pension funds and other asset managers to view and trade on the best prices available in the $4 trillion-a-day FX market from a number of major banks through a single platform and to take positions on a leveraged basis while keeping their accounts at a single institution. Worries about bank safety in the wake of the financial crisis, however, have made customers reluctant to consolidate risk in one prime broker. The fragmentation of prime brokerage means that the back office has to be capable of handling information from multiple liquidity sources. The collateral management facility, for example, has to handle issues related to collateral across numerous prime brokers.

“Although some players have four to five prime brokers, the general trend is to have two or three,” according to the report by Celent analysts Sreekrishna Sankar, based in Bangalore, India, and Axel Pierron, based in Paris. An asset manager with three prime brokers, for example, would most likely do 70% of its business through a main prime broker, while giving 20% of the total to a second prime broker and 10% to a third.

“This could be an overreaction to the crisis, but it is increasing business among established players,” the report says.
In the past few years, there has been rapid growth in the FXPB industry, as more and more market participants have discovered foreign exchange as a separate asset class.

Clients are constantly demanding more and better service. “Apart from tight pricing and superior liquidity, FXPBs are now focusing on providing a single-window view across multiple assets and newer margining models for multiple assets,” Celent says.

Since the late 1990s, FXPB has evolved from the plain-vanilla “give-up” model, whereby a prime broker accepts foreign exchange trades executed between its client and a dealer, into a more complicated set of “reverse give-up” relationships among multiple prime brokers, give-up parties, and their clients, according to the latest annual report of the Foreign Exchange Committee, an industry group sponsored by the Federal Reserve Bank of New York.

In a basic FXPB relationship, there are three parties: the client, the prime broker and the dealer who executes the foreign exchange trade. When the prime broker is notified of the trade by the client and the dealer and accepts it, the prime broker becomes the party to the transaction in place of the client.

A reverse give-up relationship introduces a fourth party, the give-up party, which is often a financial institution that acts as custodian for hedge-fund accounts for which the client trades as manager. A reverse give-up relationship can also involve a fifth party—a second prime broker—in addition to the client, the first prime broker, the executing dealer, and the give-up party.

Relationships are getting more complicated, and the fragmentation of the industry is increasing the need for new technology to keep track of who is doing what for whom. Vendors are in the early stages of developing new products, and industry groups are studying the broader risks in the business.