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The Evolution of Prime Brokerage in Foreign Exchange
06
Feb
The Evolution of Prime Brokerage in Foreign Exchange

As foreign exchange (FX) establishes itself as an asset class of choice among hedge funds, prime brokers are increasingly looking for ways to take a bigger share of the market and differentiate their offerings. Since its birth at the tail end of the last century, Foreign Exchange Prime Brokerage (FXPB) has quickly gained momentum.

Its growth has been driven by the ever increasing number of hedge funds trading FX through prime brokers. While FX has always been used as a hedging mechanism, it is now considered to be a primary investment model rather than a support mechanism. In its simplest format, FXPB is a front-end arrangement providing hedge funds with access to exchanges and execution services. Prime brokerage relationships allow hedge funds to gain access to new counterparties and large funds despite an often limited credit or high risk history.

The prime broker streamlines the credit and documentation process, easily enabling hedge funds to access pricing and liquidity from a number of dealers. The FXPB relationship differs to the traditional executing broker relationship by offering credit intermediation for over-the-counter (OTC) transactions given up by other executing brokers, cross-product margining and end of day reporting of positions directly to the fund administrators. Historically, hedge funds have been heavily reliant on manual processes.

However, these traditional operating models cannot satisfy the increasingly complex demands of the business. As a result, the role of third party relationships has become a crucial part of allowing them to respond to their clients. By outsourcing business processes, hedge funds are able to gain access to otherwise costly technology to manage their increasing volumes of trades and deliver complex products and services to their clients. Outsourcing options Outsourcing enables hedge funds to operate at a much lower cost level whilst focusing on their core competency of building successful trading strategies. By maintaining only a minimum number of staff, overheads are kept under control. In addition to providing scalability and flexibility, outsourcing also reduces operational and settlement risk. Depending on the sophistication of their requirements, hedge funds can choose to outsource their entire middle and back office to a single outsource provider. This gives them the cost benefit of operating with economies of scale and the ability to amalgamate all their information in one place. Alternatively, a hedge fund may choose to outsource only part of its back office operations, for example, to a specialist OTC derivatives unit, enabling it to benefit from expertise in complex asset classes. The backlog of unmatched and unsettled trades within the credit derivatives market is cause for concern from a risk perspective and the speed and efficiency at which a trade is matched is crucial to decreasing operational risk.

A one-stop-shop for FX has become a highly competitive and technologically advanced market leading to extended liquidity and as a result prime brokerage fees continue to be driven down.

"Prior to dealing with FXPB’s, I considered them as an unnecessary and additional layer of cost. After establishing relationships with them, I have completely changed my tune and consider them an important and necessary component of our operations" Stated George Grech who is head of the trade desk at EXANTE.

 

To counter price pressures, prime brokers like EXANTE are increasingly extending their range of services to grab as much hedge fund business as possible. Many prime brokers now provide a comprehensive package of services across multiple asset classes including start-up, capital introduction, payment services, cash management, administering client accounts, research facilities, front and back office systems and associated software consultancy. Prime brokers are always looking to expand their offering to differentiate themselves from their competitors and from fund administrators.

By opting for a full service partnership, hedge funds can benefit from cross-margining, deeper pools of liquidity, more competitive pricing and faster execution. A one-stop-shop approach brings high levels of account support and can remove many operational headaches as business processes are streamlined. From the point of view of the prime broker, the one-stop-shop approach provides a strong fee-based revenue stream. It also strengthens their client relationships as hedge funds become more dependent on their services they have to work more closely with their prime broker.

A successful prime brokerage relationship can lead to hedge funds developing relationships with the bank in other business areas.

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