This article was written by Mitch Eaglstein, founder and CEO of FDC.
Claiming an aversion to risk, several major banks have all but abandoned a large portion of the FX market. After experiencing heavy losses during the 2008 global financial crisis, major banks grew more cautious of FX prime brokerages, paving the way for a new prime of prime market where smaller financial firms act as prime brokers for companies with $1 million to $20 million in net capital.
Following the 2015 Swiss National Bank removal of the 1.20 peg to the euro, banks experienced heavy losses which caused more prime brokers to raise their requirements to the extent that many wouldn’t consider firms with less than $50 million in company capital.
Prime brokerage services are now positioned to provide tangible benefits to FX firms and fill the void. Among the more obvious benefits of a prime brokerage is the access to liquidity they afford, allowing firms to receive interbank and ECN liquidity and benefit from the economies of scale.
Furthermore, prime brokerages drive lower trading costs: historically, in the FX market, firms would utilize multiple liquidity providers (LPs). If a client opened an account at two LPs and aggregated their feed, they would often end up with a long position at one LP and a short position at the other LP. Depending on where the market moves, one LP account will make money and the other will invariably lose.
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Balance this exposure necessitates closing out the position at the account losing money, and re-opening the position at the profitable account. When the broker performs this action without utilizing a prime broker, it typically pays the spread, which can be quite expensive – for example, a one pip spread to balance out LP accounts on a 100 million EUR/USD position will cost a firm $10,000.
Clearing the trades through a prime broker, however, allows the smaller broker to bypass the challenges of balancing accounts at various LPs and subsequently to avoid extra costs. Additionally, while reducing the explicit trading costs, the prime broker allows the client to reap the benefit of LP aggregation.
A prime broker subsequently becomes the ultimate counterparty to each of the client’s trades, regardless of which LP receives them. If one of the LPs defaults on a trade than the prime broker must take responsibility and come to an amicable resolution with the customer. As the larger balance sheet players such as major banks have left or reduced exposure to the market, retail brokerages are entering the prime broker space using technology to maintain a competitive advantage and to provide significant value to their customers.
Change is inevitable – and at present, the foreign exchange landscape is ripe for it.