The past year was one of the most difficult ones for the industry as the wider regulatory crackdown in the EU signalled big changes to the FX industry. While geographical diversification was a theme throughout 2017, this year is finally set to bring us the new European regulatory framework.
After reporting on the new FCA changes to capital requirements related to negative balance protection for retail clients, we asked a set of questions to some representatives of the prime of prime industry. While limited, the spillover effects from the retail to the institutional-focused market are likely to cause short-term changes to some business models.
Following are the opinions of the top executives of three major prime of prime providers: CFH Clearing’s CEO Matthew Maloney, IS Prime’s Managing Partner Jonathan Brewer and Stater Global Markets’ CEO Ramy Soliman.
From risk-management insights to the rapidly increasing expectation for further consolidation in the industry, some of the top institutional players in the market have shared their opinions about the shifting regulatory landscape on the market.
ESMA Regulatory Framework and the Prime of Prime Market
How do you think that the new ESMA regulatory framework will affect the prime of prime market?
Jonathan Brewer: Some of our clients already give negative balance guarantees and the main impact of this has been on retail client behavior. It has led to a number of retail clients looking to game this particular parameter, by over leveraging on the long side with one broker, and over-leveraging on the short side with another, safe in the knowledge that a sharp market move will give them profits on one side, and that they will not be required to fulfil their obligations on the side that goes against them.
These are the sorts of synthetic trading behaviors that we regularly identify on behalf of our clients within our risk management consultancy offering, and brokers who are not alive to this sort of issue will find that they will have a dent in their bottom line. These aspects become more relevant to STP brokers now, whereas previously they were the principal concern of internalizers.
In general, I am not convinced that retail brokers have ever provided services to their clients in the expectation that they will be able to recoup funds in the event that a retail client goes into negative equity, so in practice I feel that the regulatory change actually makes little difference to their day to day risk dynamics.
We do not anticipate that there will be a significant impact on our business. We actually anticipate that the effect of this regulatory change will make our product offering even more relevant to the sort of client that is most affected.
Ramy Soliman: The ESMA proposals are linked to firms that service retail customers (a customer segment that most Prime of Primes do not service directly) but the impact will be on an important customer group, retail aggregators. It is important to recognize that nothing has been finalized yet. These are ESMA proposals and the FCA is considering those proposals. What is clear is that there will be a future impact on retail facing firms going forward when applying the finalized framework to their existing risk management processes.
I think that the ESMA suggestions will increase the consolidation in the space as the under-capitalized retail facing firms find it more difficult to comply and the requirement for prudent risk management increases. Both are positive for the end retail customer and for some of the Prime of Prime market as they should act as that venue for externalization and risk transfer to the market and so volumes to Stater and our peer group from the retail aggregator segment should increase. At Stater, we foresaw this market change and have diligently built our platform specifically to service this requirement from brokers that need to adapt or refine their existing business models.
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Matthew Maloney: Any regulatory change brings uncertainty, and in times of uncertainty there is often a flight to quality. CFH is seeing a marked growth in inbound approaches from firms seeking to take our front to back product offering, not just in the EU but globally.
FCA New Capital Requirements
With some brokers forced to look for additional capital or offload negative balance risk to prime of primes, do you think that the latter is a feasible solution? Will PoPs accept business from 125K brokers?
Matthew Maloney: It is inevitable that the proposed changes will alter some firms’ risk appetite. Strongly capitalized firms such as CFH Clearing are well positioned to provide brokers with both liquidity and risk management tools to help them successfully comply with any new requirements.
Ramy Soliman: I don’t believe that Prime of Primes will be willing to directly take on the negative balance risk but we are working with brokers to help find solutions to help them efficiently manage their risk transfer. Regarding facing 125k firms, it’s important to make sure that the firms are adequately funded and risk managed.
By definition, if a firm is a 125k, then we don’t need to worry about a poorly managed risk book which can be a bigger risk for Prime of Prime brokers. The point is that retail brokers need appropriate capitalization and risk management for the customer segment they face and counterparties they face to manage their risk.
Jonathan Brewer: In my experience, our main competitors are not that discerning about the sort and quality of business that they take on, so I would not anticipate that PoPs will stop accepting business from 125K brokers as a result of these changes.
There may be a requirement from some 125K brokers for their Prime of Prime to bear the negative balance guarantee risk, and there are certain circumstances in which we would be prepared to do this. We have the benefit of having a very flexible product which enables us in some cases to get very closely integrated to the operations of our clients, which means that we have access to the quality of information that enables us to take a well-informed decision, based on sound risk principles.
Compressing STP Profit Margins
With the profit margins in the STP market compressing, how do you view the sustainability of the PoP business in an environment where the maximum leverage is 1:30 and counterparty risk mandates negative balance protection?
Matthew Maloney: A diversified PoP business is likely to generate only a proportion of its income from these sources. Over time, the businesses that will succeed are those with their own efficient and low marginal cost platforms as they are able to better manage tight profit margins.
Ramy Soliman: The true Prime of Prime business is predicated on volume that is externalized to us. The ESMA steps, particularly lower-end client leverage incentivize higher externalization by prudent operators. In the retail world, Japan operates on lower leverage and is a very large market for forex trading so there is a good opportunity for all market participants, those that service retail customers and those Prime of Primes that service retail aggregators and provide intermediation, liquidity, risk management and so on.
Jonathan Brewer: The new regulation will have some unintended consequences, it will drive a number of retail clients into the arms of offshore unregulated brokers, who will still be able to offer 100x leverage and more. It will also create an artificially skewed incentive for retail brokers to take on more risk because they are being forced to take on more credit risk, which they may conclude supersedes the market risk of internalizing.
There will always be a place for STP brokers, as there will always be end clients who value the benefits of this model, but it is highly likely that these new regulations will have an adverse impact on STP retail brokers.