Foreign Exchange Prime Brokerage Product Overview and Best Practice Recommendations

33 Foreign Exchange Prime Brokerage Product Overview and Best Practice Recommendations

Overview Foreign exchange prime brokerage allows a client to source liquidity from a variety of executing dealers while maintaining a credit relationship, placing collateral, and settling with a single entity—the prime broker.

As illustrated in the figure on the following page, a prime-broker client conducts a trade with an executing dealer (also known as a “spoke ” or “give-up bank”) in the name of its prime broker. When the prime broker is informed of and accepts the transaction by the client and executing dealer, the prime broker, rather than the client, becomes the party to the transaction with the executing dealer. In addition, the prime broker will contemporaneously enter into an offsetting transaction with the client (or funds managed by the client or holding accounts managed by the client). The prime broker and the executing dealer confirm and settle the trade, while the prime broker settles with the client on a net basis. In exchange for the authority to trade in its name, the prime broker typically charges the client a fee on a volume basis for the trades conducted according to this arrangement.

Product Participants and Evolution Prime brokerage emerged in the early 1990s with the use of semi-formalized “give-up” arrangements initiated by a few financial institutions. The product gained momentum in the late 1990s when several banks entered the prime brokerage business with dedicated market and sales efforts, as well as tighter and more formal operational

35 FX Prime Brokerage Deal Process

1. Client trades with executing dealer (for example, sells 100 USD/JPY).

+ 100 USD/JPY Client Executing dealer + 100 USD/JPY + 100 USD/JPY - 100 USD/JP

Y - 100 USD/JPY 2. Client notifies prime broker 2. Executing dealer notifies of trade details. Prime prime broker of trade details. Relationship defined by Relationship defined by a broker prime brokerage agreement. give-up agreement.

3. Prime broker confirms matching details and inputs back-to-back trades. Block trades broken down according to agreed-upon allocations.

controls, procedures, and processes. This While the growth of the fund focus laid the foundation for a rapid expansion industry has contributed to the develop- of the client base. ment of the prime brokerage business, it is important to note that the client base is quite Clients diverse. In addition to hedge funds and CTAs, prime brokerage clients include small Foreign exchange prime brokerage has typically banks, other asset managers, endowments, been used by hedge funds and commodity foundations, partnerships, private family trading advisors (CTAs). Prime brokerage offices, and funds. The service is less allows these market participants, despite their frequently used by corporations and large limited credit history or higher risk profile, to banks. use the prime broker’s (presumably) higher credit rating to gain access to new counter- parties. Generally, these firms also maintain Prime Brokers low headcounts and prefer to outsource or Although the prime brokerage client base centralize as much trade processing as possible. has broadened in recent years, the rapid The industry has come to rely on growth of hedge funds is the main driver prime brokerage to such an extent that new behind the development of the prime bro- hedge fund managers include appointing a kerage service. Currently, the hedge fund prime broker among their first business industry is estimated to represent $875 billion decisions. in assets and to be growing at about 20 percent per year, with approximately 8,350 active

36 FOREIGN EXCHANGE COMMITTEE 2005 ANNUAL REPORT hedge funds.1 According to one source, in demand for end-to-end technology to 1997, fewer than ten organizations in the global support hedge funds—including risk analytics marketplace used a foreign exchange prime and portfolio management and reporting broker, and the market was dominated by four systems—so that portfolios can be actively banks. In 2005, market participants estimate monitored and analyzed. that between 450 and 600 clients use the prime brokerage service, and at least twenty The nature of prime-brokered trade different banks offer the service as a core foreign execution has also evolved. In the traditional exchange product. Despite the large number model, foreign exchange prime-brokered of institutions establishing prime brokerage transactions are initiated manually by the functions, the market has become increasingly client. While the client trades in the name of concentrated in recent years. According to the prime broker—using the prime broker’s the Hennessee Group’s tenth annual survey, credit line with the executing dealer—the the market share of the six largest prime execution of a transaction involves direct brokers increased to 83 percent in 2003, communication between the client and from 70 percent in 1999. executing dealer in which the identities of both parties are known.

Typical Service More recently, prime brokers have begun to The core services offered by the prime broker to provide trade execution via electronic commu- a client are , access to market liquidity, nication networks and electronic broking and consolidated settlement, clearing, and platforms. These platforms allow for automated reporting. In addition to allowing a client , which typically involves the to trade in its name, the prime broker can use of an application programming interface provide a range of services, which may that provides access to executable prices via include commission accrual and payment, two-way message interface between the statement and confirmation generation, and and a client’s internal housing and administering of client accounts. trading infrastructure. Notably, in the Some prime brokerage providers have electronic prime-broker model, there is begun to offer more sophisticated services, typically no identification of the trade as being with the goal of becoming a “one-stop shop” prime-brokered at the time of execution—the for hedge funds. These include start-up executing dealer only sees the name of services, capital introduction services, front- the prime broker. The identity of the client and back-office systems and technology, initiating the trade is not known to the research, and cash management services. executing dealer—providing an element of Market participants have noted increased anonymity to the client.

1Hedge Fund Association. Friedland, D. Facts About Hedge Funds .

FOREIGN EXCHANGE PRIME BROKERAGE 37 Value Proposition The client can manage a single position more easily than it can manage many individual Benefits to the Client positions with a variety of counterparties. In Prime brokerage allows the client to maximize addition, prime brokerage offers the client its credit relationships and activities while greater liquidity to execute larger trades. improving efficiency. In addition, prime brokerage streamlines the credit and docu- mentation process, given that the client is Benefits to the Prime Broker subject to one internal credit review and exe- For the prime broker, the product generates a cutes one master trading agreement and credit new, fee-based revenue stream, which is support annex with the prime broker, rather increasingly attractive as foreign exchange than many agreements with multiple dealers. spreads continue to narrow. In addition, the A prime brokerage arrangement provides for product contributes to an expansion of the the more efficient use of collateral for margin prime broker’s client base and a strengthen- relationships. Further, margin positions can be ing of its existing client relationships. netted as the client needs to manage just one Prime brokerage provides efficiencies of credit relationship to gain trading relationships scale with respect to transaction processing with many counterparties. In addition, the and technology investments and allows an client is able to access pricing and liquidity institution to leverage its technology and from a greater number of dealers and poten- operating infrastructure. As execution continues tially expand the range of its activities. to migrate to electronic platforms, prime By outsourcing operational activities, prime brokerage presents an opportunity to build a brokerage reduces a client’s operational and fee business into an institution’s electronic settlement risk while lowering its expenses. A foreign exchange platform in order to extract client realizes a reduction in capital investment costs. expenditures because back-office expenses are outsourced to the prime broker. In Benefits to the Executing Dealer addition, trade allocation, confirmation, and The executing dealer benefits from increased settlement are consolidated with the prime execution flows with the ability to transact broker, allowing firms to maintain a small business with counterparties that would typi- operations staff and still execute complex and cally require credit enhancement. high-volume trading structures.

Prime brokerage allows a client to Legal Framework and consolidate positions and improve execution. Agreements For example, a client may establish a foreign The establishment of a prime brokerage exchange position with several different arrangement requires specific legal docu- counterparties, which are then consolidated mentation that articulates the rights and into a single position with the prime broker. responsibilities of the client, prime broker,

38 FOREIGN EXCHANGE COMMITTEE 2005 ANNUAL REPORT and executing dealers. A foreign exchange the executing dealer. In addition, the client prime broker documents its relationship with can achieve efficient use of its collateral by the client through a prime brokerage agree- consolidating much of its trading position ment and its relationship with the executing with the prime broker. Lastly, the prime bro- dealer through a give-up agreement. kerage agreement describes the procedure by which the prime broker is notified of the Prime Brokerage Agreement transaction by the client. Under this agreement, the prime broker agrees that the client may enter into foreign Give-Up Agreement exchange transactions with dealers approved In this agreement between the prime broker by the prime broker and that the prime bro- and the executing dealer, the prime broker ker, rather than the client, will become the agrees to become the counterparty to each party to these transactions if the applicable transaction executed by the client with the exe- terms specified in the prime brokerage agree- cuting dealer, subject to compliance with the ment are satisfied. Generally, these terms are specified terms. A give-up agreement is custom- of two types. First, each transaction will have arily executed as a master agreement and is allowable products, such as spot, forward, or supplemented by a give-up agreement notice option transactions, and a tenor that does not for each prime-broker client that will execute exceed a specified maximum. Second, the trades with the applicable executing dealer. transaction will have to be within specified The give-up agreement notice identifies the limits, which may include settlement, open client and contains the allowable products, position limits, or both. These limits usually tenors, and specific limits that apply to the apply to the aggregate of all transactions exe- trades that the prime broker will accept for cuted by the client with an executing dealer that client. The terms specified in the give-up and are typically either specified in the prime agreement notice are typically either the brokerage agreement or sent to the client by same as those included in the prime brokerage the prime broker so as to be known to the agreement or sent to the client by the prime client at all times. broker. Because these terms are specified in the give-up agreement notice, the executing dealer The prime brokerage agreement typically is able to determine, before executing any includes agreement by the client to enter into trade with the prime broker’s client, whether or, if the client is a manager or advisor, have the prime broker is obligated to accept the give- funds or accounts that it manages enter into up of the transaction. In addition, the prime (in each case, the “relevant account”), one or broker may be contacted and asked to accept more transactions that offset the transaction transactions that may be outside the limits accepted by the prime broker. This process specified in the agreements. gives the relevant account the economic benefit of the transaction, as intended, while The Foreign Exchange Committee recently the prime broker assumes the of published a Master FX Give-Up Agreement

FOREIGN EXCHANGE PRIME BROKERAGE 39 for use by market participants in documenting will incur trading losses as a result. In so doing, foreign exchange give-up relationships. This executing dealers should evaluate the controls agreement was the product of in-depth that they have in place to reduce the chance of discussions among market participants and incurring such losses. Such controls can contains generally accepted standard pro- include internal procedures designed to visions addressing most aspects of the give-up reduce the possibility of executing trades that relationship between a prime broker and an may be rejected, use of the Compensation executing dealer. With respect to a few Agreement, or some combination of methods. provisions, the Master FX Give-Up Agreement While the risk of a prime broker rejecting a permits the parties to choose which of several trade has generally been considered by market clearly defined alternatives they want to apply participants to be minimal, the Committee in their agreement by selecting them in a suggests that executing dealers consider the schedule that is part of the agreement. execution of a Compensation Agreement as a means of addressing that risk. The Committee The Master FX Give-Up Agreement is a adds that parties asked to sign a Compensation bilateral master agreement to be entered into Agreement should recognize and understand by the prime broker and an executing dealer. the reasons an executing dealer would ask The bilateral nature of the agreement reflects them to do so. the need for efficiency and standardization and takes into account the fact that a prime broker may designate a number of clients to Best Practice engage in foreign exchange give-up Recommendations transactions on its behalf pursuant to a single Following is a collection of practices that may master agreement. mitigate some of the credit, operational, and reputational risks associated with the prime brokerage service. These best practices, consis- Compensation Agreement tent with the recommendations and guiding The Master FX Give-Up Agreement may be principles set forth in the Counterparty Risk accompanied by a Compensation Agreement, to be executed by the prime broker’s client and Management Group II report, provide greater an executing dealer. The Compensation clarity regarding the relationship among the Agreement provides for the compensation prime broker, executing dealer, and client. The of losses in the event that the give up of a implementation of these practices may also transaction is not accepted by the prime broker. help to reduce the level of risk in the foreign exchange market more generally. The recom- The Foreign Exchange Committee recom- mendations below represent practices already mends that executing dealers evaluate the implemented in varying degrees by Foreign likelihood that prime brokers will reject Exchange Committee member institutions. The transactions when they enter into give-up Committee encourages all market participants agreements and assess the possibility that they to strive to adopt these practices.

40 FOREIGN EXCHANGE COMMITTEE 2005 ANNUAL REPORT Of course, each firm should take into Best Practice no. 2: account its own unique characteristics, such as Prime brokers should establish real-time transaction volume and role in the market, credit systems to actively monitor open as it considers the adoption of the recom- positions against limits and pending give-up mendations. These best practices are intended trades. A prime broker’s sales area should be as goals rather than binding rules. able to quickly assess its credit exposure to a client and its systems should automatically The recommendations outlined below update a client’s credit status when a trade is should be read in conjunction with the accepted by the prime broker. Committee’s three primary documents— Guidelines for Foreign Exchange Trading Activities, Management of Operational Risk in Best Practice no. 3: Foreign Exchange, and Foreign Exchange Prime brokers should develop policies and Transaction Processing: Execution-to-Settlement procedures to address credit-limit breaches Recommendations for Nondealer Participants. and should document the approval of limit exceptions. A prime broker should produce reports of credit line excesses and exceptions Credit Risks on a regular basis for review. Exception Like a standard counterparty relationship, reports should identify the client and executing prime brokerage arrangements require active dealer involved in the transactions. Persistent credit-limit monitoring against the limits set credit limit exceptions should prompt a forth in the governing legal agreements; how- review and possible adjustment of a client’s ever, the prime brokerage model involves an credit limit. additional layer of complexity given the tri- party framework. An executing dealer should execute and a prime broker accept a transac- Best Practice no. 4: tion only if credit lines have been approved Executing dealers should also develop and are available for a client. appropriate tools to monitor open positions and limits against pending trades. Use of such tools with straight-through processing Best Practice no. 1: features for the acceptance and processing No trade should be finalized without confirming of trades should be encouraged, given the sufficient availability under the give-up line. increasing volumes observed in the foreign Give-up line usage information should be exchange markets. Real-time give-up line updated as soon as a deal is accepted by the management further enhances the value prime broker, and the updated information realized in monitoring positions and limits. should be accessible to prime brokerage service personnel, risk managers, and executing dealers.

FOREIGN EXCHANGE PRIME BROKERAGE 41 Operational Risks The standards and procedures governing The prime brokerage transaction process flow the notification of trade details and the is divided into four steps: 1) notification, acceptance or rejection of trades are typically 2) matching and acceptance or rejection, the subject of bilateral agreements between the 3) confirmation, and 4) allocation. The executing prime broker and the executing dealer and dealer and the client are required to notify the the prime broker and the client. In practice, prime broker once a trade has been executed— notifications from the executing dealer to the informing the prime broker of the material prime broker are made in a timely manner. terms of a transaction. The material terms of a However, notifications from the client may not foreign exchange transaction typically include: be as consistent and thus can affect the timing transaction date, settlement date, amounts of of trade acceptance or rejection by the prime each currency to be delivered by each party, broker; late executing dealer notices can have and buying and selling parties. The material the same effect. The adoption of several best terms of an option transaction typically practices can assist in facilitating efficient include: amounts of each currency, type of notification and acceptance processes. currency option transaction (for example, American or European), strike price, premium, Once a prime broker has matched and expiration date, and any other terms accepted a trade, separate confirmations considered material in the market. must be exchanged between 1) the prime broker and the executing dealer and 2) the Once the prime broker receives notification prime broker and the client, as legal evidence of a trade, it has certain rights and obligations of the terms of the transaction. Confirmations with respect to the acceptance or rejection of are important for the orderly functioning of the trade, and must determine if a transaction the marketplace since they minimize market meets the applicable conditions of the risk and the losses caused by settlement prime brokerage and give-up agreements. errors. A transaction confirmation should The prime broker may reject a trade given up include all relevant data that will allow the two for any of the following reasons: counterparties to accurately agree to the 1) the trade is not a permitted transaction terms of a transaction. In addition, all relevant type as specified in the give-up agreement settlement instructions for each transaction with the executing dealer, should be identified in each confirmation.

2) the trade is not within the specified tenor An investment manager or other party limits, acting as an agent may undertake “block” or “bundled” trades on behalf of multiple 3) the trade is not within the specified credit counterparties. Such trades, once accepted limits, or by the prime broker, are subsequently split 4) the trade details provided by the execut- into smaller amounts and allocated to specific ing dealer and the client do not match. underlying funds or counterparties.

42 FOREIGN EXCHANGE COMMITTEE 2005 ANNUAL REPORT Best Practice no. 5: prime broker as soon as practicable or other- The give-up agreement between the prime wise within the time frame specified with the broker and executing dealer and the prime relevant legal agreement. brokerage agreement between the prime broker and client should clearly specify the permit- Best Practice no. 9: ted transaction types, tenors, and credit limits Whenever feasible, executing dealers, clients, and the procedure by which such limits are and prime brokers should use electronic- to be calculated. The Master FX Give-Up trade message systems linked to the prime Agreement published by the Foreign broker’s electronic matching system. In this Exchange Committee can be used by the way, prime brokers can automate the match- prime broker and executing dealer for this ing and validation of executing dealer and purpose. client trade notifications, providing timely notice of matched and unmatched trades to Best Practice no. 6: all parties through directed communication Executing dealers and clients should have or available trade blotters. internal controls designed to monitor the per- mitted transaction types, tenors, and credit Best Practice no. 10: limits so that they execute only those trades A prime broker should notify the executing that were authorized by the prime broker. dealer and client as soon as practicable if it Because they are legally obligated to accept rejects a trade involving transactions or trades within the terms specified in the rele- amounts that were not authorized according vant agreements, prime brokers should have to the applicable agreements. Timely notifica- similar controls to determine whether they tion minimizes an executing dealer’s potential are obligated to accept a particular trade loss from the liquidation of a nonaccepted when it is given up to them. trade. Nonacceptance of an executed trade by the prime broker may place the executing Best Practice no. 7: dealer at risk of loss, especially where there is Executing dealers, clients, and prime brokers no agreement in place between the executing should have the proper processes in place to dealer and the client on the disposition of send and receive notices of give ups and nonaccepted trades. Accordingly, compensa- should provide the names and contact details tion agreements between executing dealers of the appropriate personnel to the other and clients may be considered. parties in a give-up relationship. Best Practice no. 11: Best Practice no. 8: A prime broker should confirm trades if, and The executing dealer and client should each only if, the type of trade is permitted under notify the prime broker of the details of any the give-up agreement, the trade complies trades that they execute for give up to the with the applicable trade type and tenor

FOREIGN EXCHANGE PRIME BROKERAGE 43 and is within the applicable limits, and the A prime broker must determine whether it prime broker has received matching trade notifi- will assume the basis risk in these situations or cations from the executing dealer and client. “pass through” the risk by requiring the client to Confirming trades prior to the receipt of accept the decision of the executing dealer. In matched notices may raise legal and market addition, with respect to options, parties must risks that should be avoided. For structured designate the party responsible for determining transactions, which contain unique features the occurrence of a post-trade event. such as special pricing or settlement conven- tions that affect the valuation of the trade, Best Practice no. 13: matching should include all relevant terms. The give-up agreement between the prime Mismatched trade terms may expose the prime broker and executing dealer and the prime broker to basis risk. brokerage agreement between the prime broker and client should specify the party responsible Best Practice no. 12: for the determination and notification of All parties should make every effort to post-trade events. exchange confirmations at the earliest possible opportunity. In the wholesale foreign Best Practice no. 14: exchange market, parties should make every The prime brokerage agreement between the effort to send confirmations or positively prime broker and client should specify whether affirm trades within two hours after execution the prime broker will assume or pass through and in no event later than the end of the day. the basis risk associated with varying interpreta- Standard escalation procedures should be in tions of post-trade events by the parties. place to pursue and resolve all discrepancies in a timely manner. Best Practice no. 15: The relevant staffs of the executing dealer Post-Trade Events and prime broker should be trained to identify Structured transactions involve post-trade potential post-trade issues. All such issues events that could give rise to “market” risk or should be raised immediately for timely “basis” risk for the prime broker. Basis risk can resolution. occur if the parties interpret post-trade events differently. For example, with respect to an Dispute Resolution exotic option transaction, a situation may arise From time to time, a dispute may arise regarding in which the executing dealer informs the prime the basic terms of a trade, a post-trade event, broker that the barrier on its trade has been or some other aspect of the prime-broker broken and the trade knocked out even as the relationship. As a general matter, any dispute client contends that its trade with the prime bro- will be governed by the terms of any agree- ker remains valid. ments between the parties. However, as a

44 FOREIGN EXCHANGE COMMITTEE 2005 ANNUAL REPORT practical matter, the interaction among the positions created through the give-up relation- executing dealer, prime broker, and client ship. The possibility that the sales or trading may give rise to considerations beyond the staff could use the information to the detriment usual issues raised in direct dealings. of the client exposes the prime broker to reputational and legal risk. Best Practice no. 16: The prime broker is obligated to take on a Best Practice no. 18: trade only when the material terms of the trade Except in cases of default, clients have the have been agreed upon by the executing right to expect that their identity, orders, and dealer and the client. If such details do not strategies will be handled in a manner that match, the prime broker should reject the trade protects their interests and confidentiality. At in the manner provided in the appropriate the outset of the relationship, the prime broker agreements. Assuming this is done, disputes should determine the client’s confidentiality with respect to trade details must be resolved requirements. In the absence of a formal between the executing dealer and the client. understanding, the prime broker should assume that the client requires confidentiality Best Practice no. 17: of its give-up trading activity. If a prime broker rejects a trade because the material terms of the trade submitted by the Best Practice no. 19: executing dealer and client do not match, Prime brokers should establish and control the prime broker should notify the client and, if access to their systems to ensure that only specified in the applicable give-up agreement, authorized staff are able to access or alter the executing dealer as soon as practicable so information regarding client give-up trades that the client can promptly contact the executing and positions. dealer and attempt to resolve the discrepancy. Executing dealers, clients, and prime brokers Best Practice no. 20: should have authorized personnel available Prime-broker client service and operations throughout the business day that are able to staff should understand the confidentiality work to resolve any discrepancies in a timely requirements of each client. In addition, manner. front-office staff should be similarly trained so that there is a common understanding Confidentiality between the front- and back-office staffs regarding what is and is not appropriate For many clients, confidentiality is a core information exchange. component of the foreign exchange prime brokerage relationship. Generally, clients expect that a prime broker’s front-office sales Reputational Risks or trading staff will not have access to infor- As with any other relationship, a prime broker mation regarding the trades executed or overall could face reputational risk with respect to its

FOREIGN EXCHANGE PRIME BROKERAGE 45 relationship with clients. A prime broker Best Practice no. 22: accepts trades executed by its client on an A prime broker should be prepared to arm’s-length contractual basis and does not investigate a complaint by an executing dealer assume fiduciary obligations with respect to that a client may have engaged in illegal or that client. Nevertheless, the prime broker unethical trading practices. The prime broker could incur harm to its reputation if that client should evaluate the reputational risk posed to or one of its employees were, for example, to it and assess whether it should modify its role or engage in fraud or other improper activities cease acting as prime broker for the client. through its foreign exchange trading. While this best practice does not impose a Improper activities include practices that are legal obligation on the prime broker to the exe- designed to disrupt trading or misrepresent cuting dealer or its client, the prime broker current market prices. Even if a situation does should ascertain whether the client’s trading not result in litigation, a firm’s reputation may activity gives rise to any legal or regulatory suffer as a result of such client activities obligation on the part of the prime broker. through adverse publicity or other factors.

Best Practice no. 21: To mitigate reputational risk, prime brokers should perform due diligence, including an anti-money-laundering review, with respect to their clients.

46 FOREIGN EXCHANGE COMMITTEE 2005 ANNUAL REPORT