Presentation on theme: "FX Prime Brokerage: Risks and Challenges"— Presentation transcript:
1 FX Prime Brokerage: Risks and Challenges Global Operations Managers ConferenceHosted by the FX Joint Standing CommitteeApril 20-21
2 Growth of FX Prime Brokerage Overview:Foreign exchange prime brokerage (FXPB) came to the forefront in the late 1990’s but had limited traction.Over the last 3 to 4 years, the Industry has seen explosive growth in this business fueled by increased interest in FX as an asset class and the soaring number of new hedge funds.Entering the FXPB space may be a valuable way for banks to leverage existing infrastructure and investment.Primary clients:Hedge fundsCommodity trading advisors (CTA’s)Traditional asset managers & regional banksHow it works:Clients trade with an executing brokers, who then "give-up" their trades to the FXPB for trade processing.The FXPB acts as a central counterparty to the clients’ transactions:Holding any collateral required for tradingExtending credit linesBecoming the central back office for the client
3 FX Prime Brokerage Model ClientTrades with a numberof bank counterpartiesExecuting brokerExecution + PB instructionsClient may out-source operational functionsPB confirms block trade with BrokerAllocations + broker instructionsTrade given up to PBPrime Broker Operations confirms allocations with Client and/or middle office providerService ProviderManages the operationalsupport for the clientFX Prime Broker
4 Value Proposition Client FXPB Executing Broker Access to multi-dealer pricing and liquidityRealize operational efficiencies, STP and reduction in capital expendituresCollateral requirements aggregated with the FXPBTrade allocation, confirmation and settlement consolidated with FXPBConsolidate and customize reporting through the FXPB.Primary documentation required only with the FXPBFXPBGenerate new fee-based revenue streamDevelop new and strengthen existing client relationshipsLeverage technology and operating infrastructureExecuting BrokerIncrease execution flows by transacting business with less credit worthy counterparties by implementing Give-Up AgreementsEfficient operational flows as the parties to the trade are dealersHowever, a complex web of relationships is created which has prompted review by the Industry
5 Risks & Challenges for the Prime Broker Credit RiskManaging exposure to highly leveraged clients (hedge funds)Establishing appropriate credit terms (VaR vs Initial Margin)Real time monitoring of liquidity within the terms of the Give-Up AgreementLack of standardized Give-Up AgreementsLiquidity RiskFXPB shares credit lines with the Firm’s Franchise BusinessOperational RiskMonitoring of post execution events (exercises, barriers..)Clients outsourcing operationsNotification of the “give-up” trade is primarily manual (Reuters & )Identifying incoming trades as Franchise or FXPB relatedMarket RiskManaging basis risk introduced by a client putting on option and NDF positions and taking off these positions with different executing brokers (pass through / non pass through)Resolving disputes between the client and executing brokerReputational RiskCreating a “Chinese wall” to segregate a Firm’s Franchise and FXPB business (client confidentiality)Identifying off market trades
6 Risks & challenges for the Executing Broker Credit RiskMonitoring credit limits within the parameters of the Give-Up AgreementLack of standardization in Give-Up AgreementsTrade rejection by the FXPBOperational RiskNotification of the “give up” trade to the FXPB is manual (Reuters and )Market RiskDelays in the client notifying the FXPB of a trade exposes the executing broker to extended market risk.Reliance on the FXPB to properly match trades and highlight discrepanciesReputational RiskFailure to “give-up” trades in timely fashionRequirement of the U.S. Patriot Act to Know Your Client (KYC)Electronic Communication Networks (ECNs) eliminate the ability of the executing broker to identify the underlying account.Executing off market trades
7 Risks & Challenges for the Client Confidentiality RiskReliance on PB to implement proper “Chinese walls” segregating the clients portfolio from the PB’s franchise businessConcentration RiskClients put “all their eggs in one basket”If the credit worthiness of the PB deteriorates or the relationship terminates, the client may be faced with credit, liquidity and/or operational risks.Operational RiskReconciliation of portfolio with FXPBTrade rejection by the FXPBMonitoring of post execution events (exercises, barriers..)Market RiskFailure to notify FXPB of trades in timely fashionReliance on the FXPB to properly match trades and highlight discrepanciesManaging basis risk introduced by putting on and taking off option, derivative and ndf positions with multiple brokers
8 Industry InitiativesMarket participants, central banks and industry organizations have come together to address some of the broader systemic risks emerging in the FXPB business.Current Initiatives:The FXJSC Prime Brokerage/E-Commerce Sub Group is conducting an analysis of the development and risks associated with FXPB with the goal of making recommendations of guidelines to be included in the NIPS Code.The NY Fed FX Operations Managers Prime Brokerage Sub Group is reviewing the operational issues and risks associated with the FXPB businessNY Foreign Exchange Committee (FXC) / Financial Markets Legal Group (FMLG):The FXC published a standard Give-Up AgreementThe FMLG is undertaking a review, in consultation with the U.S. Department of Treasury, of the KYC responsibilities foreign exchange executing brokers have under the U.S. Patriot ActParticipating dealers must continue to work together to create automated solutions for the notification process. Existing vendor solutions provided by Traiana and FXall but are still in the early stages.
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