Marketplace adversity brings opportunity along with it.
Swiss National Bank’s abandonment of the Swiss Franc’s peg in 2015 proved a catalyst of great change in the brokerage industry, with the advent of a new type of prime broker.
A prime of prime assists those medium-size entities in need of liquidity providers, and is causing transformation and innovation within the industry.
What has the brokerage industry been doing in recent times to try and fill the liquidity gap?
With growth in the hedge fund market now focused at the proto-end of the spectrum, this shift is having a profound impact on liquidity provision.
Ultimately, without access to deep markets and competitive pricing, it’s going to be far harder to deliver a meaningful alpha.
But with the prime broker market having undergone some significant structural change in recent years, the reality is that only the very largest of hedge funds are now in a position to strike a meaningful relationship with the true tier one liquidity providers. So what does this mean for today’s hedge funds?
By all accounts, the world changed in the wake of the Swiss National Bank’s decision to abandon the Swiss Franc’s peg to the Euro in early 2015.
Currency markets may be the most obvious association here, but the shift in the behaviour of tier one liquidity providers extended across all asset classes.
Legacy prime brokers either withdrew from the market altogether or otherwise levied significant monthly minimums. Risk appetite changed internally, while the demand for better return on equity also made smaller counterparties simply too expensive to service.
The result here has been the advent of a new genre of brokers acting as a liquidity provider, known as prime of prime.
The terminology here is still evolving as the market adapts to the new normal which is causing some challenges, but a true prime of prime broker will be able to directly face tier one liquidity providers on behalf of a hedge fund, while also having sufficient depth of credit to facilitate the necessary asset flow at any scale.
Some providers purport to offer prime of prime but only serve to recycle the liquidity of others, presenting a perfect backdrop for challenges especially in times of thin market liquidity, so if you’re looking to improve alpha by using a prime of prime arrangement, there are a few key points worth considering.
- Does the broker genuinely face a tier one liquidity provider, one of the legacy prime brokers?
- A significant balance sheet is going to be necessary to ensure that the broker can facilitate access to significant levels of market depth.
- The broker is going to need genuine credibility in the market to be able to deliver on the above two points.
If you’ve found a broker who genuinely provides prime of prime services, what should industry participants be looking for next?
That prime of prime broker is going to be your representative in the market, so you need to trust them, and equally they need to trust you.
So, demand transparency from them – and expect to see it demanded from you in return – but this should all be part of ensuring any liquidity provider can actually meet the needs of the hedge fund.
For example, just how wide is the product range? G10 currencies, oil and a handful of precious metals simply won’t cut it with the majority of hedge funds, but at CMC Markets, we offer access to indices, commodities, treasuries and over 9,000 single stock CFDs
With stock borrowing now becoming so much more expensive too, the idea of using a derivative to generate short exposure needs serious consideration.
A few years ago it may have been seen as taboo, but contracts for difference now play an ever important role with this corner of the retail market.
What’s more, an entity that can combine internal flow with that of the underlying market is arguably going to be left providing a far higher quality of liquidity.
What underlying technology are those in the industry looking towards to help them with liquidity ratios?
A small number of entities have invested heavily in proprietary software on both the back and front end, rather than relying on old technology or off the shelf solutions.
Even better, see if it’s maintained in house, as this helps ensure optimum performance at all times and the most forward-thinking prime of primes will be flexible enough to meet the ongoing evolving needs of their clients, rather than adopting a take-it-or-leave-it view.
After all, liquidity provision for the industry always used to be reliant on quality of service, so ensuring reporting, technology interfaces and APIs are working in the customer’s best interests should be seen as a critical part of the equation.
With traditional prime broker relationships now out of reach for the vast majority of hedge funds, alternative solutions need to be sought for those demanding the very best in terms of pricing and market depth.
Prime of prime offers a legitimate way forward here in a market that has otherwise been left to battle against a liquidity void.
Yes, prime of prime is still evolving and the brokers in this space certainly aren’t all created equal. Be careful as to what’s on offer, but for the majority, instinct dictates that the company with an FCA licence, London Stock Exchange listing and offices in the world’s major financial centres is going to deliver better quality liquidity and service than the privately held entity working offshore.
Expertise in this sector remains thin on the ground too, so take the time to engage with any counterparty that you may want to use here.
Ask questions such as whether they have a representative with autonomy working in a broadly aligned time zone as you? And if so, who are these people and what real-world experience can they bring to the relationship.
Perhaps most importantly of all, make sure your goals are aligned; that just as you’re looking for success, any liquidity partner is doing the same thing, too.
Scale and ambition count for a lot when you’re looking to deliver alpha. Make sure you’ve got the right partners on side to help you achieve those goals.
Ross Newell is a business development manager with CMC Institutional, the broker-to-broker division of CMC Markets. Newell works with institutional clients including hedge funds, family offices, smaller banks and FX brokerages to ensure they receive tailored liquidity solutions to meet their needs. With the company having invested over $100m in its next-generation trading services platform, he also ensures that clients have a full understanding of the institutional-grade technology which is on offer.