"Competition has already put significant downward pressure on the fees charged for foreign exchange prime brokerage," said the Bank of England’s Foreign Exchange Joint Standing Committee (FX JSC), which identified the problem at a recent meeting. And this may lead to prime brokers coming under pressure to increase their exposure to more risky names "particularly in the hedge fund sector".
But while the central bank’s concerns have been noted, few prime brokers interviewed by RiskNews’ sister publication FX Week believe they are at risk. "We’re quite confident with our ability to price credit risk," said Deutsche Bank’s head of prime brokerage, Andy Coyne in London. "Some banks will struggle more than others. Some will struggle to gather the information [needed to price credit risk] and some will struggle to do the pricing." But he declined to say which banks might be most at fault in this area.
Most prime brokers agreed that assessing the risk/return ratio from prime brokerage is difficult because it is hard to gauge the total revenues earned. “There’s a huge variance with how it’s paid for, because prime brokerage can partly be viewed as a service," said one head of prime brokerage at a UK bank in London.
Bank officials also agued that the fees a prime broker charges do not represent the total value of an account. "People may take a view that prime brokerage has more value than the fees. We share that view," said Deutsche Bank’s Coyne.
For example, prime brokers can expect to win a certain proportion of clients’ business for their parent institutions – prime brokers usually charge less for these deals than for those they transact on the clients’ behalf with another counterparty. This extra business provides additional revenue to the prime broker’s institution as a whole and should be taken into account when assessing the value of the business, said officials.
"It very much depends how you look at it," said the manager at the UK bank. "If you cut up the service you provide you’ll always find something that looks underpriced, but you’ve got to look at the picture as a whole. The whole thing is treated as a package."
Assessing the correct price of credit risk is also difficult as customers often use multiple prime brokers. But the FX JSC said banks are mitigating these risks to some extent through margin accounts and improved technology. "This enables them to manage cross-product risk, cross-product netting and margins more effectively."
Competition in the prime brokerage industry has increased in the past year or two as hedge funds – the biggest users of prime brokerage – have sought to reduce their service fees in response to decreasing returns.