The Swiss National Bank induced crisis that hit the foreign exchange markets back on January 15th 2015 has been at the forefront of industry discussions ever since. While we have been focusing on some of the issues that affected the industry long term, there are some massive challenges still to come for brokers in the industry.
One key distinction that needs to be made in terms of liquidity is the separation of the concepts of liquidity and executing the trades and clearing and giving credit to book and hold positions. What will happen to liquidity as a result of the SNB, is behind what will happen to the clearing relationships in the prime of prime space- something that is becoming increasingly difficult to get.
With some of the tier one prime brokers pulling out, and others increasing fees, the events that unfolded a year ago mostly affected prime of primes regarding the amount of credit which major banks have started to demand from brokers. The new world order that resulted in the aftermath of the Swiss National Bank crisis is a different environment altogether.
This has nothing to do with liquidity necessarily, and the spreads through retail brokers to tier ones have not changed dramatically yet, but what has changed is the ability of brokers to access clearing relationships that are forcing a lot of companies to move downstream.
As the CEO of OneZero Andrew Ralich commented to Finance Magnates for the purposes of this article: “As clearing requirements get more strict, clients move down the clearing value chain, which causes them to need to access different pools of liquidity based on the capabilities of the clearing entity that they have.”
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If a broker had Citigroup as a prime broker prior to the Swiss National Bank event, and if the balance sheet of the company was good enough to maintain the prime broker relationship with Citigroup, the liquidity of the broker is likely very similar to what it was prior to the Swiss National Bank event.
One Year Later…
If the question that we are asking today is whether liquidity has changed, the most likely answer is no, at least for the time being. But if the question is “what has changed?”, then the answer is rather that a lot of entities that were able to access a direct aggregated pool of liquidity from big banks as a result of having a tier one prime broker, now need to access a prefabricated pool of liquidity with often the prime of primes that are on the market shifting their business model from STP to internalizing risk in order to account for the fact that their margins are tightened and they need to adjust their clearing relationships.
As Mr Ralich explained: “The liquidity at each level hasn’t necessarily changed yet, but the ability for different brokers to access clearing at those different levels has changed significantly and it is still changing.”
In the words of Chief Operating Officer at ADS Securities London, Marco Baggioli: “The environment has definitely changed after the SNB in many different ways in terms of liquidity and clearing. On the liquidity side its obvious that there has been few trends – the banks have been the traditional market makers and the liquidity providers have been analyzing more the profitability of their business by counterparty. From several venues we have been seeing banks pulling out of the markets and at the same time non-bank LPs have been stepping in and have began to play a bigger role in the market in terms of liquidity provision.”
Who’s Stepping in to Fill the Void?
What is happening as a result of the changing and clearing market is at the bottom of the value chain. From there on, we are seeing that in different areas on the way up the value chain there is a push of necessity towards internalization of risk. That will inevitably start to erode volumes moving up the value chain and it means that more toxic flow could be carried up into the tier one liquidity providers and eventually their spreads are going to have to widen to account for this.
Some risks arise to the new market making brokers that are not used to internalize flows which could create volatility in the industry. An answer to this is the emergence of other entities that are presenting themselves as worthy of providing clearing relationships.
“If the trend continues, the answer to the credit crisis following SNB is one of two things: more internalization, or new entrants to the Prime of Prime space with the right tools to operate under this new model. The quality of pricing from the top down is going to erode and we’re potentially going to see a lot more instability during non-black swan market events,” Mr Ralich explained.
The market reality is that there are other options out there that claim to have strong balance sheets, however as recent months have shown to a number of brokers, those credit relationships are not that easy to handle. What the markets demand in the current environment are well capitalized entities that are flexible and have access to a solid balance sheet. Some entities with strong balance sheets like IS Prime, SucDen Financial and others have been getting into the FX clearing space and filling the void.
In the end, it’s a matter of finding the right balance – a name that is willing to step in and accept the credit risk that exists and that people are aware of, and also has the balance sheet and the withdrawal procedures that give clients confidence that they can run a Straight Through Processing (STP) A-book model where the money is safe at the clearing entity and the broker can get access to the type of liquidity that they design their business around.