By Justin Boulton ,Head of FXCM Prime at FXCM Pro.
With everything that’s happened in 2020 – the COVID-19 pandemic, the mounting geopolitical tensions and the collapse of the oil market to name a few – it’s no surprise to see non-banking financial institutions (NFBIs) wanting more security when accessing credit as well as pricing and execution, writes Justin Boulton.
The effects of the economic, geopolitical and health crises is complex and multi-layered. While they are felt in every corner of the market today, the smaller and medium-sized NBFIs are poised to suffer the most.
Even before COVID-19, banks have been tightening credit conditions and raising asset requirements to who can access their prime brokerage solutions. Over the last few years, this has squeezed out smaller market participants from accessing trading opportunities and better liquidity – a pain keenly felt during a time of unprecedented market volatility.
Access to a prime broker and all the benefits and security of they offer have never been more important than today. Luckily, as the pool of market participants has expanded over the last decade, banks are no longer the sole providers of prime brokerage services.
NFBIs no longer rely solely on tier-one banks to access better trading opportunities, liquidity, and the added security of trading through an established broker and credit provider. The same services are available at faster and cheaper entry rates than traditional tier-one banks – and this is an avenue that small and medium-sized hedge funds, emerging market banks, retail brokers, asset managers and high-frequency trading firms should carefully consider.
Managing credit risk in times of volatility
While capital markets are no strangers to volatility, no one could have been ready for the stress brought by the COVID-19 pandemic. Trading volumes hit record highs in some areas while ceasing altogether in others. As the end still seems far off, firms will need to seek alternative providers for the services that banks are less and less willing to offer.
Like banks, the biggest challenge for most firms offering prime-of-prime services is often how to manage credit lines efficiently across a range of platforms. Given the volatile nature of the foreign exchange (FX) markets, the prices offered by trading platforms vary significantly, meaning that clients may want to trade across several platforms at any time in order to hedge their exposure effectively and get the best prices. A true prime broker can help manage this exposure with low-latency software and by conducting thorough pre-trade credit checks on every trade that goes to the system.
Accessing the best liquidity
Without a prime broker, financial institutions are not only cut off from the best pools of liquidity but also see stunted trading opportunities. Always trading with institutions of the same size can limit trading opportunities as market participants are constrained by the size of their trades to the frequency of their trading activity.
By leveraging a prime broker, a neutral intermediary that facilitates access into a bigger and bolder trading space, such constraints are less likely to occur. Participants can have more trading opportunities at better prices, and trade at a greater frequency with bigger institutions.
As the growth of NFBIs in foreign exchange is set to continue, the market environment should complement an all-to-all trading model, whereby users can act as both liquidity providers and liquidity takers. While some brokers will use the words ‘prime’ to suggest they offer these services, not all offer the same depth of institutional liquidity that should rightly be expected from a prime broker.
In this respect, its key to recognise the difference between those offering direct market access to multiple venues while acting as a clearing partner, and those offering access to their own liquidity pools while claiming to be a neutral prime-of-prime broker.
Broadening the trading community with smaller participants
The increasing participation from NFBIs in the foreign exchange market is a welcome development. Prime-of-prime brokers can take on the exposure that prime banks are unable to provide and help support this all-to-all trading environment. In today’s conditions, we should look to develop trading opportunities rather than limit them.
A broader trading community with a diverse range of actors and institutions is not only necessary for the growth of our dynamic market, but it is a rapidly materialising reality thanks to the growth of prime brokers. As the access to bigger and better trading opportunities is widening, a true prime of prime broker can be the solution to greater market access, greater liquidity, and ultimately, greater profitability.