Over the past few years, some FX prime brokers have gone from aggressively competing for market share to off-boarding clients and increasing their fees. What happened to make the pendulum swing so dramatically, and is it due for another reversal? Galen Stops reports.
Relatively speaking, it wasn’t all that long ago that banks were aggressively trying to build out their FX prime brokerage (FXPB) businesses and competition was fierce. This precipitated a race to the bottom in terms of fees by some FXPBs. Numerous market sources claim that Morgan Stanley was at the forefront of this race, although they note that a number of major FXPB players were not far behind.
“Morgan Stanley was one of the firms mispricing, but to be fair they were doing it off the back of a wider strategic goal, which was to build market share. They might have been looking at FXPB as a loss leader that was potentially being subsidised by another part of the business, like equity PB, and the plan was to monetise it once they had market share. That’s a perfectly valid strategy, I think the problem was that everyone else got dragged into it,” says a source who worked in sales at a top tier FXPB during this time.
Sources that were at two of the FXPBs embroiled in this pricing battle say that fees got so compressed that some HFT customers were paying their banks 85 cents per million for FXPB services.
“You had to pay about 35 or 40 cents in CLS costs, and then with back office costs and internal processing it probably went up to about 75 cents, so when you’re making 85 cents per million, the margin was non-existent. On top of this, you’re giving this pricing to firms that could seriously damage the bank if something went wrong, so it didn’t make a lot of sense,” says one.
A race to the bottom is rarely a winning strategy for anyone, and it certainly frustrated some FXPBs in the market.
“It was difficult to understand how other firms were pricing certain deals,” says Nathaniel Litwak, managing director, head of FX prime brokerage, Americas, at BNP Paribas. “While it felt bad to lose certain deals, as a business operator, it didn’t make sense. I know what our costs are and these deals were being priced below our costs.”
Likewise, Marcus Butt, head of FX prime services at NatWest Markets, says that during this time, there was a significant amount of business that his firm let pass, because they didn’t view it as being profitable.
“I think if you’re trying to build a business, it could be attractive to print high revenues and gain market share at the
cost of bottom line contribution,” is his explanation for the mentality pervading some firms during this period.
And Then SNB Happened…
Two main factors caused a sharp reversal in terms of FXPB pricing trends and to whom the banks were willing to offer these services. The most obvious shift occurred shortly after the Swiss National Bank (SNB) decided to pull its peg to the euro in January 2015 – the market was caught wrong-footed and many trading firms suffered significant losses, along with certain FXPBs that had been charging low margins to their clients in an effort to attract business.
Market sources frequently discuss the evolution of FXPB in terms of “pre-SNB” and “post-SNB”, indicating the extent to which this marked a turning point for these businesses.
Subsequent to the SNB event, a number of the larger FXPBs began a process that one refers to somewhat euphemistically as “rationalising our client footprint”. The reality is that this involved telling clients that either weren’t meeting minimum standards, didn’t have enough capital behind them, were considered too risky or simply deemed to not be a strategic fit for the franchise, that the bank would no longer be offering FXPB services.
“After the SNB event there was a shift – risk and oversight departments started to increase control of the trading floor and credit officers started getting involved. This caused a shake-up predominantly in the prime brokerage space, but it also had an impact across trading in general,” says Roger Rutherford, COO at ParFX.
“Because of Basel III, everything was tied back to balance sheet and so every business was forced to look at their clients and the profitability of their clients in a different way.”
And yet, while the SNB event was certainly a catalyst forchange, it wasn’t simply the financial losses suffered by some FXPBs during this event that caused them to start reducing their client count.
One issue highlighted by the SNB event was that many FXPBs did not have an accurate conception of their cost base. Some current and former staff at FXPBs admit that the service became badly priced, in part, because the banks were not accurately measuring the full cost of delivering a PB ticket. Some of these businesses had not factored processing and infrastructure costs into their metrics, looking at how much revenue the business was generating without giving adequate consideration as to how expenses such as Swift fees might
ultimately eat away at the revenue.
On the risk side, some FXPBs got stung in certain instances because they didn’t have a full and complete understanding of the customers that were using their service.
“There were brokers claiming they were prime-of-primes (PoP) and that they didn’t take the other side of trades or run a book, but the problem was some of them actually were. Then there were brokers at the retail end of the spectrum where the bit of the business that the PB was seeing was the externalised part only, they didn’t have visibility into the risk managed part – because these firms were internalising and market making and so didn’t need to clear that through a PB – so the PB didn’t have visibility into the full business model,” says the former FXPB salesperson.
Another problem that came to the fore after the SNB event, according to a source at one PoP, is that FXPBs realised that some of their technology was not up to scratch.
“What happened with SNB wasn’t just a credit or risk issue, it was also a technology issue,” the source says. “FX is a realtime market, it can move pretty quickly, and all of these PBs were running their business on a T+1 risk model, so it was a technology problem.”
The source continues: “A lot of these firms are now moving their risk technology scanning process further up the trade process cycle, closer to real time. A lot of the top tier PBs are looking to margin and risk manage their clients on a more realtime basis, which gives them better control and greater comfort in offering their services out to clients, but they’ve still got a long way to go.”
As previously stated, the SNB event acted as a catalyst because even before FXPBs were beginning to view clients – and more importantly client profitability – through the prism of the new regulations coming into effect, specifically under Basel III.
The Basel III requirements impact bank PB businesses in three key ways. Firstly, the increased capital requirements
force banks to more carefully consider how much capital they are willing to allocate to which businesses, relative to how much revenue they provide. Secondly, new liquidity metrics such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR), increases the duration of prime brokers’ financing, which in turn increases costs. Thirdly, the proposed leverage ratio in Basel III reduces the availability of balance sheet for client business, making this balance sheet more expensive to access.
“Post-SNB and post the leverage ratio requirements, the market fundamentally changed overnight to a place where capital and counterparty risk were the foremost consideration. This meant that it had to be both re-analysed and re-priced with capital and costs under the lens,” says Jason Vitale, COO of the FX business and head of client execution servcies at BNY Mellon.
“I think that the customers are realising that the door is not open everywhere anymore, if you want credit with the top banks in the market you have to pay for it.”
This contributed to some FXPBs pulling back and, according to one market source, was the reason why Credit Suisse exited the business segment altogether. The source says that, following a senior management change at Credit Suisse, each division within the bank was underpressure to show that it had made significant strides towards reducing the balance sheet it consumed. The source says the FXPB business at the Swiss bank was ticking along fine, but hadn’t produced much uplift in the FX flows there because of the profile of its FX desk, and as a result it was cut completely. The source opines that the Credit Suisse FXPB desk was “something of a sacrificial lamb” to get the broader business division within the balance sheet parameters dictated by senior management.
Banks weren’t just re-evaluating business internally though. They also began re-evaluating what client business was the most profitable to support under the new rules – and what was the least profitable.
“Because of Basel III, everything was tied back to balance sheet and so every business was forced to look at their clients and the profitability of their clients in a different way,” says Tony Dalton, global head of FX at RJ O’Brien & Associates, and former global head of FXPB at Bank of America.
The easiest option when re-evaluating which clients to keep and which ones to off-board was to simply look at their
profitability to the bank as a whole. Even if they didn’t do a lot of FX trading, it made sense to maintain FXPB services to clients that did a lot of business with the bank in other asset classes.
Additionally, FXPBs were more inclined to keep low revenue generating clients if that revenue only represented a
small share of the overall client wallet, in the hope that a larger percentage of that wallet could be won later.
Dalton argues that such an approach disproportionately favoured big, cross-asset firms and disadvantaged a number of FX-specific trading firms that were good clients, however, even with the new capital requirements taken into consideration.
“There were some clients that only traded highly liquid products with short tenors that didn’t have a significant impact as far as balance sheet was concerned,” he says. “And some clients were only trading spot FX, so they weren’t really using any balance sheet and the business wasn’t charged back for the credit to support that type of business at the time. When the banks’ FXPBs were reducing their client base, they got rid of a lot of these clients – who weren’t using balance sheet and were profitable – along with the ones that they needed to get rid of because they weren’t producing enough revenue across the bank in line with their access to bank balance sheet. It felt like some of the banks were throwing the baby out with the bathwater. The banks were trying to solve for balance sheet usage and related profitability and they ended up off-boarding clients that didn’t cause problems in these areas,” he adds.
Despite this, Dalton says that a number of FXPBs did broadly need to reduce their client base to a certain degree, and he is not alone in this opinion. Butt says that the SNB event and the Basel III requirements forced FXPBs to stop looking at top line revenue generation and start looking at bottom line contributions, leading to a more sensibly priced commercial environment where banks have a better appreciation of both their costs and risks.
Similarly, Rutherford comments: “The pendulum was too far to the risk side – it had become a low ticket fees, low margin, high risk and high volumes game. After the SNB crisis, the pendulum swung all the way back in the other direction – prime brokers felt that the previous model wasn’t sustainable. They became very risk averse and their credit departments were having a much bigger say in the business. But now I think the pendulum is slowly coming back to the centre, where prime brokers have a bit more control over their business and are looking to expand again.”
If this assessment is accurate, then it’s good news for the FXPBs, but what about the trading firms that have either had to find a new way to access the wholesale FX market or have seen the cost of trading rise significantly because of re-priced prime broking fees?
One former FXPB concedes that their firm was forced to have some hard conversations with clients at the bank as they began re-pricing, but argues that the industry has moved to a point where the majority of clients understand the value the banks provide from a counterparty credit perspective and that the previous low cost environment was not sustainable.
The source adds that the banks have been working to articulate to clients on how the regulations are impacting their FXPB businesses, going through the implications of the rules trade by trade, exposure by exposure, to explain why a price adjustment needs to be made in order to maintain that relationship.
Additionally, a source at one hedge fund in New York explains that most buy side firms simply don’t have the leverage that they previously enjoyed when trying to make demands of their FXPBs.
“I think that the customers are realising that the door is not open everywhere anymore, if you want credit with the top banks in the market you have to pay for it. For a long time people could just say that they were going to take their business somewhere else and they had that leverage, but not anymore. That’s the shift in the equilibrium that’s happened, but on the PB side they need to be more sophisticated about explaining to clients the implications that their trading has ontheir balance sheet,” the hedge fund source says.
Although a number of sources widely agreed that the balance of power has, generally speaking, shifted away from the clients and towards the FXPBs, it seems that not everyone has got the memo. A senior figure at one bank recounts how a large hedge fund recently demanded pricing that would have left the FXPB business breaking even, while simultaneously requiring a long-term commitment to the business from the bank.
“These things are almost diametrically opposed: you don’t want us to make any money, but you want us to be around for a long time,” the bank source says, adding that these days, such firms represent the exception, not the rule: “I can honestly tell you that most clients that I speak to value longevity over paying slightly more for the business.”
One head of FX at a large trading firm concedes that they do throw the firm’s weight around when discussing PB pricing and arrangement in order to secure the best deal possible, but adds that ultimately, they understand that the FXPB also needs to be profitable, saying, “Look, we don’t want the FXPBs to go away, so we’re happy to find a balance where they can also make some money.”
“I’ve certainly seen a number of the tier one PBs that were previously off-boarding clients as quickly as possible begin to crawl back out of the woodwork and begin re-engaging with clients.”
This balance is key. Rising FXPB fees have been more of an issue for firms using HFT strategies because the profit margin on their trades is generally so thin, while a senior figure at one non-bank market maker says that although the firm is not haggling over pennies when it comes to PB fees, there is a point at which increases start to eat into the firm’s P&L.
Ultimately, the FXPBs and their clients need to strike a balance that allows them to form a mutually beneficial partnership. In some instances, this might require the FXPB to end up flat on a client in the knowledge that the benefit this client is delivering is a boon elsewhere in the bank’s franchise. In some instances, it might require clients to pay more because they understand how their trading impacts the bank’s cost base and because they value maintaining a long-term relationship with that bank.
A New Equilibrium
Anecdotal evidence certainly seems to suggest that the pendulum is swinging back towards FXPBs growing their
businesses and expanding their client base again, albeit in a much more circumspect manner than before.
“The pendulum won’t swing all the way back, because the fundamental reason for the shift that we’ve seen is rooted in changes in market structure and regulation,” says a senior figure at a US bank. “But I think that the FXPB ‘heavyweights’, have become more comfortable about their balance sheet requirements for a customer and the revenue expectation for a customer – those things are starting to crystalise,” .
Similarly, a source at a UK bank comments: “Will FXPB make a comeback? If by a ‘comeback’ you mean a return to the previous situation, then the answer is clearly no. What happened is that some banks over-extended liquidity and balance sheet, but now I think that there’s a more rational and quantitative approach to liquidity and balance sheet cost, and I think that overall things are better priced. This framework isn’t going to change now. But there is a need for FXPB and there is room for it to grow.”
One prime-of-prime (PoP) provider says this newfound approach and understanding of the true costs of providing FXPB services is leading the tier one banks to begin re-engaging with the market in a more significant way.
“I’ve certainly seen a number of the tier one PBs that were previously off-boarding clients as quickly as possible begin to crawl back out of the woodwork and begin re-engaging with clients, and I include even the ones that were the most badly bitten by the SNB fiasco. There is definitely a thawing of major banks’ attitudes towards FXPB services, which isn’t necessarily a brilliant dynamic for us,” the PoP says.
Indeed, one US hedge fund describes how the firm was offboarded from their FXPB following the SNB event and
subsequently moved to another, only for their original FXPB to recently enquire if they would be interested in coming back to the bank.
While some of the biggest FXPB players have shed some less profitable clients over the past couple of years, they clearly recognise the value of the FXPB business to their overall FX and bank franchise.
“Deutsche Bank values client relationships and FXPB is an integral part of meeting the needs of those relationships, along with the FX execution relationship, cross-margining and operational efficiency solutions,” says Russell LaScala, co-head of FX at Deutsche.
Meanwhile, some of the traditionally smaller FXPBs are clearly looking to take advantage of the supply and demand skew for FXPB services that currently exists and have in many cases been quietly scooping up the clients that were, for whatever reason, off-boarded by other banks.
In other cases, banks have off-boarded clients, but have referred them to PoPs, meaning that they can still derive profits from this client because these PoPs ultimately rely on credit from the banks.
Causes for Optimism?
Credit conditions in the FX market are still constrained to a degree, however, and it seems that some market participants expect things to get worse. In a recent survey conducted by Profit & Loss, 50% of respondents said that they expect accessing credit to become more difficult over the next 6-12 months, compared to 17.7% who said the opposite.
In terms of expectations regarding FXPB growth, survey respondents were more divided. In total, 25% said that they expect the number of FXPB clients to remain stable, while 37.4% said they expect FXPBs to expand their client footprint in the next 6-12 months, the exact same percentage that said they expect FXPBs to reduce their client footprint during this period.
Despite this mixed sentiment, there are certainly reasons to be optimistic about the future of FXPB businesses. Yes, regulations have made offering an FXPB service more expensive, but at the same time new margin rules regarding uncleared derivatives products could open up new client segments to these businesses. In addition, evolving technologies – such as new pre-trade credit and risk controls, compression and distributed ledger technology – could build new efficiencies into FXPB businesses, making them more profitable.
Expect the pendulum to keep swinging but, hopefully for the sake of the market, less violently than before.