Credit Agricole Indosuez (CAI) is stepping into the FX prime brokerage business, a market that it believes has yet to realise its full potential. Dominated by a select few ‘ notably AIG, ABN Amro Bank and the former Bankers Trust (now Deutsche Bank) ‘ CAI plans to be at the top of this list very soon.
The bank is launching an FX prime brokerage business this month, after several months of preparation led by manager Keith Gill, who joined the bank from ABN Amro in July. Gill is no novice to the trade ‘ he spent 11 years with Barclays, where he ran margin trading and set up the first FX prime brokerage facility in London before moving to ABN Amro in 1997, where he started a leading FX prime brokerage business from scratch.
So what is FX prime brokerage?
FX prime brokerage was first developed by Futures Commission Merchants (FCMs) such as Refco, PruBache and Bear Stearns, which benefited from their strong relationships with Commodity Trading Advisors (CTAs) through their futures operations.
However, these FCMs have been unable to compete on credit terms with the larger commercial banks, so a few major players today dominate the top-end of the market. AIG was the first large, creditworthy institution to enter the market, followed about two and a half-years ago by ABN Amro and Bankers Trust. Other banks in the market include Barclays, Chase, Bank of Montreal and WestLB. Several other major banks are said to be looking into establishing a presence.
FX prime brokerage enables a fund manager to source his FX liquidity from whichever bank he wants (within pre-agreed limits) and yet, he only has to place collateral with one institution. Some of the main benefits of FX prime brokerage include enhanced execution, simplified collateral management and a reduction in operational risks associated with numerous back office relationships.
“The problem of inefficient execution is a serious issue for fund managers who raise money from a wide source of brokers or banks,” explains Gill. “This is because the banks or brokers generally insist that the FX relating to the capital raised by them should be traded through their own FX desks. This in turn leads to the problem of having to trade with multiple banks each time these fund managers want to execute trades, leading to undue slippage, which adversely impacts the fund manager’s trading performance.”
Gill notes that one fund manager claims to be losing as much as 2-3% off its trading performance each year due to slippage, which can amount to millions of dollars for the largest fund managers.
The product appeals primarily to FX fund managers ‘ hedge funds, CTAs and currency overlay managers ‘ because their investors generally lack the credit status to obtain delivery limits.
But CAI sees scope for an even broader customer base. “Whilst FX prime brokerage is not yet an established product within the corporate and more traditional fund management markets, a number of large corporate treasuries have expressed an interest due to the significant operational and risk management benefits that this product offers,” says Gill.
“With FX prime brokerage, all trades originated with third party banks are channelled through the prime broker, who acts as principal to both the third party banks and to the fund managers’ investors. The fund manager would pay brokerage to the FX prime broker for assuming the settlement risk on its behalf, as well as for providing the related operational services. So for small organisations that lack substantial operational infrastructures, it enables them to focus on trading rather than operational risk issues,” Gill adds.
FX prime brokerage also eliminates problems associated with executing by means of the currency futures markets. “The lack of liquidity in currency futures means that the larger players are unable to satisfy their execution requirements in this market. From a pricing point of view, even the development of Exchange for Physicals (EFPs), which enable fund managers to tap into the liquidity of the cash markets and clear through futures exchanges, hasn’t been wholly satisfactory because of the charges levied by the exchanges for clearing cash originated currency futures. Consequently, clearing FX in the cash market can be more cost effective.”
One reason so few banks have entered the business, says Simon Eedle, CAI’s London-based treasurer, is because they don’t know where to put it. “It’s a hybrid business ‘a back office type of product ‘ but the question is, does it belong in the front office, back office or alongside the futures business? It also needs to be run as a separate business ‘ Chinese Wall rules apply, because of the implications of a fund manager dealing directly with a bank that is also its prime broker. A lot of banks are looking at prime brokerage, but they are still grappling with these issues,” he says.
FX prime brokerage is also very operations intensive. “There is a lot of documentation and you need very robust systems,” adds Gill.
CAI’s FX prime brokerage business will be run by a 24-hour, five-man desk headed by Gill in London, which will increase to eight over the next year.
“There is a clear need for this type of service in Europe, where the market is less developed than it is in the US,” says Gill. “We feel CAI is well-positioned as the first dedicated FX prime brokerage business that we are aware of in this time zone. Nevertheless, our operational infrastructure will be fully equipped to service the important US market as well.”
“We also see a very good opportunity in Asia, where CAI has historically has had a strong presence,” adds Gill. “It isn’t a product that has been sold there, but there is strong demand from second tier financial institutions which are unable to obtain unsecured settlement limits.”
Icing on the Cake
One of the things that attracted CAI to the FX prime brokerage business is the strong franchise that already exists within the bank for the provision of services to the FX fund management industry. “FX prime brokerage is an important new product we can offer them,” adds Gill.
There are three major advantages for the prime broker: 1) it is a fee income business because the majority of business is for less than 14 days maturity so there are generally no formal capital requirements; 2) the institutional sales desk can leverage off these relationships; and 3) it provides transparency. “Number one justifies the business and numbers two and three are icing on the cake,” says Eedle. “We have a much better view of what our clients are doing ‘ we don’t just have a snapshot ‘ we see the whole picture from a risk management point of view.”
But there are many other important issues that any prime broker must consider. For example, if it is to handle all the foreign exchange that a CTA trades, that bank must be able to provide a service in all the tradable currencies, including NDFs.
He adds that there is strong demand for options clearing, but very few banks offer a service at the moment because the capital and risk implications are more far-reaching than straightforward FX. However, he believes this will develop as banks increase their expertise in this field.
Eedle says CAI is in a good position to offer an FX prime brokerage service because of its strong credit rating and systems capabilities.
“FX is increasingly a commoditised business, so we see this as a way of differentiating ourselves from our competitors,” says Gill. “The ultimate goal is to establish a cross product prime brokerage capability, combining FX prime brokerage with equivalent services in futures, equities and fixed income ‘ although there are many legal and operational issues to overcome first.”