The significance of a well-capitalised prime broker

Andrew Wood, business development manager at CMC Institutional, explores the pivotal connection between capitalisation and the future success or failure for funds starting up, and the importance of minimising order rejection.

The recent trend of liquidity provision shows no sign of abating any time soon. But as it becomes increasingly difficult for all but the biggest of banks and brokers to gain direct access to the traditional Tier 1 liquidity suppliers, a new generation of prime brokerage (PB) is proliferating. On the surface, the respective propositions of these PBs may appear to come with a high degree of homogeneity, and the concept of new challengers being able to provide added competition in an ostensibly stale market may be welcome. However, dig a little deeper and the adequacy of their capitalisation can be the difference between success or failure for an emerging manager’s successful execution of their strategy. Sydney-based Andrew Wood, business development manager at CMC Institutional Asia-Pacific (APAC), answers some key questions on this defining challenge being faced by the next generation of hedge funds. 

 

What will define success or failure for a fund starting up today?

Andrew Wood, CMC Institutional: Even before any discussion of asset classes or strategies, the most critical point is profitability. An unprofitable fund won’t impress existing investors and will struggle to get new money through the door. But key to achieving that goal is – if the fund is in a high-volume mindset where aggregate profits must eclipse losses – ensuring the most is made out of every single trade. That boils down to pricing, eliminating slippage and ensuring orders can be filled in a single transaction. 

 

So what is the relationship with capitalisation? 

Andrew Wood: A well-capitalised prime broker should be in a position to offer a fund better lines of credit and also tap into greater depth and better pricing with traditional Tier 1 liquidity providers. The primary risk of using a smaller start-up in the PB space is that they either won’t be in a position to execute orders at scale, instead having to fill trades in multiple lots. This increases the risk of slippage, and/or the recycling of liquidity from other prime brokers, with the incremental costs incurred through this process passed on to the fund. There may be a lower headline price per million being quoted, but the risk is that it’s masking pricing issues elsewhere. With the difference between success and failure being so marginal, even losing just the occasional pip can decimate a fund’s performance. 

 

How can you tell if a prime broker is well capitalised? 

Andrew Wood: It isn’t always easy. There has been a proliferation of privately held entities operating in this sector, which can make it difficult to establish a clear understanding of the finances. Furthermore, it’s fair to say this is a capital-intensive business, so shareholder enthusiasm for bankrolling liquidity provisions in isolation can sometimes be short-lived. The risk here can, however, be mitigated to an extent by considering a range of factors such as the ownership structure or the jurisdiction of regulation. A company of any size listed on a major stock exchange is likely to be subject to quarterly public reporting, offering the highest level of transparency when disclosing its capital position. The underlying share price itself can also give an early notification of any deterioration in the balance sheet.

Beyond this, regulatory oversight has the potential to provide an added layer or security for listed companies and offer some useful guidance on the strength of those that are privately held. A traditional regulator such as the Australian Securities and Investments Commission, Germany’s BaFin or the UK’s Financial Conduct Authority will typically demand higher capital adequacy levels for a broker than would be found among some other jurisdictions, while careful analysis of the order fill ratio can provide helpful guidance over the brokerage’s funding position. A sharp rise in rejections without any obvious change in the underlying market could indicate a more stressed financial position at the prime broker. 

 

Does an occasional rejected order make a big difference to profitability? 

Andrew Wood: It certainly does. That means not only do you want to ensure the price you are quoted can be executed against, but you also want to understand what the broker is doing to ensure you’re seeing high-quality liquidity as that can ultimately improve a fund’s performance. CMC has developed a series of protocols that provide market-leading visibility over the sources of liquidity, and, if abusive patterns are identified, CMC can simply cut this flow from the book. Furthermore, CMC participated in a research project conducted by a Tier 1 liquidity provider, which highlighted that a quoted spread of 0.7 pips with a 15% rejection rate actually equated to a spread of around 1.1 pips. Applied over time, that sort of margin could be the difference between success and failure of a fund’s strategy, so understanding how processes are arrived at should be an important aspect of any counterparty due diligence and will ultimately end up impacting the total cost of execution. 

 

What is the upshot in this area? 

Andrew Wood: When investing in a fund – especially a proto-fund – part of the due diligence process needs to go well beyond the fund’s strategy and the track record of its managers and quants. Take the time to dig a little deeper and really understand who they plan to work with in terms of accessing pricing and liquidity. The reality is that for all but the very largest of funds, traditional Tier 1 brokerages won’t be interested, so it’s critical to ask the questions and see where they expect to be sending their flow. 

A string of unknown names regulated in fringe geographies is probably a good reason to start asking more questions, whereas listed firms subject to stringent regulation and which are seeing significant internal flow should be far better placed to assist with profitability in the long term. There may be a higher upfront cost per yard, but a fund manager who fails to acknowledge the risk of cutting corners here may themselves be a cause for concern. 

 

What is the significance of internal flow?

Andrew Wood: There are two key benefits to be realised in internal flow. Because the internal flow is already on the books, the prime broker isn’t having to pay any fees to access it in the first place, which gives a price advantage. Furthermore, by blending that with the liquidity available in the wider market, depth can also be improved. That means more orders being filled successfully up to a greater size and at potentially lower costs. Second, the internal flow can also provide a greater range of options when it comes to the assets on offer. Tier 1 liquidity providers are likely to be limited in the currencies they offer, with typically only about 60–80 pairs available. Brokerages with internal flow may have a far wider range of products, such as exotic currency pairs or even different asset classes, delivering greater flexibility when a counterparty needs it. 

 

^{CMC Markets provides retail and institutional services to a global audience of investors, blending both internal and external liquidity. The company is listed on the main market of the London Stock Exchange and is regulated under a range of jurisdictions including BaFin in Germany, the Financial Conduct Authority in the UK, the Monetary Authority of Singapore and the Australian Securities and Investments Commission.}

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