B-Book Prime of Primes Are Risky for Brokers, but A-Book Counterparts Are Rare

The popularity of prime of prime (PoP) brokers has increased over the years. These financial companies provide smaller retail brokers with access to the services and liquidity of top-tier prime brokers. They can typically be large, reputable financial institutions or banks that provide services like trade execution, credit intermediation, and clearing services.

There are two types of PoPs: B-book PoP and A-book PoP. These are categorized based on the risk management models offered by these companies.

Under the A-book model, brokers operate on an agency model, acting as an intermediary between the client and the interbank market or liquidity providers. However, B-book brokers operate on a market-making model and take the opposite side of the client's trade.

The majority of PoPs operate on a B-book model. They essentially sign revenue-sharing agreements with brokers. The brokers that do not have the appetite or capital to B-book the trades with clients' losses offload them to PoPs who B-book them instead and share the revenue with the broker.

B-Book PoP Providers: Popular yet Troubled

Although such agreements between brokers and PoPs are popular, they often lead to problems, resulting in terminations. For instance, the long periods of range-bound markets, like the first three quarters of 2023, generally end in significant losses, which result in the end of such agreements and even disputes.

While such B-book PoP models are an integral part of the industry and are widely used by many brokers, they require minimal specialised knowledge or capability, which is why there has been such a proliferation of providers. However, there is a constant search for the next “trustworthy” PoP that won't end the arrangements when market conditions do not favour them.

Despite the challenges, there are many benefits of such B-book PoP models, which attract brokers to them. Some of the key benefits are:

• Low or very close margin requirements match what brokers offer their clients.

• Brokers can offload their risk.

• Standard and easy-to-understand retail profit and loss.

Another big issue with many PoP service providers is that they won't disclose that they operate on a B-book model. They often advertise that they take all types of order flows, and brokers see them as the place to dump the undesired flow. And that is when disputes and contract terminations become inevitable.

Generally, when a PoP offers retail-like terms, they B-book the trades. It becomes a problem if these are trades that the broker picked, as they aren’t the ones destined to lose.

A-Book PoP Providers: A Replacement for Bank Prime Brokers

A-book PoP providers allow brokers to hedge the flows they don’t want to B-book or to offload exposure when it breaches their risk limits. These providers specialise in enabling brokers to access a wide array of liquidity from banks, high-frequency traders, and other institutions that would otherwise require a real prime brokerage. A-book PoPs have access to genuine bank prime brokers.

Similar to B-book PoPs, A-book PoPs also benefit retail brokers. These include:

• Lower margin requirements compared to the requirements of bank prime brokers.

• There are usually no large monthly minimums, compared to the $25,000 to $50,000 per month charged by bank prime brokers.

• Instantaneous settlement of profits and losses using retail FX accounting standards instead of T+2 settlements.

• Uniform rolls and swaps.

Despite the advantages, only a few A-book PoP providers exist, as they require access to bank prime brokers. Offshore companies generally do not get access to bank prime brokers, and even the PoPs within the jurisdictions of bank prime brokers are required to show a healthy balance sheet.

Other hurdles to accessing the bank prime brokers include most brokers' lack of accounting expertise, inadequate capital to fund the differences in margin requirements, and the settlement time difference between retail venues and banks.

Retail FX firms settle profit and loss from a trade instantly and book them in the denominated currency of the accounts. However, banks settle trades at T+2 in the FX markets and settle the trades in the second currency in the trading pair. Converting currency balance residuals and dealing with settlement differences require skilled back-office and account teams.

Now, for brokers with the capital, access, and expertise, starting a PoP is a natural extension of their business. They need to satisfy their prime brokers with lots of volume and thus onboard institutional and professional clients who help in this area. The institutional clients are considered professional clients, so their money can be rehypothecated to the PB and used as collateral, unlike retail deposits, which must be segregated from the company’s monies in heavily regulated jurisdictions.