It’s not often that a prime broker exits the market, but when it occurs it can trigger an avalanche of movement in the industry as former customers rush to secure new relationships, while competitor firms scramble to scoop up clients. Such a case is currently taking place ever since the Dutch firm, Rabobank, alerted customers that it would no longer provide FX Prime Brokerage services (FXPB).

First reported earlier this month, Rabobank stated to Forex Magnates about its prime brokerage business, “The bank considers these specific activities to only partially align with our strategy. We will support the clients affected, through the diligent winding up of the relevant services.” Before the announcement, the unit had appeared to be struggling as its management head resigned and the firm broke off ties with a technology partner. Nonetheless, the exit came as a surprise to customers due to FXPB being a growing unit within the bank.

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15 Million Dollar Losses?

At the core of Rabobank’s struggles was what sources familiar to the company referred to as a “technology problem”, vulnerable to being exploited by customers. As a prime broker, customers posted collateral at Rabobank, which then extended them credit to be used among many venues, such as FX ECNs like KCG Hotspot, Currenex and FXall. The sum of the credit lines though was well above the total allowance of leverage being allowed to the credit. Relying on post trade monitoring solutions, Rabobank could view what a customer’s total aggregated positions were to ensure they remained below their credit allowance.

Depending on post trade monitoring, Rabobank and other prime brokers are vulnerable to rogue trading when a customer enters simultaneous orders to fill their credit limits across connected venues. In such a situation, firms relying on post trade monitoring solutions to determine a customer’s total position size have little control to ensure total margin allowance isn’t filled. The problem can become even greater if post trade reports are latent in being produced. While not typically occurring, during periods of volatility such as those after economic news announcements, post trade reports are known for being effected by latency of up to 15 minutes. Explaining the vulnerability, Gil Neihous, Managing Director at Fluent Trade Technologies, stated to Forex Magnates, “Today’s FX Prime Brokerage relies on weak post-trade Risk Management methodologies. This is a guaranteed recipe for a credit disaster. Do the math: A small $1 million hedge fund directly trading with 10 venues 50x credit per venue, leaves a prime broker exposed up to $500 million in credit risk with a single fat finger mistake or an algorithm glitch.”

In Rabobank’s case, sources connected to the firm explained to Forex Magnates that it was well known that the bank was vulnerable to clients over-leveraging during volatile periods, with little the firm could do to prevent it from occurring. It was added that the above vulnerability ultimately led to Rabobank’s decision to exit the market, after a client with losing positions that were well above their credit limit, put the bank on the hook for a loss that is rumored to be up to around $15 million.

“Toxic Flow”

With Rabobank out, the immediate question in the industry is who will pick up the slack to pick up their former customers. According to several insiders in the PB space who spoke to Forex Magnates, the answer isn’t so simple. It was explained that Rabobank carved out a niche of mid-sized customers in the $1-$5 million collateral range. Many of the customers were operating using algorithmic and high-frequency trading arbitrage strategies. Typically deemed toxic flow due to their predatory trading strategies, using Rabobank’s credit, customers would connect to dozens of ECNs, aiming to take advantage of inefficiencies in the market. Along with the access to an array of venues, Rabobank was known for being aggressive with its rates, thereby offering some of the lowest costs for trading. As a result, for many, replacing Rabobank means finding another prime broker comfortable with accepting toxic flow as well as offering low fees.

About the gap in the market, Fred Ponzo, Managing Director at GreySpark Partners, said to Forex Magnates, “The number of prime brokers willing to extend credit to HFT firms is dwindling, since this flow is toxic.” Although a prime broker would benefit from the commissions, Ponzo explained that for them it is a “zero sum game” since these same banks are also liquidity providers (LP). Therefore, gains the bank receives from commissions to HFT would be mitigated by arbitrage related losses in venues where they stream liquidity to. In Rabobank’s case, not known as a leading source for FX liquidity, their overall exposure to predatory HFT flow was minimal, allowing them to benefit from servicing toxic flow customers without experiencing risks to their FX market-making unit.

Dwindling Credit

Beyond the trading restrictions being applied to operators of ‘toxic flow’ models, the overall prime brokerage is also experiencing a period of reduced credit allowance. Speaking to Forex Magnates, Jasper Chua, Head of FX Prime Brokerage for the Americas at Newedge, stated, “In FX credit was a lot looser, especially in the spot space.” Chua added that now, prime brokers are viewing extensions of credit as a “function of the balance sheet of the company and its posted margin instead of just the type of asset being traded. Even though a client isn’t taking overnight positions there is still intraday exposure which needs to be accounted for.” Chua explained that firms are taking a closer look into what value a PB business provides to the entire firm. Overall, credit provided by prime brokers is an opportunity cost of funds which could be applied elsewhere. As such, prime brokers are now evaluating more closely what the best strategy is for the extension of those funds.

Prime of Primes

As a primary prime broker, Rabobank was connected directly with the tier one interbank FX market, allowing them to offer reduced fees for customers. This contrasts with prime of primes (PoP), who themselves are customers of a larger prime broker. Although PoPs onboard small and mid-sized accounts, sources close to former customers of Rabobank indicated to Forex Magnates that the issue comes down to pricing. As a result, many former Rabobank clients are struggling to find the same pricing conditions from PoPs whose strategies they are dependent on. Nonetheless, Rabobank’s exit is expected to be a boon for PoPs as they grab portions of the business that they can absorb.

Speaking to several PoPs, they indicated that they were receiving a lot of interest from former Rabobank customers. Names that appeared in discussions were FCStone and London Capital Group. Another new entrant is FXCM’s new PoP unit that was launched last week. Without offering primary liquidity themselves, PoPs are up to an extant able to be more flexible in terms of the type of trading flow they onboard. A source close to former Rabobank customers indicated that he believed pricing would ultimately keep making it difficult for PoPs to grab too much new business, and he expected firms would end up partnering with several PBs.

Newedge

Among names that have popped up as possible destinations for Rabobank customers has been Newedge. Fully acquired by Societe Generale last month after previously being owned via a 50/50 arrangement with Credit Agricole, Newedge has a reputation of providing services to mid-market clients. As such, by virtue of their typical client size type, Newedge has been linked to former Rabobank customers. However, people associated with former Rabo clients stated to Forex Magnates that although their name has come up, they didn’t believe Newedge was a serious destination to land many of these customers.

Speaking with Jasper Chua about Newedge’s core areas of strength, Chua stated that Newedge takes a holistic view of prime brokering and clearing. Rather than focus on one asset class, they aim to provide value by offering customers access to a cross-assets prime clearing services platform. Chua explained, “Having a holistic view allows customers to have products that offset each other, since unused margin and collateral can be spread across multiple assets.” In addition, Chua mentioned that Newedge provides customers with capital introductions and market research, thereby providing mid-sized asset managers and CTAs opportunities to grow their businesses. As such, without a straight focus on FX, Newedge’s PB model appears to be a more dynamic solution for former Rabobank customers.

Saxo Bank

More than any firm, the emerging player in the field is Saxo Bank and their new prime brokerage offering. Having hired former Rabobank Head of FXPB, Peter Plester, to a similar role at Saxo Bank, it puts the new division as a front runner to court former Rabo customers. Due to contractual limitations on when he could begin to work for a competitor, Plester had yet to begin at Saxo Bank when Rabobank announced it was exiting the PB market.  However, according to sources, the restrictions were eased when Rabobank announced its exit, allowing Plester to begin his new role last week.

Speaking to Saxo Bank, the firm declined to officially comment on this article about the PB unit and whether it would be equipped to offer both the low fees and credit to a wide array of venues that former Rabobank customers are known to be seeking. However, sources from the firm mentioned to us that with Peter Plester arriving you can “put two and two” together on which clients they are targeting, as well as that they are prepared to become aggressive in pricing to quickly grow the business.