The world of liquidity provision across all asset classes has been through a period of wholesale reform in recent years. Changes to the capital adequacy framework adopted by banks and brokerages as part of the Basel III accord have left legacy tier one liquidity providers to focus their attention on only the very largest of clients. The following q+a explores just how profound an effect this is having on the hedge fund industry, the service providers who have sprung up attempting to fill this gap, what to look for in a liquidity provider and critically how managers are now adapting to tackle these changes.
Why have Tier One providers moved the goalposts?
A: There have been a whole host of factors combining to create something of a perfect storm in this market over the last few years. We’ve seen capital adequacy change through Basel III, plus mounting risk aversion in general after a number of tier one players saw counterparties get caught on the wrong side of those significant market movements. That’s meant Tier One liquidity providers are being more discerning as to who they are willing to do business with, whilst their own internalisation of flow has also served to further change the economics of providing liquidity to a large number of relatively small parties.
What has this meant in real terms for managers?
A: It’s put another step in the chain when it comes to finding liquidity, which has all too often meant lower quality service provision and higher transaction costs. The former can at least to an extent be accounted for but the reality is that the latter results in a direct impact on the viability of a fund’s strategy. This was a disappointing situation for the industry to find itself in as the biggest managers are no longer versatile enough to make good returns, whilst the smaller ones were struggling to keep costs low. Failure for the underlying market to address this changing narrative really wasn’t an option, hence the need for some degree of evolution.
How is the industry adapting to change?
A: There has been a slew of brokers coming to the market offering so-called prime services, where they’re aggregating demand for flow. It’s worth bearing in mind however there are some subtle differences here and not all participants are providing the same product. A number of smaller players are simply recycling liquidity which doesn’t help in terms of cost or indeed quality, especially if market depth is lacking. However, there are a number of major players who have entered this prime brokerage space, such as CMC Markets. We use our own balance sheet and existing tier one relationships to leverage significant liquidity on behalf of our institutional clients.
Can you explain more about the mix of prime service providers?
A: Prime brokerage requires two key aspects. Genuine relationships with tier one liquidity providers and a significant supply of capital to fund the operation. If those two factors aren’t present in tandem, then it’s unlikely you’re going to be getting a quality service. This recycling of liquidity by those providers who aren’t sourcing directly from a tier one broker could end up presenting systemic risk when you’re in a fast moving and potentially highly contested market. Furthermore, without adequate financial backing, a service provider isn’t going to be in a position to secure the credit lines necessary to deliver flow at any meaningful scale. As well as an influx of brokers moving into this space, in recent years we’ve also notably seen exits, including one recent high-profile departure. Ultimately, if the broker’s backers believe the capital can be better deployed elsewhere then that’s a simple consequence of business. It does however also suggest that at present, prime brokerage fees may be lower than they should be, and again those who can blend genuine tier one liquidity with their own internal flows have the potential to provide a clear USP.
What about product innovation?
A: Synthetic products are becoming significantly more prevalent in the arsenal of fund managers. A few years back, using a Contract for Difference or CFD to generate short exposure for something like an equity was seen as a poor second to stock borrowing. However, rising costs and the sheer demand for stock loan means that working with a counterparty who can provide native access to instruments like this has its advantages, too. It’s all about minimising the cost and maximising flexibility when it comes to maximising alpha, but arguably it’s only a small number of well-regarded brokers who are now in a position to help you achieve that goal.
Where does that leave the market now?
A: Technology is going to remain a key driver when it comes to providing the highest quality product, which in turn helps foster a return to the personal and supportive service which was the hallmark of this industry before the financial crisis. CMC Markets has invested over $100 million in its next-gen trading platform, which not only has the ability to handle over 50,000 prices per second, but also comes with the functionality to allow institutional counterparties to harness its full potential, too. Whether that is through the ability to trade via a FIX API connection across multiple global data centres which in turn connect directly into the OMS or CMC’s Prime Derivatives platform, or by having the position keeping and reporting functionality available which integrates seamlessly with the counterparty’s existing infrastructure, smart use of technology is making a real difference here.
The market has fundamentally changed and it’s difficult to see a return to where we were a couple of decades ago. However, Malcolm’s key take-away here seems to be that evolution is already well advanced and service providers are working hard to build a liquidity ecosystem that reflects the needs of today’s environment. What’s more, as tier one brokers have increasingly internalised their own flow, those institutional brokers who can blend their own order books with that of the broader market’s liquidity will be well placed to deliver the most competitive combination of depth and price. That said, despite these recent changes, this is now a fully commoditised sector of the industry and pricing models still need to be honed. There’s a race to zero underway, but as the old adage says if something’s too good to be true, then it probably is. Change may not always be comfortable, but it’s not always bad, either.
Malcolm Ford is CMC Institutional’s equity and derivatives broker specialist. With thirty years of experience working for companies ranging from start-ups to tier one banks, Ford is responsible for growing the company’s range of services to the hedge fund industry. Having worked with both the buy and sell side across Europe, Asia, South Africa and the USA, previous employers have included Credit Agricole Cheuvreux, Morgan Stanley and Liner Investments, as well as assisting a series of fintech startups through Jon Carp’s Finceler8.