Traditionally, it is often argued, the principal focus of the prime brokerage (PB) business was on market share above profitability. Many of the banks that dominated the business offered their services on the cheap, partly as a way to win more profitable business from those clients elsewhere in the bank.
At some banks it was seen as a particularly good way of generating business for the trading desks, with which PB units were often closely aligned.
|Raj Sitlani, IS Prime|
However, a number of factors have conspired to shake up the PB business generally, and FX PB in particular, which has always been less fashionable than other parts of the business such as equity PB.
The Swiss National Bank (SNB) debacle was the most obvious of these. FX funds suffered considerable losses, as did the prime brokers servicing them, with those that had built up the biggest balance sheets suffering the most, via the leverage they offered.
Even before that, new capital rules were making the business more expensive for banks, forcing them to rethink their approach. One head of FX PB at a top-tier bank says SNB accelerated a process that was already under way by around six to 12 months.
The banks were always going to tackle the issue by the end of this year, with new Basel III capital requirements coming into effect in early 2017. Many are still working on this, meaning 2016 is likely to see more changes to the business.Jack Inglis, CEO of the Alternative Investment Management Association (AIMA), says: “There is no doubt that the Basel III banking standards are having a significant impact on hedge funds and other alternative asset managers. Financing costs are rising and the fund manager / prime broker relationship is changing fundamentally.” According to an AIMA survey of global fund managers worldwide, financing costs have risen for 50% of firms, with 75% of respondents expecting further cost increases over the next two years. Three quarters of them also said they have been asked to change how they do business with their prime brokers, while more than 67% have had to cut the amount of cash they keep on their brokers’ balance sheets.
The most important result of this industry-wide business review to date has been the impact on pricing, which has become more defensive. Commissions have gone up, with many in the business acknowledging they might go up further.
Banks have also recognised that increased electronification and algorithmic trading means the subsidy many trading desks offered to their PB units no longer makes sense.
The PB banks are now much more selective about the business they do. Some, such as Credit Suisse, have exited FX PB altogether, preferring to focus their energy on other areas. Others remain, but with a new strategy of cherry-picking the biggest and most profitable clients, or offering it only as part of a package alongside other PB business.
This has left new entrants to the market, predominantly prime-of-prime (PoP) houses, which act as a middleman between the bank and the client, but are themselves clients of the bank. They leverage their balance sheet and pass on their services to the smaller funds.
Clients seem, so far, to have accepted the rationale for rising prices for PB, and no longer expect this to be the main area of competition between providers.
Peter Plester, head of PB at Saxo Bank, says: “A few years ago, clients were primarily focused on price and leverage. It was always seen as good to secure the maximum amount of leverage, even for those not planning to use it.
“Today, those are not the most important factors for clients – the first questions they ask are about things like service and technology.”
One head of FX PB at a large European bank agreed that these two, formerly all-important factors have become less of a focus among clients. While price remains important, he says, banks have a clearer idea what the bottom line is for them in terms of ensuring the business remains profitable, and are less willing to get into a race to the bottom on fees to win business.
However, one prime broker at a top-tier bank cautioned that PoPs might view things differently. Some might be making the same mistakes as banks, he warns, by underestimating the risk of the business they are taking on as they look to increase market share.
The PoPs dismiss this suggestion. Rising commissions already mean prime brokers are being paid more for the risk they take, they say. However, more importantly, many of the PoPs, as well as the bigger banks, have invested heavily in better risk-management systems, benefiting themselves and their clients.
Patrick O’Brien, communication director at Exante, says: “Most of the quality and trusted brokerages like Exante have made significant investments in real-time risk visibility systems, so that if there is another SNB type incident they can react.”
Plester agrees, saying: “Risk management is the biggest theme in PB at the moment.”
This is partly because the market has become so risk averse, especially since the SNB crisis, but particularly evident again in recent months as traders fret about China. It also demonstrates how the industry as a whole had been neglecting risk management. Investment in this area was long overdue, and offered a substantial return on the investment.
|Peter Plester, Saxo Bank|
Saxo’s flagship technology upgrade offers clients pre-trade risk controls, among other services such as liquidity optimization. Pre-trade risk controls enable Saxo to provide them access to credit and liquidity without exposing itself to undue counterparty risk, while preventing clients from breaching their own position limits, with only a small impact on latency.
Few dispute the value of this innovation, though some question whether it will be necessary in all cases. For some it might prove impractical and expensive, says one prime broker at a big bank, for example where clients trade on a limited number of exchanges.
There might be some push back from clients on cost, he says, while the biggest beneficiary is the prime broker given the corresponding reduction in risk. It might therefore be a service best offered selectively, he says.
Other providers emphasise different advantages of technological evolution.
O’Brien says: “Technology has certainly allowed for higher velocity programs and strategies in this market, resulting in higher volumes, which give clients a greater foundation for aggressive pricing.”
So while prices have increased, and might have further to go, providers insist clients are still getting value for money as service improves.
Raj Sitlani, managing partner at IS Prime, says: “The cost of the business has gone up and, of course, this has been passed downstream to clients, but overall it is a clearer and more efficient market now.”