foreign exchange prime brokerage

33

PrimeBrokerage

Product Overview andBest Practice Recommendations

Foreign Exchange

OverviewForeign exchange prime brokerage allows a client to source liquidity from a varietyof executing dealers while maintaining a credit relationship, placing collateral, andsettling with a single entity—the prime broker.

As illustrated in the figure on the following page, a prime-broker clientconducts a trade with an executing dealer (also known as a “spoke bank” or“give-up bank”) in the name of its prime broker. When the prime broker isinformed of and accepts the transaction by the client and executing dealer, the primebroker, rather than the client, becomes the party to the transaction with the executingdealer. In addition, the prime broker will contemporaneously enter into an offsettingtransaction with the client (or funds managed by the client or banks holding accountsmanaged by the client). The prime broker and the executing dealer confirm and settlethe trade, while the prime broker settles with the client on a net basis. In exchangefor the authority to trade in its name, the prime broker typically charges the client afee on a volume basis for the trades conducted according to this arrangement.

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

35

PrimeBrokerage

Product Overview andBest Practice Recommendations

Foreign Exchange

36 FOREIGN EXCHANGE COMMITTEE 2005 ANNUAL REPORT

controls, procedures, and processes. Thisfocus laid the foundation for a rapid expansionof the client base.

ClientsForeign exchange prime brokerage has typicallybeen used by hedge funds and commoditytrading advisors (CTAs). Prime brokerageallows these market participants, despite theirlimited credit history or higher risk profile, touse the prime broker’s (presumably) highercredit rating to gain access to new counter-parties. Generally, these firms also maintainlow headcounts and prefer to outsource orcentralize as much trade processing as possible.The hedge fund industry has come to rely onprime brokerage to such an extent that newhedge fund managers include appointing aprime broker among their first businessdecisions.

While the growth of the hedge fundindustry has contributed to the develop-ment of the prime brokerage business, it isimportant to note that the client base is quitediverse. In addition to hedge funds andCTAs, prime brokerage clients include smallbanks, other asset managers, endowments,foundations, partnerships, private familyoffices, and pension funds. The service is lessfrequently used by corporations and largebanks.

Prime BrokersAlthough the prime brokerage client basehas broadened in recent years, the rapidgrowth of hedge funds is the main driverbehind the development of the prime bro-kerage service. Currently, the hedge fundindustry is estimated to represent $875 billionin assets and to be growing at about 20 percentper year, with approximately 8,350 active

FX Prime Brokerage Deal Process

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

+ 100 USD/JPY

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

+ 100 USD/JPY

2. Client notifies prime broker of trade details. Relationship defined by a prime brokerage agreement.

2. Executing dealer notifies prime broker of trade details. Relationship defined by give-up agreement.

Executingdealer

Client

Primebroker

- 100 USD/JPY

+ 100 USD/JPY

- 100 USD/JPY

hedge funds.1 According to one source, in1997, fewer than ten organizations in the globalmarketplace used a foreign exchange primebroker, and the market was dominated by fourbanks. In 2005, market participants estimatethat between 450 and 600 clients use theprime brokerage service, and at least twentydifferent banks offer the service as a core foreignexchange product. Despite the large numberof institutions establishing prime brokeragefunctions, the market has become increasinglyconcentrated in recent years. According tothe Hennessee Group’s tenth annual survey,the market share of the six largest primebrokers increased to 83 percent in 2003,from 70 percent in 1999.

Typical ServiceThe core services offered by the prime broker toa client are leverage, access to market liquidity,and consolidated settlement, clearing, andreporting. In addition to allowing a clientto trade in its name, the prime broker canprovide a range of services, which mayinclude commission accrual and payment,statement and confirmation generation, andhousing and administering of client accounts.

Some prime brokerage providers havebegun to offer more sophisticated services,with the goal of becoming a “one-stop shop”for hedge funds. These include start-upservices, capital introduction services, front-and back-office systems and technology,research, and cash management services.Market participants have noted increased

demand for end-to-end technology tosupport hedge funds—including risk analyticsand portfolio management and reportingsystems—so that portfolios can be activelymonitored and analyzed.

The nature of prime-brokered tradeexecution has also evolved. In the traditionalmodel, foreign exchange prime-brokeredtransactions are initiated manually by theclient. While the client trades in the name ofthe prime broker—using the prime broker’scredit line with the executing dealer—theexecution of a transaction involves directcommunication between the client andexecuting dealer in which the identities ofboth parties are known.

More recently, prime brokers have begun toprovide trade execution via electronic commu-nication networks and electronic brokingplatforms. These platforms allow for automatedprogram trading, which typically involves theuse of an application programming interfacethat provides access to executable prices viatwo-way message interface between theforeign exchange market and a client’s internaltrading infrastructure. Notably, in theelectronic prime-broker model, there istypically no identification of the trade as beingprime-brokered at the time of execution—theexecuting dealer only sees the name ofthe prime broker. The identity of the clientinitiating the trade is not known to theexecuting dealer—providing an element ofanonymity to the client.

37FOREIGN EXCHANGE PRIME BROKERAGE

1Hedge Fund Association. Friedland, D. Facts About Hedge Funds <http://www.thehfa.org/AboutUs.cfm>.

Value Proposition

Benefits to the ClientPrime brokerage allows the client to maximizeits credit relationships and activities whileimproving efficiency. In addition, primebrokerage streamlines the credit and docu-mentation process, given that the client issubject to one internal credit review and exe-cutes one master trading agreement and creditsupport annex with the prime broker, ratherthan many agreements with multiple dealers.A prime brokerage arrangement provides forthe more efficient use of collateral for marginrelationships. Further, margin positions can benetted as the client needs to manage just onecredit relationship to gain trading relationshipswith many counterparties. In addition, theclient is able to access pricing and liquidityfrom a greater number of dealers and poten-tially expand the range of its activities.

By outsourcing operational activities, primebrokerage reduces a client’s operational andsettlement risk while lowering its expenses. Aclient realizes a reduction in capitalexpenditures because back-office expensesare outsourced to the prime broker. Inaddition, trade allocation, confirmation, andsettlement are consolidated with the primebroker, allowing firms to maintain a smalloperations staff and still execute complex andhigh-volume trading structures.

Prime brokerage allows a client toconsolidate positions and improve execution.For example, a client may establish a foreignexchange position with several differentcounterparties, which are then consolidatedinto a single position with the prime broker.

The client can manage a single position moreeasily than it can manage many individualpositions with a variety of counterparties. Inaddition, prime brokerage offers the clientgreater liquidity to execute larger trades.

Benefits to the Prime BrokerFor the prime broker, the product generates anew, fee-based revenue stream, which isincreasingly attractive as foreign exchangespreads continue to narrow. In addition, theproduct contributes to an expansion of theprime broker’s client base and a strengthen-ing of its existing client relationships.

Prime brokerage provides efficiencies ofscale with respect to transaction processingand technology investments and allows aninstitution to leverage its technology andoperating infrastructure. As execution continuesto migrate to electronic platforms, primebrokerage presents an opportunity to build afee business into an institution’s electronicforeign exchange platform in order to extractinvestment costs.

Benefits to the Executing DealerThe executing dealer benefits from increasedexecution flows with the ability to transactbusiness with counterparties that would typi-cally require credit enhancement.

Legal Framework andAgreementsThe establishment of a prime brokeragearrangement requires specific legal docu-mentation that articulates the rights andresponsibilities of the client, prime broker,


and executing dealers. A foreign exchangeprime broker documents its relationship withthe client through a prime brokerage agree-ment and its relationship with the executingdealer through a give-up agreement.

Prime Brokerage AgreementUnder this agreement, the prime brokeragrees that the client may enter into foreignexchange transactions with dealers approvedby the prime broker and that the prime bro-ker, rather than the client, will become theparty to these transactions if the applicableterms specified in the prime brokerage agree-ment are satisfied. Generally, these terms areof two types. First, each transaction will haveallowable products, such as spot, forward, oroption transactions, and a tenor that does notexceed a specified maximum. Second, thetransaction will have to be within specifiedlimits, which may include settlement, openposition limits, or both. These limits usuallyapply to the aggregate of all transactions exe-cuted by the client with an executing dealerand are typically either specified in the primebrokerage agreement or sent to the client bythe prime broker so as to be known to theclient at all times.

The prime brokerage agreement typicallyincludes agreement by the client to enter intoor, if the client is a manager or advisor, havefunds or accounts that it manages enter into(in each case, the “relevant account”), one ormore transactions that offset the transactionaccepted by the prime broker. This processgives the relevant account the economicbenefit of the transaction, as intended, whilethe prime broker assumes the credit risk of

the executing dealer. In addition, the clientcan achieve efficient use of its collateral byconsolidating much of its trading positionwith the prime broker. Lastly, the prime bro-kerage agreement describes the procedureby which the prime broker is notified of thetransaction by the client.

Give-Up AgreementIn this agreement between the prime brokerand the executing dealer, the prime brokeragrees to become the counterparty to eachtransaction executed by the client with the exe-cuting dealer, subject to compliance with thespecified terms. A give-up agreement is custom-arily executed as a master agreement and issupplemented by a give-up agreement noticefor each prime-broker client that will executetrades with the applicable executing dealer.The give-up agreement notice identifies theclient and contains the allowable products,tenors, and specific limits that apply to thetrades that the prime broker will accept forthat client. The terms specified in the give-upagreement notice are typically either thesame as those included in the prime brokerageagreement or sent to the client by the primebroker. Because these terms are specified in thegive-up agreement notice, the executing dealeris able to determine, before executing anytrade with the prime broker’s client, whetherthe prime broker is obligated to accept the give-up of the transaction. In addition, the primebroker may be contacted and asked to accepttransactions that may be outside the limitsspecified in the agreements.

The Foreign Exchange Committee recentlypublished a Master FX Give-Up Agreement


for use by market participants in documentingforeign exchange give-up relationships. Thisagreement was the product of in-depthdiscussions among market participants andcontains generally accepted standard pro-visions addressing most aspects of the give-uprelationship between a prime broker and anexecuting dealer. With respect to a fewprovisions, the Master FX Give-Up Agreementpermits the parties to choose which of severalclearly defined alternatives they want to applyin their agreement by selecting them in aschedule that is part of the agreement.

The Master FX Give-Up Agreement is abilateral master agreement to be entered intoby the prime broker and an executing dealer.The bilateral nature of the agreement reflectsthe need for efficiency and standardizationand takes into account the fact that a primebroker may designate a number of clients toengage in foreign exchange give-uptransactions on its behalf pursuant to a singlemaster agreement.

Compensation AgreementThe Master FX Give-Up Agreement may beaccompanied by a Compensation Agreement,to be executed by the prime broker’s client andan executing dealer. The CompensationAgreement provides for the compensationof losses in the event that the give up of atransaction is not accepted by the prime broker.

The Foreign Exchange Committee recom-mends that executing dealers evaluate thelikelihood that prime brokers will rejecttransactions when they enter into give-upagreements and assess the possibility that they

will incur trading losses as a result. In so doing,executing dealers should evaluate the controlsthat they have in place to reduce the chance ofincurring such losses. Such controls caninclude internal procedures designed toreduce the possibility of executing trades thatmay be rejected, use of the CompensationAgreement, or some combination of methods.While the risk of a prime broker rejecting atrade has generally been considered by marketparticipants to be minimal, the Committeesuggests that executing dealers consider theexecution of a Compensation Agreement as ameans of addressing that risk. The Committeeadds that parties asked to sign a CompensationAgreement should recognize and understandthe reasons an executing dealer would askthem to do so.

Best PracticeRecommendationsFollowing is a collection of practices that maymitigate some of the credit, operational, andreputational risks associated with the primebrokerage service. These best practices, consis-tent with the recommendations and guidingprinciples set forth in the Counterparty RiskManagement Group II report, provide greaterclarity regarding the relationship among theprime broker, executing dealer, and client. Theimplementation of these practices may alsohelp to reduce the level of risk in the foreignexchange market more generally. The recom-mendations below represent practices alreadyimplemented in varying degrees by ForeignExchange Committee member institutions. TheCommittee encourages all market participantsto strive to adopt these practices.


Of course, each firm should take intoaccount its own unique characteristics, such astransaction volume and role in the market,as it considers the adoption of the recom-mendations. These best practices are intendedas goals rather than binding rules.

The recommendations outlined belowshould be read in conjunction with theCommittee’s three primary documents—Guidelines for Foreign Exchange TradingActivities, Management of Operational Risk inForeign Exchange, and Foreign ExchangeTransaction Processing: Execution-to-SettlementRecommendations for Nondealer Participants.

Credit RisksLike a standard counterparty relationship,prime brokerage arrangements require activecredit-limit monitoring against the limits setforth in the governing legal agreements; how-ever, the prime brokerage model involves anadditional layer of complexity given the tri-party framework. An executing dealer shouldexecute and a prime broker accept a transac-tion only if credit lines have been approvedand are available for a client.

Best Practice no. 1:No trade should be finalized without confirmingsufficient availability under the give-up line.Give-up line usage information should beupdated as soon as a deal is accepted by theprime broker, and the updated informationshould be accessible to prime brokerageservice personnel, risk managers, and executingdealers.

Best Practice no. 2:Prime brokers should establish real-timecredit systems to actively monitor openpositions against limits and pending give-uptrades. A prime broker’s sales area should beable to quickly assess its credit exposure to aclient and its systems should automaticallyupdate a client’s credit status when a trade isaccepted by the prime broker.

Best Practice no. 3:Prime brokers should develop policies andprocedures to address credit-limit breachesand should document the approval of limitexceptions. A prime broker should producereports of credit line excesses and exceptionson a regular basis for review. Exceptionreports should identify the client and executingdealer involved in the transactions. Persistentcredit limit exceptions should prompt areview and possible adjustment of a client’scredit limit.

Best Practice no. 4:Executing dealers should also developappropriate tools to monitor open positionsand limits against pending trades. Use ofsuch tools with straight-through processingfeatures for the acceptance and processingof trades should be encouraged, given theincreasing volumes observed in the foreignexchange markets. Real-time give-up linemanagement further enhances the valuerealized in monitoring positions and limits.


Operational RisksThe prime brokerage transaction process flowis divided into four steps: 1) notification,2) matching and acceptance or rejection,3) confirmation, and 4) allocation. The executingdealer and the client are required to notify theprime broker once a trade has been executed—informing the prime broker of the materialterms of a transaction. The material terms of aforeign exchange transaction typically include:transaction date, settlement date, amounts ofeach currency to be delivered by each party,and buying and selling parties. The materialterms of an option transaction typicallyinclude: amounts of each currency, type ofcurrency option transaction (for example,American or European), strike price, premium,expiration date, and any other termsconsidered material in the market.

Once the prime broker receives notificationof a trade, it has certain rights and obligationswith respect to the acceptance or rejection ofthe trade, and must determine if a transactionmeets the applicable conditions of theprime brokerage and give-up agreements.The prime broker may reject a trade given upfor any of the following reasons:

1) the trade is not a permitted transactiontype as specified in the give-up agreementwith the executing dealer,

2) the trade is not within the specified tenorlimits,

3) the trade is not within the specified creditlimits, or

4) the trade details provided by the execut-ing dealer and the client do not match.

The standards and procedures governingthe notification of trade details and theacceptance or rejection of trades are typicallythe subject of bilateral agreements between theprime broker and the executing dealer andthe prime broker and the client. In practice,notifications from the executing dealer to theprime broker are made in a timely manner.However, notifications from the client may notbe as consistent and thus can affect the timingof trade acceptance or rejection by the primebroker; late executing dealer notices can havethe same effect. The adoption of several bestpractices can assist in facilitating efficientnotification and acceptance processes.

Once a prime broker has matched andaccepted a trade, separate confirmationsmust be exchanged between 1) the primebroker and the executing dealer and 2) theprime broker and the client, as legal evidenceof the terms of the transaction. Confirmationsare important for the orderly functioning ofthe marketplace since they minimize marketrisk and the losses caused by settlementerrors. A transaction confirmation shouldinclude all relevant data that will allow the twocounterparties to accurately agree to theterms of a transaction. In addition, all relevantsettlement instructions for each transactionshould be identified in each confirmation.

An investment manager or other partyacting as an agent may undertake “block” or“bundled” trades on behalf of multiplecounterparties. Such trades, once acceptedby the prime broker, are subsequently splitinto smaller amounts and allocated to specificunderlying funds or counterparties.


Best Practice no. 5:The give-up agreement between the primebroker and executing dealer and the primebrokerage agreement between the prime brokerand client should clearly specify the permit-ted transaction types, tenors, and credit limitsand the procedure by which such limits areto be calculated. The Master FX Give-UpAgreement published by the ForeignExchange Committee can be used by theprime broker and executing dealer for thispurpose.

Best Practice no. 6:Executing dealers and clients should haveinternal controls designed to monitor the per-mitted transaction types, tenors, and creditlimits so that they execute only those tradesthat were authorized by the prime broker.Because they are legally obligated to accepttrades within the terms specified in the rele-vant agreements, prime brokers should havesimilar controls to determine whether theyare obligated to accept a particular tradewhen it is given up to them.

Best Practice no. 7:Executing dealers, clients, and prime brokersshould have the proper processes in place tosend and receive notices of give ups andshould provide the names and contact detailsof the appropriate personnel to the otherparties in a give-up relationship.

Best Practice no. 8:The executing dealer and client should eachnotify the prime broker of the details of anytrades that they execute for give up to the

prime broker as soon as practicable or other-wise within the time frame specified with therelevant legal agreement.

Best Practice no. 9:Whenever feasible, executing dealers, clients,and prime brokers should use electronic-trade message systems linked to the primebroker’s electronic matching system. In thisway, prime brokers can automate the match-ing and validation of executing dealer andclient trade notifications, providing timelynotice of matched and unmatched trades toall parties through directed communicationor available trade blotters.

Best Practice no. 10:A prime broker should notify the executingdealer and client as soon as practicable if itrejects a trade involving transactions oramounts that were not authorized accordingto the applicable agreements. Timely notifica-tion minimizes an executing dealer’s potentialloss from the liquidation of a nonacceptedtrade. Nonacceptance of an executed tradeby the prime broker may place the executingdealer at risk of loss, especially where there isno agreement in place between the executingdealer and the client on the disposition ofnonaccepted trades. Accordingly, compensa-tion agreements between executing dealersand clients may be considered.

Best Practice no. 11:A prime broker should confirm trades if, andonly if, the type of trade is permitted underthe give-up agreement, the trade complieswith the applicable trade type and tenor


and is within the applicable limits, and theprime broker has received matching trade notifi-cations from the executing dealer and client.Confirming trades prior to the receipt ofmatched notices may raise legal and marketrisks that should be avoided. For structuredtransactions, which contain unique featuressuch as special pricing or settlement conven-tions that affect the valuation of the trade,matching should include all relevant terms.Mismatched trade terms may expose the primebroker to basis risk.

Best Practice no. 12:All parties should make every effort toexchange confirmations at the earliest possibleopportunity. In the wholesale foreignexchange market, parties should make everyeffort to send confirmations or positivelyaffirm trades within two hours after executionand in no event later than the end of the day.Standard escalation procedures should be inplace to pursue and resolve all discrepanciesin a timely manner.

Post-Trade EventsStructured transactions involve post-tradeevents that could give rise to “market” risk or“basis” risk for the prime broker. Basis risk canoccur if the parties interpret post-trade eventsdifferently. For example, with respect to anexotic option transaction, a situation may arisein which the executing dealer informs the primebroker that the barrier on its trade has beenbroken and the trade knocked out even as theclient contends that its trade with the prime bro-ker remains valid.

A prime broker must determine whether itwill assume the basis risk in these situations or“pass through” the risk by requiring the client toaccept the decision of the executing dealer. Inaddition, with respect to options, parties mustdesignate the party responsible for determiningthe occurrence of a post-trade event.

Best Practice no. 13:The give-up agreement between the primebroker and executing dealer and the primebrokerage agreement between the prime brokerand client should specify the party responsiblefor the determination and notification ofpost-trade events.

Best Practice no. 14:The prime brokerage agreement between theprime broker and client should specify whetherthe prime broker will assume or pass throughthe basis risk associated with varying interpreta-tions of post-trade events by the parties.

Best Practice no. 15:The relevant staffs of the executing dealerand prime broker should be trained to identifypotential post-trade issues. All such issuesshould be raised immediately for timelyresolution.

Dispute ResolutionFrom time to time, a dispute may arise regardingthe basic terms of a trade, a post-trade event,or some other aspect of the prime-brokerrelationship. As a general matter, any disputewill be governed by the terms of any agree-ments between the parties. However, as a


practical matter, the interaction among theexecuting dealer, prime broker, and clientmay give rise to considerations beyond theusual issues raised in direct dealings.

Best Practice no. 16:The prime broker is obligated to take on atrade only when the material terms of the tradehave been agreed upon by the executingdealer and the client. If such details do notmatch, the prime broker should reject the tradein the manner provided in the appropriateagreements. Assuming this is done, disputeswith respect to trade details must be resolvedbetween the executing dealer and the client.

Best Practice no. 17:If a prime broker rejects a trade becausethe material terms of the trade submitted by theexecuting dealer and client do not match,the prime broker should notify the client and, ifspecified in the applicable give-up agreement,the executing dealer as soon as practicable sothat the client can promptly contact the executingdealer and attempt to resolve the discrepancy.Executing dealers, clients, and prime brokersshould have authorized personnel availablethroughout the business day that are able towork to resolve any discrepancies in a timelymanner.

ConfidentialityFor many clients, confidentiality is a corecomponent of the foreign exchange primebrokerage relationship. Generally, clientsexpect that a prime broker’s front-office salesor trading staff will not have access to infor-mation regarding the trades executed or overall

positions created through the give-up relation-ship. The possibility that the sales or tradingstaff could use the information to the detrimentof the client exposes the prime broker toreputational and legal risk.

Best Practice no. 18:Except in cases of default, clients have theright to expect that their identity, orders, andstrategies will be handled in a manner thatprotects their interests and confidentiality. Atthe outset of the relationship, the prime brokershould determine the client’s confidentialityrequirements. In the absence of a formalunderstanding, the prime broker shouldassume that the client requires confidentialityof its give-up trading activity.

Best Practice no. 19:Prime brokers should establish and controlaccess to their systems to ensure that onlyauthorized staff are able to access or alterinformation regarding client give-up tradesand positions.

Best Practice no. 20:Prime-broker client service and operationsstaff should understand the confidentialityrequirements of each client. In addition,front-office staff should be similarly trainedso that there is a common understandingbetween the front- and back-office staffsregarding what is and is not appropriateinformation exchange.

Reputational RisksAs with any other relationship, a prime brokercould face reputational risk with respect to its


relationship with clients. A prime brokeraccepts trades executed by its client on anarm’s-length contractual basis and does notassume fiduciary obligations with respect tothat client. Nevertheless, the prime brokercould incur harm to its reputation if that clientor one of its employees were, for example, toengage in fraud or other improper activitiesthrough its foreign exchange trading.Improper activities include practices that aredesigned to disrupt trading or misrepresentcurrent market prices. Even if a situation doesnot result in litigation, a firm’s reputation maysuffer as a result of such client activitiesthrough adverse publicity or other factors.

Best Practice no. 21:To mitigate reputational risk, prime brokersshould perform due diligence, including ananti-money-laundering review, with respectto their clients.

Best Practice no. 22:A prime broker should be prepared toinvestigate a complaint by an executing dealerthat a client may have engaged in illegal orunethical trading practices. The prime brokershould evaluate the reputational risk posed toit and assess whether it should modify its role orcease acting as prime broker for the client.While this best practice does not impose alegal obligation on the prime broker to the exe-cuting dealer or its client, the prime brokershould ascertain whether the client’s tradingactivity gives rise to any legal or regulatoryobligation on the part of the prime broker.


foreign exchange prime brokerage

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