An estimated US$1.3 trillion credit gap has opened up in the global foreign exchange (FX) market due to stricter regulation, less appetite for risk and the falling number of prime brokers (PBs). That’s according to a new report from ADS Securities, which says a 25% fall in FX trading lines means wider spreads, an uptick in prices and greater exposure to foreign currency exposure.
Back in 2013 average daily volumes were around US$5.3 trillion and forecasters anticipated those volumes would hit US$6.5 trillion by September 2016. Fast forward to today, however, and it looks like the market will either stay flat or volumes could even fall.
“A daily global FX industry credit gap potentially affecting as much as US$1.3 trillion in daily volume is extremely significant and is changing the overall balance of the market,” says Marco Baggioli, COO, at ADS Securities London. “The lack of credit will lead to much wider spreads and increased pricing for all, from banks, to hedge funds, international businesses and all FX traders and, at the moment, no one is facing up to the problem.”
With the number of FX PBs falling and those that remain becoming more risk averse, Baggioli believes the FX industry needs to step in where banks fear to tread to help close that gap and make sure FX firms can get access to a range of different credit lines.
“I see a need for prime-of-prime services that are a true reflection of a direct prime brokerage relationship, with direct access to liquidity backed by strong capital and credit relationships,” he says.
His colleague James Watson, Managing Director at ADS says a potential US$1.3 trillion shortfall “cannot be overlooked” and will have repercussions right across the financial services sector.
“It is our opinion that well-capitalised FX brokerages need to step-up and support the institutional FX market by addressing the market gap in credit intermediation facilities,” says Watson. “If brokerages do not respond then the gap will continue to grow and all traders will be faced with a much less efficient market.”
This situation hasn’t happened overnight of course. Tier 1 banks became much more risk averse in the wake of the 2008 financial crisis, meanwhile regulation requiring them to hold more capital meant that they reduced more capital-intense activities such as FX-only prime brokerage services.
“Two years ago a broker with US$5m capital might have been able to access a PB, but the capital they must now have has gone up to as high as US$50-75m – so many cannot get the credit lines they need,” says Baggioli. Some smaller firms may be able to trade bilaterally with each liquidity provider and post margin accordingly, but this approach has a lot of limitations, including netting of risk and margin requirements. The situation is as dire for start-up Hedge Funds or those whose assets under management do not make the cut with the FX PBs.”
He says that if the market is going to maintain a mix of balanced FX flows and competitive pricing it has to develop new solutions. He says that after many years of highly profitable growth and investment in technology the systems and knowledge are in place to allow true downstream credit intermediation.
“Leading brokerages should have a role sitting between clients and their own PBs, providing access and sharing their credit lines. Clients will need to pay for this, but at least they will be trading and stay in business; savings need be found elsewhere in their FX value chain,” he says.
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