Making the Case for the Prime-of-Prime Model

The traditional assumption in the FX industry is that accessing a bank prime broker is always preferable to using a prime-of-prime. Galen Stops speaks to service providers seeking to challenge that assumption.

“One thing that’s quite interesting is that in the mindset of the FX industry, there’s a certain hierarchy,” says Jonathan Brewer, managing director of IS Prime. “There’s basically an assumption that if you want to participate in the FX market, then the pinnacle provider that you should aim for is a tier one prime broker (PB), and then you should only go and look for a prime-of-prime if, for whatever reason, your face didn’t fit at a tier one PB.”

Although to some degree this hierarchy might be psychologically driven, there are also very valid reasons why market participants might prefer an FXPB to a prime-of-prime (PoP) offering.

For starters, although some PoPs have a very sizable balance sheet, none of them can compete with those of the big international banks in this regard. The FXPBs have the most credit to give out, and can provide the client with the comfort of the massive balance sheet they have behind them.

In addition, it’s a fundamental truth in any business that every level of intermediation incurs additional costs. The PoPs are selling the FXPB’s credit, which they have to pay for and then they have to add extra cost onto that in order to make profit themselves. Therefore, if going to the source of the credit is an option, then market participants are understandably eager to do so.

However, Brewer makes the case that the service provided by a firm like IS Prime is materially different to that provided by an FXPB, and that sometimes the former will fit the business requirements of a firm better than the latter. Emphasising this point, Brewer claims that the five biggest clients at IS Prime are big enough and sophisticated enough to get a tier one FXPB, but have chosen not to, because of the ancillary benefits that they wouldn’t receive at a tier one FXPB.

Making Things Simple

Giving an example of one of these benefits, Brewer says: “If you look at a retail broker, they have a number of different aspects to their business. A retail broker is partly a trading business, so a risk business, but really a lot of them are mostly online marketing operations because the way that a retail broker improves their bottom line the most is by getting new clients in through the door.

“So the more we can reduce the burdens associated with trading and execution, the more they can focus on going after clients,” he says. “By trading through us, they only need to speak to one counterparty and one company for the purposes of execution, they only have to do one set of reconciliations, only have to maintain one relationship, etc. With an FXPB, they might have 10 banks providing liquidity, which means 10 different relationships and 10 times the work when they won’t experience 10 times the marginal gain as a result.”

Peter Plester, head of FX prime brokerage sales at Saxo Markets, is also quick to point out how PoPs can simplify clients’ operations compared to trading through an FXPB. He says that once clients complete one onboarding with Saxo, they can have direct market access (DMA) to 25 bank and non-bank liquidity providers, but to achieve the same thing via an FXPB, they would have to onboard those 25 liquidity providers separately, speaking to each one, going through the Know Your Customer (KYC) check 25 times and establish liquidity, connectivity and integration with all 25.

“They would then need to have an ongoing discussion with all of these liquidity providers about the pricing, they would also need to develop systems to analyse the pricing, reject rates and response times from all these different liquidity providers. They would need their own liquidity manager to really manage all those relationships effectively and then they might have to do things like renew their KYC with each liquidity provider if there’s a shareholder or director change at the company. It’s a lot of work,” says Plester.

Therefore, according to Plester, if a PoP can enable clients to onboard once and then have the connectivity, the relationship management with the liquidity providers, liquidity optimisation, and flow analysis provided as an outsourced service, this is a big advantage.

“In a way, clients don’t need to do all this themselves, because everything is electronic now and so the emphasis is more on the technology and being able to do the analysis and the reporting rather than on having a physical face-to-face relationship with a liquidity provider,” he adds.

Pricing Advantage

Another potential advantage that can be derived from using a PoP can be found in the pricing of liquidity. Although PoPs can’t offer their clients disclosed liquidity, Noel Singh, head of e-FX business development at Sucden Financial, says that often the aggregated liquidity provided by Sucden can be priced better than the disclosed liquidity that firms were getting at their tier one FXPBs.

He explains: “Because of the volume and value of the e-FX flow that we drive down the channels to our liquidity providers, we often receive much tighter pricing and greater skew than these clients did when they were trading directly through an FXPB. And because we don’t “A” or “B” book any of our flow, all the best prices are passed down to the customer. So there may actually be no benefit in moving to a tier one FXPB, even when they do grow to the size where they could secure one.”

The key point here is that, while clients pay more for the extra layer of intermediation, they might more than offset this by taking advantage of the PoP’s scale to receive better pricing. A firm hedging $3 billion per month between 10 liquidity providers via an FXPB, will only be able to give each liquidity provider $300 million per month, which is unlikely to lead to particularly aggressive pricing.

By contrast, a firm transacting $3 billion per month with a PoP could benefit on one side because they become a sizable client for the prime service provider and can therefore negotiate good terms for themselves.

They could also benefit on the other side because if the PoP has enough scale that it is transacting hundreds of millions, or billions, with its various liquidity providers each day, then it in turn becomes a significant client for these liquidity providers and is therefore able to secure competitive pricing that can be passed through to its clients.

Galen Stops

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