Citi Report Advocates New FXPB Pricing Model

Incoming regulations will increase the cost of FX prime brokerage (FXPB) services and all market participants – including executing brokers (EBs) – will have to share these costs, says a new report from Citi.

The report, Collateral Damage? How Uncleared Margin Rules Will Revolutionise the FXPB Business Model, argues that FXPB is entering a “new market paradigm” driven by upcoming regulatory requirements that will increase both the value proposition and the cost of the services that they provide.

The Uncleared Margin Rules (UMR) alluded to in the title of the report require market participants to post and segregate initial margin (IM) for derivatives transactions, including FX forwards, swaps and options, that are traded bilaterally. Currently, only firms trading an aggregate notional daily amount of $1.5 trillion of derivatives are subject to UMR, but that threshold drops to $750 billion in September of this year and then down to $8 billion in September 2020, meaning that buy side firms will increasingly get swept up in these rules.

Source: Citi, “Collateral Damage? How Uncleared Margin Rules Will Revolutionise the FXPB Business Model”

The Citi report notes that, upon first glance, UMR looks like bad news for FXPBs because posting IM to both their clients and executing brokers whilst also segregating the margin that they receive will impose a drain on liquidity and add significant funding costs on what is already a capital-intensive business. In addition to this, many firms could look towards central clearing as an alternative because by putting more FX products into clearinghouses firms can reduce their bilateral exposures and therefore get back under the UMR threshold.

However, while the authors of the report state that the migration of some FX products towards central clearing “is inevitable and welcome”, they claim that there are certain products that clearinghouses simply aren’t capable or commercially interested in clearing. In particular, they say that existing infrastructure gaps in the market make the clearing of physically settled products, such as FX options, unfeasible on a large scale right now.

Further, the Citi report argues that UMR will make capital efficiency a more prominent concern than ever for market participants and therefore, with no viable clearing solution for certain FX products, the services of FXPBs will become “more valuable than ever”.

The bad news for these market participants is that the cost of these services is set to increase, according to the report. The good news is that it claims that the increased efficiencies the FXPBs offer might more than negate these costs.

“Funding costs and FXPB pricing will inevitably increase to offset these regulatory challenges. However, by consolidating activity with an FXPB, the netting benefits achieved and capital saved by recognising offsetting trades under an approved UMR model such as ISDA’s Standard Initial Margin Model (SIMM) will far exceed these new FXPB costs,” says Citi in the report.

Indeed, these potential efficiencies has FXPBs eyeing new client segments such as asset managers, as Profit & Loss has previously reported.

However, one of the more interesting elements of this report comes not when it is highlighting the benefits of the services that FXPBs can offer existing or new buy side clients, but when it argues that they have “vastly overlooked” they value that they already provide to EBs, who currently pay them nothing in return.

Source: Citi, “Collateral Damage? How Uncleared Margin Rules Will Revolutionise the FXPB Business Model”

“In today’s model, FXPBs allow competitive execution desks to trade and monetise bid/offer with their clients without having to assume counterparty risk or the resulting regulatory capital and balance sheet costs associated with client-facing activity. In addition to insulating EBs from client counterparty risk, FXPBs also deliver operational efficiencies to their EB counterparts by allowing them to consolidate and net settlements and other cash flows. For some unexplained reason, EBs have not traditionally compensated FXPBs for this undeniable value-add. In the FXPB model, risk and capital are continuously pushed onto the balance sheet of the FXPB, and it is assumed that buy side fees alone will cover this cost,” says Citi in the report.

It adds: “Under the new UMR regulatory construct, this imbalance can no longer be ignored.”

The report draws parallels with the cleared model, stating that, like central clearing counterparties (CCPs), FXPBs stand between two parties to a trade, functioning as the buyer to the seller and the seller to the buyer. But while in the futures and cleared derivatives markets, EBs pay for the capital/balance sheet, operational and risk benefits that CCPs offer, currently they do not pay FXPBs. Given that in the context of UMR FXPBs will offer identical benefits, the report claims that “EBs should pay their fair share”.

Speaking to Profit & Loss, Christopher Perkins, global head of OTC clearing and FXPB at Citi and one of the authors of the report, explains that charging EBs is best way to maintain a structural balance in the market at a time when new regulatory requirements are undeniably set to change the economics of FXPB businesses.

“You need to have an equilibrium where all the players in the system share in the costs and share in the risks, this is good for market structure,” he says.

The fact is, adds Perkins, that FXPB’s costs are going up in the face of UMR, it’s in everyone’s interest to have healthy FXPB businesses operating in the market – especially in light of the new requirements – and therefore it makes sense to share some of these costs with the EBs.

He continues: “I hope that this approach will re-establish equilibrium at a time when the changes that are coming can’t be ignored. You can’t just put your head in the sand and think that the uncleared margin rules are not going to have an impact on this business model because they are – certainly for options and NDFs, spot is a different story.”

Discussing how the fee charged to the EBs will be calculated, Perkins explains that it will be based on the return on capital that the FXPB business is seeing.

“Every time we trade there’s a return on capital metric and so we need to price in order to ensure that we can meet our return on capital. Now there’s actually a number of ways that we can work with the EBs in this regard to reduce the fees by eliminating various capital requirements. Compression and central clearing are two great examples. The fact that we will price based on capital returns could incentivise more EBs to focus on compression and central clearing because either the fees come up or the amount of capital we have to deploy needs comes down. One way or the other, we have to meet our capital return targets,” he says.

Of course, one potential unintended consequence of charging EBs for FXPB services is that it could lead to them effectively passing that cost onto clients by widening their pricing. However, Perkins thinks that the competitive nature of the FX market will prevent this from happening.

“One of the beautiful things about the market is that bid/offer matters, and it’s very competitive. If an executing broker misprices then the client will likely trade with somebody else. Since we expect to price based on returns, executing brokers should be incentivised to work with FXPBs to optimise capital,” he says,

Perkins is also quick to swat away any questions about whether Citi’s FXPB businesses unilaterally beginning to charge EBs could cause these desks to avoid trading with them.

“Look, if their business model dictates that they can’t pay a ticket fee to compensate for the value we’re providing them, that’s their business decision. But the point of the matter is, the economics here are real and the costs need to be allocated. Should all that cost be dumped on clients? Personally, I don’t think so, because they’re not the only ones benefiting from this arrangement, the dealers are too. So why should they get  these undeniable efficiencies for free?”

Galen Stops

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