Financial Journalist

Gerry O’Kane Finance Week 7 July 2008

Just as I started to write this Avon and Somerset police announced that another pensioner had been the victim of a distraction burglary by someone pretending he was from British Telecom.

My heart goes out to the 83-year old, but she must only remember telephone companies being owned by the Post Office because if anyone approached my doorstep and says they’re from BT, I’m reaching for the SRAW/Eryx (my personal anti-tank weapon) stashed behind the door.

There are a couple of reasons for this. Firstly, BT actually trying to approach you personally is so rare that you figure there’s something wrong. Secondly, since my transfer to their broadband my life has been less than smooth.

The latest has been yet another demand for money with absolutely no clarification for what exactly they were charging. They expected me to cough up £95 with no breakdown of the expenses: is this a style of accounting that Hanif Lalani the firm’s CFO believes is a good one? This is not the first time this has happened: last time it was some direct debit but didn’t again say exactly what they were billing for.

Harry, my FD mate who likens dealing with BT to going through the pain of divorce, is rubbing his hands at the idea of a consultancy on implementing financial tracking systems at BT. “I could invoice them without telling them what it was for, that’d pay for replacing the brassicas!” he trumpets. (He hasn’t quite got over the Great Brassica Slaughter of 2008 when a concerted attack of commando rabbits took out over 2000 various members of the genus known collectively as cabbages, in two fields in 24 hours. We’re sending them to the States to train up Delta Force.)

I had tried to call BT before the latest bill, but it was a maze of phone options that took 15 minutes before you were put in a queue and told how valuable you were as a customer. By this stage your brain is hurting because if you were a valued customer they’d answer the bloody phone.

This time I persevered. Success, someone answers. Headache goes. Headache returns: I was back in a Bangalore.

This irritates me because (a) the money for my over-priced bills is paying to take jobs out of the UK, (b) they have no idea of why we all hate BT and (c) you know that it is pointless venting your spleen on these clueless victims of outsourcing gone mad, who continue to dream of taking their double-first in Brain Surgery to somewhere sensible.

Anyway I was told that part of the bill was from my BT Option 75a, which I don’t use because I get better rates from my third party call supplier who is forced to use the BT landline.

But he had no idea what the “fine” of £2.75 was for, nor what was going on with the broadband charges, oh yes it was on there. I had to talk to the broadband department which was either in Delhi or three desks away. I then went through the palaver of phone numbers, customer billing numbers, post code, inside leg measurements, all over again.

This time I was told to go online and get a break-down of my bill, because she couldn’t be bothered to tell me. Well she didn’t say this, but did tell me to look it up for myself.

My voice did go up an octave at this point, with me arguing that since I was expected to pay them money they could at least break down what it was for and sod their paperless billing since they’re about as interested in the environment as telling me what they’re billing me for.

She put me on hold and went to speak to her supervisor because evidently she didn’t know either.

It appears I was now paying three months in advance for something-broadband and apparently I was meant to know this, the half price offer too, the fine (still don’t know what for), VAT and something towards African national debt, but it was me who had to add up what was happening on the landline side too…

The last time I had something like this was a week before I got thrown out off the National Union Of Journalists for having the temerity of asking what I had on account with the union and into which charge band they had now put me, since I had just joined the BBC. When they didn’t tell me, I refused to pay. Then they told me I was blacklisted.

That saved me a fortune over the years.

What staggers me is that BT pretends to be technology company - yet two departments can’t communicate. It espouses good value: yet it keeps hiking prices including charging me for not allowing a multinational corporation with monopolistic tendencies to have access to my bank account and remove whatever cash it sees fit. It certainly sees no need to tell me what I’m paying for.

Is this how a company retains customers, is this what is meant by improved reporting, is this good corporate governance?

If they didn’t have an effective monopoly I’d be one less customer.

No wonder the company’s preliminary pre-tax fourth quarter results were up 3% at £715 million. Oh no, my brain is melting, my brain is melting…

FT Mandate, March 2009

The dire economic situation towards the end of 2008 saw asset-servicers battening down the hatches, but now the institutions have to convince their clients that they provide a safe haven in these troubled times. By Gerry O’Kane.

If 2007 was a relatively low-key year for the asset servicing industry, with the merger of Bank of New York and Mellon Financial Corporation a rare highlight, 2008 was more a year that market players want to remain low-key in discussing, save to say there has been no flight of clients.

It is what happened in the last quarter of 2008 that most preoccupies the sector, with few asset-servicers trumpeting mandates they have won, although major players report clients re-examining the ranges of services they have and how they will stand up in the post-apocalyptic financial world.

“I think it was the speed with which the economic situation deteriorated throughout last year - no one quite expected it,” admits Mark Austin, head of multinational client relationships at Northern Trust.

“The industry will certainly be looking at a new landscape in the coming years, expectations on services like cash management, transparency and risk assessment have all changed because of what has happened,” says Jay Hooley, head of the global investor services business at State Street. Such viewpoints were less common at the beginning of the year.

As the fallout from the sub-prime crisis continued, institutions were more interested in examining their portfolios and trying to discover if they could have better assessed their risk. The search for new asset valuation procedures was on.

“I think it’s true to say there was little action on gaining new custodial clients during most of 2008, however we did see renewed interest in examining portfolios and trying to reassess the risk of these investments,” says Chris Adams, head of product alternatives for BNP Paribas Securities Services.

It is a view that Jim Palermo, co-chief executive officer, BNY Mellon Asset Servicing agrees with: “Prior to October last year, pension funds were being obligated to comply with new accounting rules and that triggered much more attention on getting a full valuation of the portfolio. It was a case of know your exposures globally.”

Transaction revenues up

And while custodians saw their assets shrink alarmingly, market volatility brought increased transaction revenues, at least in the short term. Across the board the issue of increased pressure for transparency and costs reduction compelled clients to outsource certain elements of the value chain that they had not outsourced in the past.

“The net result is that the top service providers could look at increased business because of increased servicing even though the whole market was shrinking,” observes Neeraj Sahai, global head of securities and funds services at Citi.

However by the time Lehman Brothers collapsed in September and the Madoff crisis hit the headlines, investors’ preoccupations had become more focused. “Recent events have brought more to the forefront the risk of a service-provider going out of business, especially for hedge funds, and what we’ve seen is a flight to quality service,” argues Mr Hooley.

Mr Palermo calls it a “dash to strength” and says that BNY Mellon’s win of the federal government’s $700bn (€549bn) troubled asset relief programme (Tarp) helped boost the institutions’ profile of a safe haven. Similarly State Street’s slice helped too. Nobody would accept that being the recipient of federal funds was a bad thing for your reputation; everyone was doing it.

While the asset servicing industry accepts that all institutions including pension funds, looked at reassessing their risk and how reliable their valuations were, the biggest movers in the custodial and administration stakes were the hedge funds. “In order to mitigate risk, hedge funds in particular have considered moving to multiple providers solutions, but are also faced with the need to reduce costs and administrative overheads, they’ve sought out new solutions,” says Mr Sahai.

Counterparty risk

While for some time custodians grumbled that prime brokers had been muscling into their business, the problems caused by the buyout of Bears Stearns and Merrill Lynch and the failure of Lehman Brothers have caused all institutions to review their counterparty risk. Indeed, according to Colin Rainbow of consultants Watson Wyatt, UK pension funds like many other global institutions continued in the market but this time placing assets with six or seven counterparties to further reduce risk.

For hedge funds, assets that were supposedly held safely by Lehman’s prime brokers were not held in their own name and could not be quickly recovered. The rehypothecating of clients’ collateral and assets by prime brokers, by switching the assets into the prime broker’s name so they could be lent out in the repo market to raise cash, brought risk that the investors did not want.

And the response has been swift. Both institutional and private clients to hedge funds have demanded greater transparency of both the assets held and their valuations. It is similar story from most institutions. In an effort to reassure their clients, hedge funds have been seeking safe harbour, usually with the traditional custodians.

“We’ve seen a trend whereby hedge funds are trying to ring fence their assets they’re not using for leverage and we’re seeing an uptake in demand for those sort of services,” says Mr Sahai.

Utilising escrow accounts has become a more common request in the European market accoring to BNP Paribas’ Mr Adams. And as they fled prime brokers in search of security of assets and increased transparency, they brought cash, in spite of record withdrawals. “We saw massive cash inflows in the third quarter,” says State Street’s Mr Hooley.

While the yield offered on cash by the custodians has been nowhere near the levels found from traditional prime broker lending, the quest for generating alpha on these assets is now less important. Perhaps paradoxically these events have led to an increase in over-the-counter trading, making the last few years of investment in handling alternative assets for the biggest custodians a worthwhile exercise.

“Traditionally a pension fund would call the money manager and say I need $20m for an investment call. They can’t do that any more because there is not enough liquidity. At the same time they don’t want to sell into such a down market, so what they are doing to maintain their exposure is to go the derivative road,” explains Dan Wywoda, head of products at BNY Mellon Asset Servicing.

Another consequence of this concern about counterparty risk has been a downturn in securities lending. While Dutch pension funds were early and vociferous on halting all securities lending, other markets have simply reduced it, demanding much higher levels of counterparty risk assessment, usually from custodians. “I’d expect securities lending to continue on a reduced level but on the other side of the coin we’ve seen other collateral vehicles used such as overnight repurchase and government backed loans,” says Mr Hooley.

Other areas of security servicing have seen a definite downturn. “Transition management has fallen away because you’re not seeing institutional investors change managers to the same degree,” highlights Mr Austin. “The last half of 2008 was very much a case of battening down the hatches before the storm broke; now is a period of trying to evaluate the damage and what the long-term environment is going to be.”

As the markets recover so too is there anticipation of the re-emergence of the importance of a transition manager; even so the current crisis has seen Citi close its transition management arm in London.

As for the future of the business? Technology investment spend is likely to be reduced, although BNY Mellon reports an increase this year as the final stages of its merger goes through, but there will be an increased focus on areas such as valuations and risk. As for industry consolidation, the large players have neither the cash nor appetite to digest new companies, but pressures on smaller administrators to both the private equity and hedge fund industry are likely to Increase.

“If you consider that its height the hedge fund industry was worth about $2000bn and this has shrunk to $1400bn today, that reduction is likely to lead to some degree of consolidation among smaller players,” says State Street’s Mr Hooley. With 2000 specialist administrators in off-shore and hedge fund sectors still existing, the loss of one third of your customers’ asset base is likely to have a knock-on effect.

TOP 10 GLOBAL CUSTODIANS (FIGURES AS AT END-2008)

1) Bank of New York Mellon $20,200bn

2) JPMorgan Worldwide Securities Services $13,205bn

3) State Street $12,000bn

4) Citigroup Global Transaction Services $10,700bn

5) BNP Paribas Securities Services $4650bn

6) Societe Generale Securities Services $3563bn

7) HSBC Securities Services $3500bn

8) Northern Trust $3000bn

9) Caceis Investor Services $2780bn

10) RBC Dexia Investor Services $1896bn

TOP 10 GLOBAL CUSTODIANS (FIGURES AS AT END-2007)

1) Bank of New York Mellon $23,100bn

2) JPMorgan Worldwide Securities Services $15,900bn

3) State Street $15,300bn

4) Citigroup Global Transaction Services $13,100bn

5) HSBC Securities Services $6100bn

6) Northern Trust $4100bn

7) BNP Paribas Securities Services $3800bn

8) Caceis Investor Services $3358bn

9) RBC Dexia Investor Services $2900bn

10) Societe Generale Securities Services $2585bn

Source: FT Mandate Research. Ranked by total volume of assets under custody worldwide ($bn)

REGULATING FACTORS

Those companies playing in the securities and capital markets are simultaneously being faced with a downturn in earnings and the need to improve efficiencies and cut costs. On top of that, the hoary old subject of increased regulation is expected to further pressure operations.

“Asset managers are going to be faced with the issue of overcoming increased regulation, reducing risk while tackling issues of cost and that means they’ll take a deeper interest in electronic dealing automation,” advises Christy Bremner, global managing director of Thomson Portia, a systems supplier for the back office of buy-side asset managers.

Apparently, these systems are no longer referred to as straight-through processing (STP) in Asia or North America, but the search for the seamless electronic trading holy grail continues. It has gradually moved down the trading chain, reaching the middle and back office, the less glamorous links and the poorer cousins when it comes to technology investment.

According to Ms Bremner, those on the sell side trading face the biggest hole in their electronic systems, often having issues with settlement and reconciliation with custodians. But, she adds, size doesn’t matter as even the larger houses which may have bigger pockets, were faced with real obstacles in handling their more complex asset mix. “There are no standardised solutions out there, and while firms like Omgeo and SunGuard and custodians have their own answers, none are standard and none seem likely to become so.”

While rates in exchange traded equities are nearly fully regarded as being processed electronically from purchase to settlement, other investable assets are not so far advanced. “It must be said that there has been progress in electronically trading OTC products but there remains much to be done,” adds Ms Bremner.

FT Mandate, March 2009

There are huge opportunities in private equity, but can boutique houses offer the services and security that are in demand? By Gerry O’Kane.

You can almost hear the increasing pitter-patter of the administrators’ heartbeat when they speak about private equity prospects in 2009. While much is made of a grinding down of the sector, fund administrators are rubbing their hands in glee – at least if they are one of the bigger players.

Some of the larger custodians saw private equity administration business grow by as much as 60 per cent in 2008. Many are hoping to realise increases in business of 20 per cent this year. “Best industry estimates say that only about 15 per cent of private equity funds outsource the administrative function,” reveals James Hutter, global business executive, JP Morgan Private Equity Fund Services.

“In these uncertain times, private equity firms may want to hire a strong, global administrator, so they have more time to focus on their core business,” he adds.

“Post-Madoff, regulators and clients are seeking a greater separation of duties and as so many private equity funds do all forms of administration internally, this applies to a lot of companies,” says Jack Klinck, State Street’s head of global investment product services. But the statistics for this sector are nearly as depressing as those for the global banking industry: financial sponsor teams at investment banks reported that the total global revenues generated fell by 79 per cent between the collapse of Lehman’s in September and February this year, according to data provider Dealogic.

In February research from Nottingham University and Barclays Private Equity showed that buyouts hit their lowest level since 1994, while a research paper by Spain’s IESE Business School and management consultancy Boston forecasts that half of them will default on their debt and only one third of buyout firms will survive.

Mr Hutter accepts that the private equity sector may contract, but the need for new services, perceived transparency, and increased efficiency in order to save money will push many of them into the arms of fund administrators for the first time. In terms of systems that provide transparency and a clear line of audit work, most do not have them.

FT Mandate December 2008

The idea that Asia and China might be immune to a sneeze in the US economy has been proved incorrect and cross-border asset flows continue to run like a raging torrent.

Paradoxically this fact has strengthened the will of large asset servicing houses to parade themselves as a global one-stop shop for fund managers: the outflow of money from emerging markets in recent months has been more a case of Western institutions bringing money home, than a failure in the local investment economies.

“Our clients want to access the growing wealth in the Middle East and Asia and they see these markets as doing relatively better in the coming years than Europe or the US,” agrees Tim Keaney, head of asset servicing at BNY Mellon.

But can the fund administrators, large or small, be all things to all people globally? While global reach has long been a message of Neeraj Sahai, global head of securities and fund services at Citi, it has little presence in the Middle East, for example, where fund managers are panting to get a look-in.

Lock down any of the major securities servicing houses to answering whether they can provide this all-encompassing global answer for fund administration and you’ll get comments ranging from how blue the sky is to a semantic debate on what fund administration is.

The reality is that no house can provide all the services often demanded as part of an administration package in every jurisdiction in the world. But some are more pragmatic in facing up to limitations.

“You can’t be everywhere but you can position yourself to take advantage of growing trends,” explains Mr Keaney. “The larger business of fund administration involves economies of scale – no-one will make money in Vietnam and the small guys will dominate the market until there is a macro-economic push into the wider market.”

There is no doubt, however, that the industry is getting there. As John Campbell, senior managing director of investor management services at State Street points out, the sector has come a long way since the 1970s and 1980s when fund administration was almost exclusively a domestic-only affair. “By 2001 we were looking at a shake-out, losing fragmentation and inefficiencies and funds were beginning to look for regional players,” he says.

Custody came first

It has also to be remembered that for the players with the larger reach fund administration often came with custody: if there was no custody contract, they didn’t want to know about the administration. And it was custody that took the first global role.

But like custody (and this is where the global one-stop shop model becomes hazy)to compete in these markets, add-on services both became desired by fund managers and offered as incentives by the administration firms. Should the international fund manager want to move from a regional presence to more global, the desire in taking along the global custodian was one of confidence and other services often followed.

“When you’ve got a close client-relationship you go where the client goes, domestic to regional to global,” observes Mr Campbell. He points to Pimco emerging from the Californian marketplace to take a more global position.

In some circumstances these clients may demand services that attach to administration and custody including transfer agency and everything from securities lending to collateral management. Local suppliers can rarely meet these demands.

“You can have a global contract on funds, but in one country or another operate with a local partner,” explains Toby Glaysher, head of global fund services, EMEA for Northern Trust.

This step-by-step approach is one undertaken by all administrators whether they admit it or not. Mr Keaney agrees expansion follows or predicts demand. “Over the last few years we’ve done it organically, through partnerships or takeovers.”

“It’s a series of moves as clients become more open about their own product development and if you’re not there and they have a requirement, they’ll find someone who can fulfil it and that may be a risk to your longer-term business,” adds Mr Keaney.

One way providers have found in playing the global fund administration card is by following the sun, multiple centres each passing on the work that needs to be done, although this is dependent on a single platform.

“Technology is the first pre-requisite of being in business, you need it to support your clients and your costs,” agrees Mr Campbell.

Moving around the world

Offshoring also helps to keep costs low in order to remain competitive (although frequently the fund administration business is seen as a loss-leader to sell other services). GlobeOp, a specialist in hedge fund administration uses an operation in India where they have trained people in OTC administration and argues that with 80 per cent of hedge funds registered in the Cayman Islands and institutional in sales, it too can be a global one-stop shop.

“It’s a global operating model but a single platform based in different centres. Clients of UK funds investing in the Far East can have the net asset value following Asian close and for the UK morning by moving the processing around the world,” says Mr Glaysher at Northern Trust.

What does put the kibosh on both this model and any claim to global presence, is that many markets still demand fund administration, including valuations, be done within the jurisdiction it is registered or sold.

The success of Luxembourg and Dublin in becoming financial centres is not that they have any size of fund management or investment bank business, but in that they prepared for Ucits III and hedge funds, allowing funds to easily domicile while demanding that all administration functions must be done where the fund is domiciled. In other emerging markets these restrictions are even greater.

Ucits global reach

But the Ucits III label has its advantages too, especially in Asia. While Ucits III was originally focused on EU opportunities, it is having knock-on effects elsewhere boosting the need for international reach.

“The reality is that a Ucits III product has a perceived stamp of quality, especially in markets where the local regulatory regime does not always inspire confidence,” observes Toby Glaysher. It is fulfilling that pan-Asian role by default.

The result of that single factor has pushed fund managers to sell their offerings there, broadening the reach and demanding support from the administrators and securities servicing companies they know best.

And once the eye was on Asia, other opportunities emerged. The problem for the fund administrator there is that there can be many idiosyncrasies in Asian markets, from tax legislation to the fact that many processes remain manual. Often the fastest way to hit the ground running is to partner locally, eventually leading to takeover or buyout: again a global model serviced locally when needed.

The new investment landscape of the past few months also impacts administration, presenting growing opportunities. “We’re seeing a lot of activity and a lot of nervousness in the last few months with clients wondering what the shape of the new map might look like and simply wanting consistency and low risk,” observes Mr Campbell.

Indeed for those investment banks whose prime brokerage arms reached into the administration market, customers don’t like all their eggs in one basket. Pricing and validation is separating.

“It’s certainly true in the hedge fund sector,” says Hans Hufschmid, CEO at GlobeOp. “They don’t want their administration exposed to illiquid assets and they’re taking another look at their counterparties.”

“Now funds are looking to rationalise, looking to save costs. There are lots of big RFPs [requests for proposals] out there as they look to move from fixed costs to variable,” adds Mr Glaysher. While it should be no surprise that both the hedge fund and mutual fund landscape is shrinking, a desire to again cut costs and find new markets means the opportunities for new fund administration business is high and not only in traditional markets.

INVESTMENT OPERATIONS OUTSOURCING

Seeking outsourcing solutions is back on the map. The question is what form is it going to take?

Tim Keaney, head of asset servicing at BNY Mellon, admits that while it’s neither his desire to have administration without custody or provide parts of an administration service, it’s a route he’d take if future business was a possibility or maintaining relations with an existing client. “We’re seeing an uptick in in interest in outsourcing the middle office (for those under $10bn (€7.8bn)) from clients who have so far only used us for transfer agency,” he says. He sees the sector going through a similar process of consolidation as did custody years ago.

As the larger securities servicing businesses, especially the trust banks, seek a global position they’re happy to start with component outsourcing and wait for the big contract.

But it seems in the search to become the global all things to all people, one-stop shop, lift-out is not dead, at least in the Asian market. “Lift-outs as a method of transitioning business is not viable…. unless you get something else, expertise or systems and I’m specifically thinking about Asia,” says Mr Glaysher.

Global+Fund+Administration

October 2008 FT Mandate

The one consistency the markets have been showing in recent months is volatility. Where there is movement, the investment sector finds opportunity and in recent years volatility trading has found a ready market amongst the top-feeders, hedge funds. But there are indications that more traditional investors, pension funds and insurance companies, have embraced forms of volatility trading too.

Backed by options, OTC products or the limited number of volatility indices, it allows traders and institutions to invest in the volatility of the trading markets, volatility being defined as the standard deviation of shares or indices and in falling markets there are elevated levels of volatility compared with climbing markets.

“In terms of trading in the current world, we’re seeing strategies evolving by minutes,” says Adrian Valenzuela, head of equity derivatives investor sales at JPMorgan. “Volatility trading was traditionally the domain of hedge funds, even until three years ago in its purest form it was almost exclusively their territory.”

Even then, however, those hedge funds were not as much in demand as they are now. “At least until two years ago volatility was operating in a tight band – about 15 per cent. There was a lot of convergence, companies had low debt levels and then the banks had solid asset asset to equity ratios,” explains Gerry Fowler, head of European multi-strategy trading at Citi.

As the markets have changed, especially at the start of 2007 as US real estate problems started to become noticed, volatility began to increase. The fairly neutral market of the previous five years began offering volatility players opportunities with spikes hitting up to 25 per cent and higher. RBS has gone from 2 per cent volatility to 105.

“In general this was good for volatility trading positioning long and there was a scramble for put options,” explains Mr Fowler. The use of put options has found favour among traditional long-only asset managers. These options give the holder the right to sell a security for a fixed price at or before a given date. Investors use options to guard against fluctuations in the price of securities they own, speculating on volatility.

While getting reliable figures for the volume of trades relating to volatility strategies are difficult, the huge leap in equity derivative contracts (up 75 per cent year-on-year for Eurex) indicate its growing acceptance. As counterparty worries have continued, the OTC volatility products, most commonly variance swaps, have taken a back-seat to exchange-traded derivatives.

Currently the first index (1990), the Chicago Board Options Exchange Volatility Index (VIX) measuring volatility based on the price of options, hit a record high at the beginning of October, moving to 56.32. To put this in perspective its previous high was 49.53 set in October 1998, when Long-Term Capital Management collapsed.

“There are two basic ways to trade volatility: to diversify portfolio or smooth out the risk profile by exposure to returns,” explains Nick Tranter, head of European equity derivative flow sales at BNP Paribas.

“The most significant area of change in the past two years are institutional clients looking at hedge fund volatility players, not so much for profit but for risk,” explains Mr Tranter. He points to insurance companies as moving to exploiting these strategies for risk purposes, “With CP195 rules to realistically mark to market of liabilities of insurance companies, they have used hedge funds, but also options effectively taking a notional benchmark such as the FTSE 100 and play an option with a 25 year maturity.”

JP Morgan’s Mr Valenzuela also points to more complex strategies including expressing views on skew as correlation and broadly arbitraging option prices as ways of building positions on de-corollated assets, but warns these deals require well-groomed pricing, structuring and trading skills.

Market+Volatility+investment

December 2006

— Alistair Smith, Barclays Capital

As a self-regulated market, foreign exchange has generally avoided any big scandals, yet it is still considered a risky deal, especially with the recent increased volumes of trades. Gerry O’Kane assesses the risks faced by prime brokers and the new solutions available to them.

Risk is an ongoing headache for any party in the chain of a foreign exchange deal. Equities’ dealers might find the forex market something of a nightmare, only having a choice of almost exclusively over-the-counter (OTC) products in an unregulated marketplace that has no central exchange.

Whatever about the theoretical problems, history shows that out of all the markets, the self-regulated foreign exchange environment has managed to tick over without the sorts of high profile scandals that have hit other securities.

However, the FX environment is changing. There are huge increases in volumes, new players, new ways to access markets, greater demands for credit and faster trading and there are worries that risk can only increase.

Each player in the chain is open to risk, although it is generally accepted that it is the FX prime broker that faces it the most since he is providing credit lines.

Risk to both parties

Firstly, there is the relationship between the prime broker and the client. This introduces risk to both parties, even from the stage of choosing a suitable prime broker. Then there is the relationship between the client and their executing broker and the executing broker and the prime broker.

“The obvious first step in limiting risk for the client is in the choice of prime broker,” states Devin Graham, global head of FX prime brokerage at UBS.

“In judging risk you need to look at the institution’s name and reputation, the credit worthiness of the counterparty, the size of the balance sheet, the brokers’ systems, reporting, cross collaterisation of asset classes and the trading system and the ability to communicate electronically,” summarises David Aldrich, head of Bank of New York’s hedge and broker business in Europe.

According to an analysis by Bank of America, the clients are faced with confidentiality and concentration risk and operational risk and market risk.

“Confidentiality is very important for clients – but then that’s why they moved to prime brokers from a single margin account,” says Roger Allen, director of FX prime broking at Dresdner Kleinwort. “There has to be a fair exchange of information with your prime broker but to give them everything is not a great idea but then it’s rarely an issue,” he adds.

As for concentrating risk with a prime broker, the system grew up specifically to move clients from the limitations of a single bank. “It’s essential in the system to trade with multiple parties, no one bank would take on all the risk of a fund and the client needs to adjudge the creditworthiness of the prime broker,” says Mr Aldrich.

The client faces several issues in operational risk: reconciliation of portfolio with the prime broker, trade rejection by the FX prime broker and the monitoring of post execution events.

Utilising technology

But as with so many of the risks facing all the parties in the chain, the use of technology goes a long way to mitigating much of the operational risk faced by all three right through the process.

“It’s important to have a sophisticated system covering trade entry to reconciliation,” explains Mr Allen. “A high level of automation is required through the process and minimising the manual process is important – each time something is re-keyed equals an increase in operational risk which is something you strive to reduce.”

“From the client’s perspective, using prime brokers to effectively provide the infrastructure and integration to track and manage positions limits their risk,” says Mel Gundewardena, global head of fixed income prime brokerage at Deutsche Bank.

As for issues of market risk, such as failing to notify the prime broker of trades in timely fashion, relying on the FX prime broker to properly match trades and highlight discrepancies and derivative issues with multiple brokers, these issues come down to the client’s internal management.

All these failings could happen to a company which did not use a prime broker but the advantage of having one is that these sorts of issues are discussed during initial contract stages and in adjudging levels of creditworthiness. In terms of mitigating risk the prime broker acts as a de facto extra line of defence. Apart from a client gaining market access and a best price advantage by going through a prime broker, its procedures and systems outlined as part of the contract push for business efficiencies too.

It could be argued that the core of any risk lies primarily with the prime broker. They face liquidity, credit, operational and market risks with both executing broker and client.

In reality, the majority of executing broking work they will deal with tends to be within the same institution since prime broking is generally offered free when using the dealing desks. It certainly limits credit and operational risk.

Managing exposure to their highly leveraged clients and establishing appropriate credit terms with them is at the heart of a prime brokers business. “Certainly there’s a clear distinction in the market between funds as an asset class, running alpha rather than hedging – the risk dynamics are completely different,” says Mr Aldrich.

“You must judge the clients suitability based on capital, strategies, personnel and come to a conclusion on what sort of risk positions you want and manage them efficiently,” says Mr Gunewardena. This often relies on real-time processing and managing the clients’ collateral and margin calls efficiently. On top of that he points to technology as limiting the impact risk factors, as with a cross-collateralising system that saves client’s margins and will automatically monitor credit levels at the give-up stage.

And the importance of the use of technology in limiting risk factors through the process cannot be underestimated. “Not every FX product is the same. With a spot trade you know all’s fine very quickly but with a 30-year interest rate swap if the trade does not get accepted it’s more difficult,” warns Alistair Smith, head of global netting products at Barclays Capital. “The communication of some trades is more complicated and small errors can creep in which is why we recognise that it’s important that the derivative transactions go through an electronic process even if it means rekeying at the beginning,” he adds.

Sell-side competitors have different systems for different products and that can make it difficult to ensure standards across the board. It is at this level that a client needs to find just how technically proficient their prime broker really is. “We have a very minimal set of transactions that reach us manually. All are processed electronically through our derivative PB system and fed into downstream booking systems,” explains Mr Smith.

And these sophisticated systems have an increasingly important place in the new developments in FX trading. “As algorithmic trading has expanded, for example, it is necessary to improve intra-day risk analysis and a capability to reconcile these sorts of trades,” says Steven Li, head of prime broking at Barclays Capital.

As for the executing brokers they too face many of these issues. Credit risk is generally the executing brokers prime concern, monitoring its limits within the parameters of the give-up agreement and avoiding trade rejection by the FX prime broker. At this point the prime broker needs to rely on its client to have given clear instructions on both process and procedure to their executing broker – what is permitted (in terms of product and delivery) and what is not.

Credit protection

Much of this will fall within the agreement outlined between the prime broker and client at the beginning. “We want to work with banks and clients within a transparent STP electronic framework, where we feel we can take risk that is well managed through our operational infrastructure,” says Mr Li.

In certain circumstances this may even specify what technology is to be used. But probably most importantly for the executing broker is the fact that the majority of the prime brokers operating in this market are parts of highly rated financial institutions, affording at least some credit protection.

Additionally, worries over give-up agreements seem exaggerated. “The give-up process is much the same regardless of whether it is spot FX, interest rate swaps or credit derivatives. Our system applies the same controls and matching consistently across all asset classes,” says Mr Smith.

“It’s been made even easier with the industry bringing in standard ‘give-up’ agreements,” agrees Mr Gunewardena, referring to the New York Foreign Exchange Committee release of standardised agreements.

It’s an issue which also falls under operational risk since it is considered a manual process and while it is based on a messaging system, many do feed automatically into the prime brokers’ systems. According to Mr Graham, the Harmony messaging system acts as an industry-wide de facto standard. “It makes sense to use one technology, although it is true that deals should be given up as soon as possible – legally within two hours – we aim for real-time because we’ve got a significant investment in the technology,” he says.

In truth, the sector is not facing any risks it has not faced before. As cross-asset management platforms become virtually de rigour, experience in handling derivative products is sliding into the forex office from the experience of the derivative brokers. While the levels of credit risk increase, only reflecting the boost in business volumes and products available, the technical systems to manage them get more efficient.

However, while most players seem happy with the regulatory status quo within the industry there are murmurings of change. There is debate that the regulatory authorities may decide to enforce best execution rules on the FX world and push features like transaction costs analysis on a deal. Both the European MiFID rules and the recent US Regulation National Market System (RegNMS) seem to be trying to do just that.

But as these developments are only rumoured others are worried that they will open another danger. “Getting consensus among industry bodies is important to develop methodologies to keep the forex market orderly and with a defined process,” says Mr Gunewardena. “But the danger lies when institutions with their own ideas try to cut those existing costs work outside the system. By short circuiting the process that has developed could create a systemic risk and effectively increase costs for the whole industry.”foreign exchange, FX, OTC products, risk, prime broker, investment manager, technology, services

FT Mandate December 2006

Electronic communications networks are increasingly used to handle forex deals – but their rise in popularity has been so dramatic that the market remains a mystery to some. Gerry O’Kane talks to the major players and lifts the lid on this technology revolution.

For an industry that likes to dot the ‘i’s and cross the ‘t’s, the fact that no one seems to know how many electronic communications networks (ECNs) handling forex deals are out there is a tribute to their dramatic proliferation.

And the effect of this proliferation over the past few years has been equally dramatic, being attributed to increased turnover in the spot markets and bid/offer spreads sliced wafer-thin.

An ECN brings together multiple market makers, matching buyer and seller together for a small fee and displaying the bids and offers from all market makers and traders on the platform. Orders are matched to the best available price.

eFX, as the techies like to say, has arrived, whether trading takes place over smaller private networks, or networks provided (often under licensing agreements or white-labelling deals) through brokers.

“The biggest change to the traditional FX prime broking landscape, apart from the huge growth in hedge fund strategies, is electronic trading and the growth in networks,” says Stephen Li, head of derivative prime brokerage sales at Barclays Capital.

Volume increases

A study by financial research firm Greenwich Associates found that of foreign exchange traders, 53 per cent traded electronically in 2005, up from 32 per cent only three years
earlier. Currently the average share of total forex trading volume captured by e-trading systems, regardless of size, is about 50 per cent. And it is the UK that tops the league with about 64 per cent of forex volume traded online, compared with 60 per cent traded that way in the US.

“The typical user of e-trading systems executes slightly more than half of its overall FX trading volume electronically, but e-traders tell us that they expect electronic trading to account for a full 57 per cent of their FX volume in 12 months’ time,” says Greenwich Associates consultant Robert Statius-Muller. “These expectations suggest that e-trading volumes will continue to grow for the foreseeable future.”

But Greenwich also warned that growth could be tempered by the fact that eFX platforms would have a harder time attracting new institutional customers.

Even so, size is no discriminator. Greenwich’s research shows that 51 per cent of players who handle more than $10bn per year in the FX market do so electronically.

This electronic market has long been dominated by EBS and Reuters, who in particular cater for interbank trading and who have seen their own trading activity quadruple over the past 18 months. But even these big boys are taking note of the changes in the FX trading environment.

Reuters and Chicago Mercantile Exchange (CME) announced plans in June last year to
create FXMarketSpace, the world’s first centrally-cleared, global foreign exchange marketplace, through a new 50/50 joint venture company. How it will affect the forex trading world is yet to be seen.

The recent acquisition of EBS by ICAP, the world’s largest interdealer broker, shows those in the know do not believe it is a contracting market. But both these deals further blur the clear divisions between regulated markets such as stock exchanges and the unregulated market dominated by OTC FX deals.

Nevertheless, other ECNs are unlikely to go away. There are newer platforms such as multi-dealer firms FXall, Currenenx and State Street’s FXConnect, while Hotspot is a multibank prime credit system. These companies are also experiencing serious growth, with many of them finding success in niche markets that produce enough trade volume to support their business.

“Our revenue growth was 23000 per cent in the past four years and although we’re only seven years old, our monthly volume turnover is hitting $100bn,” reveals Glenn Stevens, managing director of GAIN Capital.

“What we’re able to do is offer the more ‘downmarket’ sector an opportunity to trade – banks can’t service the $500,000 to $5m deals.”

The effects of these new dealing channels has been profound. The affordability of eFX
trading technology allows start-up investor groups to access the markets. It has allowed the smallest sorts of players to access the forex market – the micro hedge funds, the high-net worth individual or the retail speculator.

“The advent of e-commerce has lowered the barrier of entry to the FX market,” observes David Aldrich, head of Bank of New York’s hedge and broker business in Europe.

They have also allowed existing players to adopt strategies they would have found both
difficult and expensive to follow previously and with the cover of anonymity. All benefit from workflow efficiencies and integration into other systems.

Alpha opportunities

Many of these new participants reflect the growing trend of hedge fund and investment managers recognising that the foreign exchange market can produce alpha for their portfolios (although the hedging use of forex remains the dominant strategy).

“To a large extent the increased growth has been because of the recognition of forex as an alternative asset class and an alpha opportunity,” says Mr Stevens.

But for the banks that provide liquidity to the forex market, the emergence of these trading networks has been one of the critical factors in the plummeting bid/offer spreads in the spot market. Both the recognition of alpha opportunities and the price transparency now available across dozens of independent online markets, have pushed spreads dramatically downwards.

This search for alpha has seen technologies active in the equity and fixed income-markets, and algorithmic systems, enter the FX markets. Algorithmic trading is a way of timing entry and exit into a market, exploiting pricing opportunities and pushing up trade volumes.

According to Deutsche Bank, 15-25 per cent of all FX activity is due to algorithmic trading, and these liquidity suppliers have no way to cope with the speed of some of these systems.

Many of them have become unhappy with the growth in these ECNs. Blame has even been heaped upon the opening of EBS Prime to buy-side institutions like hedge funds for starting this trend. While the banks want to regain more control over the market and dream of pushing spreads towards historical highs, the opportunity for influencing dealing patterns remains distant.

“Even between Reuters and EBS, each trading platform is more suited to certain FX players than others for either strategy or product requirements, and while there have been attempts and discussions by certain parties for a central marketplace, the market simply doesn’t want a monopoly,” warns Roger Allen, director of FX prime broking at Dresdner Kleinwort.

He believes that past reactions to players trying to capture parts of the market had shown it was a strategy unlikely to succeed. In his view reactions included direct and outspoken resistance to anyone trying to control the FX marketplace and an organic movement of business. This flow of business also reflected the idea that the FX market is not suited to an overly structured environment.

Indeed GAIN finds its own niche comfortable for avoiding larger deals, but even so there are indications of a certain amount of convergence between some of the ECNs and dominant players such as EBS.

“While a $50m trade would be big for us, EBS is designed to handle such trades,” explains Mr Stevens. “While the smallest trade on it is $1m, its average trade size is about $1.3m, while ours has risen from $250,000 to $700,000 converging towards their levels.”

Whatever the grumbling about falling spreads from the liquidity banks, they still participate on the ECNs. The trading platforms connect in an automated fashion to banks and act as a message hub that can translate the messages of any customer and bank so they can each talk to each other.

“We’re complementary to the banks who find our liquidity useful, and we’re a member of EBS Prime and have access to 10 top banks and remain in the sector because we’re acting like a prime broker,” says Mr Stevens. He views staying ahead of the technology is vital for any ECN’s long-term survival.

“We’re not wanting to re-invent the wheel. We have to keep up with demand for example enabling application program interfaces (APIs) with our system for things like algorithmic or auto-execution trading. We need to be able to provide real-time margining, for example,” says Mr Stevens.

An advantage of these sorts of systems is that they do allow clients to carry out transaction cost analysis, something that organisations with a fiduciary responsibility for best execution need and something that future regulatory changes may require.

One criticism of the way the market is developing is that there are so many ECNs, which, in theory, create market inefficiencies and boost costs to interface with them. But the industry argues these are marginal costs, not linear, and being able to both access the business and see developing trends makes viable whatever extra costs there are.

Additionally, the ease with which clients can get onto this web-based systems attracts both established forex players and the individual speculator. “You sign up in the online environment get a technical demonstration and then await our due diligence activities. After about three days you can start trading,” explains Mr Stevens.

For the ECNs, signing anyone up is good news, since research by Greenwich shows that once a party starts trading electronically, the volume of trades executed that way increases.

As for the future of the sector those involved show boundless optimism. However with so many players in the market few disagree that there will be some consolidation. Acquisitions are likely to be based on both profitability of the companies and also their technical expertise. Buying technology for this sector can be cheaper than developing it – and to stay in the forex business, having enabling technology is crucial.

Electronic communications networks, forex, FX, foreign exchange, trading, growth market, liquidity

FT Mandate December 2006

— David Aldrich, Bank of New York

Prime brokers are investing in technology as the hedge fund industry develops. Gerry O’Kane looks at what the major players are doing, and hears some expert opinions on getting past the wall of secrecy to evaluate the best approaches for clients.

Cross-asset prime broking has become common in the industry, swept along by the ever-increasing volumes of business from the hedge fund sector.

Hedge funds have been seeking multi-asset trading for some time, allowing them to apply their complex strategies across foreign exchange, fixed-income, options, futures and equities. To keep up with this sector’s interest and lower elements of risk and boost their marketability, prime brokers have sought to provide complementary systems at their end.

“The prime broking industry has developed more into cross-product support as the hedge fund industry has developed,” says Mel Gunewardena, global head of fixed-income prime brokerage at Deutsche Bank. “There are more multi-strategies surrounding FX and fixed-income especially with more sophisticated hedge fund strategies. As a result people have been looking for ways to handle the complexities of market and infrastructure needs.”

In the simplest of terms for FX brokers, the global trading of fixed-income instruments and forex-linked derivatives issued in various currencies has boosted volumes in the FX market and further pushed demands for platforms that can deliver better functionality and lower costs. However, this appears to be only a minor part of the industry.

What has been happening is a drawing together of the strings found across the prime brokerage business, not purely in the FX marketplace. There is little doubt, however, that the development of derivative products to go hand in hand with FX strategies and an acceptance that they can act as a source of alpha, has driven the forex brokers to embrace these systems more enthusiastically.

Widespread demand

To put it in perspective, in March 2006 Dresdner Kleinwort announced its entry into the FX prime brokerage market as part of its strategy to complete its Digital Markets cross-asset class prime brokerage (PB) product offering.

As with many offerings, the Dresdner Kleinwort FX prime brokerage platform purports to support clients with access to products and services including FX spot, forwards and swaps, vanilla and exotic FX derivatives, local market currencies and derivatives and precious metals and commodities.

“We have a full products cross system – fixed-income, equity, forex, all consolidated on one platform in real time. It reports net margins providing collateral efficiency and consolidated reporting,” explains Roger Allen, director of FX prime broking at Dresdner Kleinwort.

In truth the development of these cross-asset platforms has been driven by a demand found across the investment spectrum and not at the behest of FX prime brokers. Indeed research by technology consulting firm Datamonitor indicates that the investment banks are leading the charge rather than any specialist FX prime broker, with the usual suspects such as Goldman Sachs, JP Morgan, Bear Stearns, UBS and Deutsche Bank all promoting their services.

“The ability to provide a suite of services to be integrated across asset classes that hedge funds and asset managers want to adopt is vital,” says Mr Gunewardena.

This should be unsurprising for two reasons. First the investment required to develop these systems demands deep pockets, and second much of the technology comes from leveraging the knowledge of the sell-side business in understanding how to rate and value asset classes, in particular over-the-counter (OTC) derivatives products.

According to Datamonitor, spending on systems to handle both margin management and securities lending will increase, and is estimated to reach $1.3bn (€1bn) globally by 2009, much of it ($666m) from broker dealers trying to compete further with the big investment banks. But this is spending across the prime broking business, and not just in the forex sector.

“Multi-strategies are now so common that the attractiveness of signing up to a platform is often not just to handle FX but across the assets,” says Alistair Smith, head of global
netting at Barclays Capital.

Smith points out that any relationship with a prime broker must include a longer-term view that even if you do not want the facility now, where might the future of your business lead?

The general industry consensus is that for most clients the future has already arrived. Bank of International Settlement figures for the first half of 2006 show a huge growth in over-the-counter derivatives. Notional amounts of all types of OTC contracts stood at $370,000bn at the end of June, 24 per cent higher than six months before. Outstanding credit default swaps (CDS) increased by 46 per cent, while interest rate derivatives rose by 24 per cent and FX contracts expanded by 22 per cent.

The expansion in use of these products in any forex strategy lends itself to using cross-asset management systems, but some believe the nub of the question for the FX prime broker is clearer than that.

“I think that the issue of cross-asset management systems is a red herring in this business. Cross margining, however, is something that’s important to customers,” argues Justyn Trenner, head of research firm ClientKnowledge. “Having systems that recognise and revalue portfolios and apply the margin calculations to FX related assets is what the customers are interested in.”

The fund manager uses the credit line provided by the prime brokerage by placing collateral with it and allowing it to trade and source liquidity from many other counterparty banks. The broker handles the clearing and operational aspects of a transaction and the execution broker bank ‘gives up’ the trade to the prime broker, which accepts the settlement and credit risks on both the client and counterparty.

For the client the system provides better market liquidity and more competitive pricing, in part because they can deal with a variety of counterparties but also because they are only seen to be trading under the prime broker’s name. Essentially the system gives the client a certain amount of leverage on their own assets.

Real-time reports

“These platforms enable a portfolio margining approach and you should find that the net
margin required is substantially lowered, giving you greater utilisation of capital through cross-collateralisation,” explains David Aldrich, head of Bank of New York’s hedge and broker business in Europe.

Mr Smith of Barclays Capital adds: “The attraction of cross-product margining is that clients aren’t employing so much of their capital. If on one master agreement you’ve lost $10m but on another you’ve made $50m, that’s a lot of cash moving around on an individual deal basis. But with cross-margining there is no need to move margin so capital is freed up.”

Mr Smith comments: “Clients are looking for cross-products margining, but not necessarily in real time.”

For other strategies, real-time information is vital. “Online real-time reconciliation across derivatives is important if, for example, a hedge fund has booked a trade the wrong way and has been hedging incorrectly for two days. That’s a lot of money lost on margins,” says Mr Smith. In theory, extending this capability across a hedge fund’s portfolio of assets can bring big savings. From the prime broker’s point of view, the system also reduces their credit risk and enables them to offer additional loans to their customers. Traditionally many of the brokerage departments worked in silos, duplicating effort in managing collateral and sometimes, with overlapping use of collateral, giving inaccurate cover to the bank.

Another driver is rapidly changing regulation. Under Basel II, cross-collateralisation can reduce the capital charge that a bank needs to allocate for its exposures. It also provides operational efficiencies.

Another boost for the FX sector is the emergence of algorithmic trading. This rules-based investment strategy has seen the number of trades expanding exponentially and has become a regular, if relatively small, source of alpha for hedge funds. The ability to cross-collateralise in real time on these sorts of trades again boosts the client’s capital base and reduces the prime broker’s risk.

But there are those in the industry who view with scepticism many of the claims to offer a full cross-asset platform.

“A lot of players profess to offer a comprehensive cross-asset platform but just how efficient they are in cross-margin calculations is debatable, and there remains a lot of manual work behind,” observes Nick Jones, head of European sales and marketing of FX at Bear Stearns. “Many are fine on handling vanilla FX products but some OTC stuff is not there yet.”

Secrecy is all

Mr Smith at Barclays Capital agrees. “There are some products that don’t lend themselves to off-setting such as distressed bonds,” he says. However, as part of initial contract negotiations, prime brokers insert portfolio calculations to assess these sorts of margins and risks and as technology develops add solutions to the platforms.

“A lot of the dominant players in the prime brokerage area have heritage systems and find it difficult to provide a true cross-asset handling service. The newer players don’t have that older technology but the investment required in any area of prime brokerage is very, very substantial,” says BNY’s Mr. Aldrich.

As with so much of the prime brokerage business, secrecy is paramount. While companies such as Barclays Capital have developed systems from scratch and generally get mentioned as one who has ‘done it’, those with weaker product offerings are generally not identified. cross-asset prime broking, multi-asset investment, derivatives, hedge funds, investment managers, FX, foreign exchange

FT Mandate December 2006

The explosion within the FX market is no secret, but now prime brokers are looking to get a piece of the action as the asset class evolves into a potential alpha generator. Gerry O’Kane reports.

It has become almost a cliché over the past few years to say that the business of foreign exchange is booming. Year-on-year volume turnover is growing, liquidity is improving and there are more players in the forex game. Even the business infrastructure has evolved.

“There’s no doubt that the market continues to grow for those in foreign exchange prime brokerage (FXPB) with substantial changes over the past six years,” agrees Devin Graham, global head of FX prime brokerage at UBS.

Few would argue that it was only a single factor that has changed the business. New business models have gone hand-in-hand with a fundamental change in the investment strategies of asset managers, hedge funds, pension funds and corporates.

“I see more interest from clients in the market use of forex for alpha rather than only hedging,” says Mel Gunewardena, global head of fixed income prime brokerage at Deutsche Bank.

The figures for the business are certainly impressive despite a recent slow-down in the market. The Bank of International Settlements (BIS) tri-annual survey showed a massive 25 per cent growth in 2004 when daily volumes were calculated to be $1700bn (€1283bn), while research firm Greenwich Associates reported a 14 per cent growth in 2005.

New research from TowerGroup concludes that by 2007, global FX daily average volumes will exceed $3000bn. It expects that over 44 per cent of that volume will be traded electronically, a far cry from the antiquated methods of the 1990s whereby trading was nearly solely by phone or fax.

While FX trading is still dominated by the large dealing banks in the final provision of liquidity and market-making, it is the FX prime brokers who have made the biggest changes to exploit new technologies and new demand.

“In the past, funds held margin accounts directly with the banks for forex trading but because their positions were known, they frequently didn’t get best price and became fed up with markets going against them,” says Roger Allen, director of FX prime broking at Dresdner Kleinwort.

“The prime broker is segregated from the sell-side of the bank and the system of ‘renting’ part of our balance sheet to trade developed,” he adds. Trading under a prime brokers account gave players not only a line of consolidated credit but a certain amount of anonymity.

“The FX prime broker central market is clearer for a client – placing his collateral with one counterparty (the prime broker) to get effective access to the market, also extending his credit lines to access executing brokers,” explains Mr Graham.

What differentiates the FX market from others such as equity or bonds is that it has evolved as an over-the-counter (OTC) market. Operationally that creates problems in as much as it is a principal to principal deal. By using a prime broker the client can get access to more liquidity; the credit line. It also reduces cost and risk in settling trades since the client has one or two relationships (with prime brokers) rather than having perhaps dozens by dealing directly.

“It is very much a service and no-one makes very much money on FXPB, but we’re always looking to add value and hopefully win execution business where the money is made,” reveals Nick Jones, head of European sales and marketing of FX at Bear Stearns.

Indeed one source says prime broker margins on handling clients’ credit has fallen from about $20 per million ten years ago, to $5 per million today. But while that may be true, it has not seriously hurt the business. “Fees have come down a lot but effectively we’ve bettered our position through the use of technology,” explains Mr Allen. “It’s important to realise you pay for what you get and with prices too low there’s no service or investment but the industry knows this.”

Indeed the development of FXPB reflects much of what has happened elsewhere in the financial services world. As with securities lending and securities servicing, there is an ongoing leveraging of technology in particular utilising experience and systems from the sell-side of their institutions. The objective is not only to protect their own assets and assess risk but provide more efficient trading to cut costs and to an extent provide a level of outsourced services to the clients.

“It’s the availability of that technology that makes prime brokers more accessible to the players even enabling smaller banks to trade with a wider range of second tier banks. The market has grown dramatically with different types of users utilising different channels,” outlines Justyn Trenner, head of research firm ClientKnowledge.

The FX prime broker is not the only player to have facilitated a greater access to the marketplace.

The more traditional request for quotes primarily from the largest banks is being challenged with exchange-like models using a bid-and-offer system.

This growth in electronic communications networks (ECN) has made it easier for traders to enter the FX market and reduce the risks associated with these transactions. In part the ECNs have introduced the liquidity always held by the sell-side to those on the buy-side.

In spite of many of the new traders being low-value, high-volume players, the plummeting costs of transactions over these, and the bigger networks dominated by EBS and Reuters, has seen the growing use of black box technology. The algorithmic systems give speculative trading in search of alpha a boost.

Traditionally the FX market was nearly solely one which found business from hedging strategies, protecting equity or bond positions from moving currency rates. The dramatic shake-up in investment strategies following the equity crash at the millennium saw long-only asset managers, pension funds and hedge funds seek out alternative investment strategies.

“We’ve seen a lot of growth from hedge funds and asset managers seeking alpha – some are asset managers launching hedge funds, pension funds are accessing FX through them and hedge funds, all add to the business,” says Mr Graham.

In part the alpha strategies are facilitated by the use of algorithmic trading which has become cost-effective. However, the macro economic outlook has changed as well. The convergence of G7 monetary and fiscal policies in the 1990s saw fewer alpha opportunities, but the current environment of policy divergence has once again boosted the opportunities for creating alpha.

But alpha strategies remain a minor part of the business. “Speculating in forex is only a fraction of the market and currently hedging remains a much bigger component there,” says Ted Platt, head of prime brokerage in EMEA at Merrill Lynch. He says the industry is more concerned with broadening its offering, handling alpha strategies, hedging and systems.

Cross-product investments

“As hedge funds develop bigger and more multi-asset strategies and asset managers move into new classes as a way of generating returns, there is more demand for cross-product trading and integrated prime brokerage platforms,” explains Marek Robertson head of FX liquidity solutions at Barclays Capital.

As with all the issues facing FX prime brokerage the strategies have created certain chicken and egg situations.

“FX prime brokers are now challenged to service both high volume cash products and increasingly complex derivatives products,” adds Mr Robertson. “It’s one thing to service vanilla products but harder to do so for high frequency traders and multi-asset derivatives traders, and this is pushing the development of cross-asset platforms to manage risk and consolidate margins.”

Similarly the investment in technology has allowed prime brokers to service clients in spite of the increase in trades. “Constant investment has led to grand economies of scale and it’s easy to add 10,000 tickets a day whereas if those tickets had to be handled in the old fashioned manual way you wouldn’t have the capacity,” says Mr Allen.

The issue of technology is now at the heart of the development of the forex markets. It is vital to be able to give access to the burgeoning numbers of ECNs, offer application programme interfaces to clients to allow their own black box technology access to the markets, process tickets, reduce operational risk by automating processes wherever possible and simply provide services that clients demand.

“It’s not a business so much about pieces of technology, but front-to-back systems that simplify trade capture, handle reconciliation, process settlement and offers clear reporting. It should be a smooth process from trade booking onwards,” advises Mr Platt.

Today, the importance of these systems cannot be under-estimated. Not only are they crucial in reducing risk between all the parties, the client, the prime broker and the executing broker, but there is an element of expectation from many of the clients that that is what they expect.

Hedge fund clients and the like are hugely important to the prime brokers. According to BIS figures one third of FX activity in 2004 came from hedge funds, commodity trading advisors (CTAs) and professional money managers. Most of the rest lies with interbank FX dealing, the largest of whom have their own exclusive dealing networks obviating the need for prime broking.

As with elsewhere in the financial world, hedge funds and now CTAs want to concentrate on their core business and wish to outsource the process to the prime brokers. Without having the facility to service this demand leaves a prime broker out in the cold.

And there is every indication that this business will grow. In early 2006 TowerGroup estimated that the compound annual growth rate in hedge fund FX assets would be 15 per cent, around $2000bn by 2008, a figure it now acknowledges to be on the low side.

foreign exchange, FX,alpha, prime brokers gaining business, derivatives, OTC products,/tag>

FT Mandate December 2006

The future might look rosy for foreign exchange prime brokerage, but those who refuse to provide a broader service through new technology may find themselves left behind. Gerry O’Kane discusses this and other issues facing FX prime brokers in the next few years.

There is little doubt that the industry sees the future of prime brokerage in the foreign exchange market as healthy. Trade volumes may not be growing at the rates of a year ago but they show no signs of declining either.

“In a nutshell, future developments will include many more clients attracted to the prime brokerage model not just for leveraging credit but also to avail themselves of the sort of outsourcing models the prime brokers have,” says Roger Allen, director of FX prime broking at Dresdner Kleinwort.

However, there are likely to be changes as the industry develops and adjusts itself to the ever-increasing demands of existing clients and new entrants.

“I’d expect FX prime brokers will continue to focus on client problems, including efficient pricing or risk management, in order to give them some edge over competitors. They’re pushing to bundle more products” says David Aldrich, head of the Bank of New York’s hedge and broker business in Europe.

At the back end of the process, integration will continue, he believes, making it easier to move data through to custodians and fund administrators.

While technology solutions are seen to be the main driver of change over the immediate future, one area that may get a shake-up are those prime brokers who only specialise in foreign exchange. “I think that FX prime brokerage is a subset of the business and when you’ve got hedge funds only dealing in forex that’s fine but when they want broader market access then capabilities will be important” warns Ted Platt, head of prime brokerage in EMEA at Merrill Lynch.

For these smaller FX-only operations finding the money to invest in the technology required by this broader service demand will not be easy. As a result there is likely to be an increase in white labelling systems and one ECN, GAIN Capital already generates half of its revenues from that business.

But it is unlikely to be an immediate disappearance of the specialist players since it seems that about half the players in forex continue to use non-electronic trading.

“It’s fair to say that technology will move to make the process more automated and reduce the reliance on phone deals and not to be able to go with that growth could cause problems,” says Mr Platt. “I’d never write off a specialist but I do expect broader prime broker players,” he adds.

Elsewhere some expect to see consolidation in the number of ECNs. “There are a wide variety of these systems now and while its likely that both EBS and Reuters will remain the main players, more are likely to come in,” says Mr Allen. “But I’m certain we’ll see a consolidation process in that sector too and it’s starting already.” In June 2006, ICAP, the world’s largest interdealer broker acquired EBS.

“For the future I’d see ECNs offering more tools such as cross-collateral trade to pick up margins and certainly an improvement in real-time servicing,” says Glenn Stevens, managing director of the GAIN Capital Group, an electronic communication network (ECN).

He also notes that as the ECN market develops, players may look for technologies that allow them to disaggregate large trades, something only the more sophisticated FX prime brokers currently offer. This means executing deals in smaller pieces over time concentrating on market impact rather than pure price.

The use of technology to create further operational efficiencies and lower risk will continue to develop, as will an ever-increasing use of electronic trading. The development of more workflow solutions for clients is likely to continue.

As algorithmic trading has left the equities world and moved into forex, some expect more sophisticated models to emerge. The one caveat with it, however, is that it functions better in low-volatility environments, as the forex market-place has been for some time. Should this change there may be a fall-off in some of the volumes coming from the less-sophisticated players, leaving the advantage to those with models that spread risk.

According to Mr Stevens, modelling systems are likely to become more sophisticated. Post trade data-mining is one area tipped for growth. While some of the bigger banks already do this, it is not yet a common but could tighten spreads still further as the systems extrapolate the effects of certain deals in the market.

Already algorithmic trading has highlighted issues of pricing across ECNs, as banks complain that they are being hit by sniping. They argue that some players are putting in bids and offers to EBS and Reuters and then hitting ECNs at the same time for larger amounts. It creates a ‘liquidity mirage’ and hurts the liquidity providers, the big banks, and because the speed of using algorithmic techniques it is hard to respond.

“Sniping does happen but the counterparty banks figure it out after a while and refuse to do business for a time,” says Nick Jones, head of European sales and marketing of FX at Bear Stearns.

The effects of this are two-fold. Firstly few see future bid/ask spreads widening any time soon and secondly, it will push the banks to reassess how they will provide liquidity. The critics of the banks’ complaints on sniping is that it highlights an inefficiency in their pricing methodology and their own systems will have to improve – boosting data mining technologies, for example.

prime broker, foreign exchange, FX, technology, ECNs, Gain Capital