Hidden Road ready for rush hour after FCM approval

Prime broker is trading “trillions” of notional with “a few hundred” counterparties in FX and crypto

When Hidden Road Partners joined CME Group’s roster of futures commission merchants (FCMs) in January, it took the industry by surprise. Since 2008, the number of firms clearing client trades on the exchange has dwindled from more than 150 to fewer than 65. Hidden Road was only the second new entrant in more than a decade.

“When Hidden Road submitted its application to be an FCM, they thought we had ticked the wrong box,” jokes Michael Higgins, the firm’s global head of business development.

Approval took around two and a half years to come through. Higgins says it was worth the wait – the FCM licence allows Hidden Road to offer something few others can: access to foreign exchange and crypto futures as well as over-the-counter spot trading via a single prime brokerage relationship.

They can trade multiple products. But they have a single account at Hidden Road, the positions are cross-margined and the margin is financed

Michael Higgins, Hidden Road Partners

This is particularly appealing to principal trading firms (PTFs) that trade the spot-versus-futures basis in FX and crypto markets. Typically, these firms need to have separate prime brokers for the FX and crypto spot trades and an FCM to clear the futures. None of them would be able to cross-margin the offsetting positions and the client would be left with the operational headache of reconciling the positions.

The FCM licence means Hidden Road can now consolidate all of this activity within a single account – allowing PTFs to run the spot-versus-futures basis trade in FX and crypto on a regulated exchange through that single prime brokerage and clearing account.   

“They can trade multiple products,” says Higgins. “But they have a single account at Hidden Road and the positions are cross-margined and the margin is financed.”

Hidden Road’s timing was also opportune. In November, CME surpassed Binance to become the largest player in crypto futures, in addition to housing the largest liquidity pool in FX futures.

Related

Born again: Citi’s forex prime brokerage 

After a $180 million gut-punch, the apex brokerage is now evangelising to amused rivals about the perils of mispricing

While the addition of futures clearing has solidified Hidden Road’s position as the biggest prime broker in the crypto markets, the firm actually got its start in foreign exchange – an asset class Higgins is intimately familiar with, having worked for a decade at the retail foreign exchange broker FXCM.

Hidden Road had just closed its first funding round when Citi’s FX prime brokerage disclosed a $180 billion loss in 2018. The bank overhauled its FXPB business and cut ties with scores of PTFs – including HC Technologies, Jump Trading and Virtu – over concerns about the amount of credit it was extending to these clients.

Hidden Road saw an opportunity to snap up some PTF clients that traded in the FX spot and tomorrow/next markets. Many of these PTFs also wanted to trade the spot versus futures basis, but most FXPBs did not offer clearing as part of their service, which meant they couldn’t cross-margin between the two legs.

This was one of the reasons behind Hidden Road’s decision to become an FCM at CME even as a number of banks were stepping away from the clearing business – a trend that is only expected to get worse if new capital charges included in the US Basel III endgame proposal are adopted.

“CME is interested in growing products and volumes, but there’s a dwindling number of clearing firms looking to expand their clearing capacity given Basel III and operating cost constraints,” says Higgins. “These are big challenges.”    

Trading in the ‘trillions’

While Hidden Road started as an FXPB, crypto is where it has really made a name for itself. Along the way, the firm has found itself at the heart of the evolving market infrastructure that supports everything from crypto spot and derivatives to tokenised real-world assets.

Similar to FX, liquidity in crypto markets is fragmented across a number of different venues. Hedge funds and PTFs wanted a way to access those liquidity pools through a single prime brokerage relationship – a service that banks have so far been unwilling or unable to provide.          

“Institutions are creatures of habit, and they require certain infrastructure to access any market. And we think of digital assets really as just another asset class,” says Higgins. “We understand how to model the risk, how to put the trades into our books and ledgers, and net and settle – all of the same processes that occur in traditional markets can be applied to digital assets.”

We have been the prime broker for most of the large hedge funds coming into digital assets because they didn’t want to face these exchanges from a credit risk or operational perspective

Michael Higgins, Hidden Road Partners

Hidden Road began by providing access to the leading unregulated offshore platforms where crypto spot and futures liquidity resided at the time, such as Binance, FTX and OKX. This allowed PTFs to run spot-versus-futures basis trades with portfolio margining. Hidden Road’s ability to handle FX and crypto also allowed PTFs to dabble in other strategies, such as triangle arbitrage – exploiting the dislocation between crypto and major fiat currencies, such as the dollar and yen.

The firm also tackled one of the big problems with trading on unregulated offshore exchanges – counterparty credit risk. These venues typically require margin posted against derivatives positions to be stored on the platform. If the exchange collapses, these assets could disappear along with it. Firms can pay Hidden Road a so-called exchange risk spread to take the credit risk to the venue instead.

“We have been the prime broker for most of the large hedge funds coming into digital assets because they didn’t want to face these exchanges from a credit risk or operational perspective,” says Higgins.

This arrangement was put to the test when FTX failed in November 2022, wiping out $9 billion in client funds. Hidden Road’s customers suffered no losses.

Related

A powder keg in forex: the prime broker business 

US Basel endgame hits clearing with op risk capital charges 

Since then, Higgins says there has been uptick in OTC trading of crypto derivatives via Hidden Road, reflecting a general wariness of the counterparty risks associated with unregulated venues, as well the lack of pre-funded margin requirements for OTC trades.

In spot, Higgins has seen a substantial increase in demand for trading on FX-style electronic communications networks, such as Crossover Markets’ CrossX venue, Cypator and SBI and Six Group’s AsiaNext venue.

The venues provide anonymous execution-only trading, with custody and settlement handled by a third party and no assets held on the venue itself. Trades executed on CrossX, for instance, are given up to Hidden Road, which acts as prime broker for both parties.

All told, Higgins says Hidden Road trades “trillions” of dollars of notional a year across all asset classes, across “a few hundred” counterparties.

The perp walk

Hedge funds and PTFs initially flocked to unregulated venues such as FTX to trade so-called perpetual futures. Similar to contracts-for-difference, these products afford leverage without an expiry date and have an inbuilt balancing mechanism, called a funding rate.

When the futures price diverges too much from the underlying spot, holders are paid or charged an interest rate, depending on whether the basis is negative or positive, creating an incentive for the futures to trade in line with spot. While clients have lost their appetite for trading on unregulated exchanges, the product itself remains popular.

“They said, ‘Wow, these are neat,’ and we want to trade them, but we need a regulated product with a regulated counterparty,” says Higgins.

So, a year ago, Hidden Road began working on a solution to enable market participants to trade perpetual futures in a regulated manner without the custody, compliance and counterparty problems that come with offshore platforms.

Called Route28, the product went live in January, with delegated regulatory reporting to both the Depository Trust & Clearing Corporation and Unavista trade repositories. It is structured as a matched principal trade, with the prime broker providing an OTC perpetual swap to the client and hedging itself in the market on the other side.

Higgins sees Route28 as an alternative to the crypto-linked swaps that banks trade with clients and currently hedge at the CME with quarterly and monthly expiry futures. Hidden Road’s perpetual futures trade 24/7 and are unaffected by the curve dynamics and roll risks inherent in dated expiries.   

Route28 also allows buy-side firms to run another popular basis trade in crypto – perps versus spot, where the buyer is long spot or expirable futures and short perpetual futures to remain delta neutral while receiving periodic funding payments from the latter – on a regulated venue.

“If they have an account at Hidden Road, they might be able to buy the spot on CrossX or the future on CME, and sell the perp using Route28 where the underlying tech is from CrossX,” says Higgins.

The design of Route28 isn’t restricted to crypto. Hidden Road plans to expand the product set to include other asset classes, including equities and commodities.