This article is devoted to explaining some of the finer points of prime brokerage arrangements using Currenexs ECN platform. Many people have only a general sense of what prime brokerage means, others have explored it more in depth, but there are nevertheless a lot of details that arent necessarily obvious at first glance. In this article we will try to shed light on some of the more significant aspects of prime brokerage. Our discussion will be conducted from the vantage point of Alpari, a company which has gone through the entire process from the very first steps of negotiating agreements all the way to introducing a full-fledged prime brokerage and ECN dealing model.

Lets start by introducing the key players that will form the center of discussion in this article.

Alpari has been in business since 1998, and is currently one of the leading providers of online trading services around the world. In 2006, the Alpari Group began a period of international expansion which was headlined by the acquisition by Alpari Group companies of two major licenses: an FSA license for London-based Alpari UK and an NFA license for New York-based Alpari US. Offices were also opened in Shanghai and Dubai, among other major financial hubs.

Currenex is the worlds largest electronic trading systems and a recognized global leader in providing financial services to institutional investors. Currenex includes major banks and brokerage houses among its partners

Lets start by looking at how Alpari arranged things in the old days. In order to hedge client trades, we opened accounts with other, larger brokers, deposited money and hedged our clients trades at the best prices we could. But this system is replete with drawbacks: first of all you have to open accounts with a lot of different brokers. That in and of itself isnt the difficult part. But then you have sufficiently fund all your accounts because you never know what volume you will need with which broker. Of course you can move money around among your various accounts but this takes time and is not cost effective. And most critically, its slow a serious concern when hedging trades. The next problem is that even if we manage to open a position at a good price, we will have to close the position with the same broker with no guarantee that a good price will be available when the time comes to close the position.

In Europe and the US, the world of finance realized the inefficiency of such a system and developed a model thats called prime brokerage. We will take a look at the UK as an example of how this works. Lets assume theres a bank which is considered a prime broker (generally only major banks, though some second echelon banks). Alpari goes to this bank to open a prime brokerage account. Before opening such an account, however, the bank will want to know if the company has a license to offer brokerage services. In our case, Alpari offices in the UK and US can show licenses from the FSA and NFA respectively. Needless to say, licenses from various island enclaves and other unrecognized authorities will not pass muster here. This is the first filter and not every company makes it through. Next the bank will be interested in the approximate trading volume the company can achieve; banks arent interested in going through the trouble of opening an account if it wont be generating a steady flow of commissions from the company. Low-volume companies are either rejected immediately or have their accounts closed when it becomes apparent the companys actual trading volume falls well short of expectations. Trading volume, the second filter for prospective companies, implies a client base sufficiently large to reach the necessary volumes. Generally speaking, were talking about volumes of billions of dollars a month.

Lets take a look at a model of prime brokerage (illustration 1):

Alpari reaches an agreement with a bank and opens a prime brokerage account. One of the stipulations is that the balance of the account cant go below 10 million dollars. The bank in turn gives Alpari access to pretty much any major bank, i.e. liquidity providers.

We tell our prime brokerage bank that we want to trade with two banks: well call them Bank 1 and Bank 2. Two three-way agreements are reached: Alpari, Prime Broker (PB), and Bank 1 and Alpari, Prime Broker, and Bank 2. Alpari then gets either access to the trading terminal (if trading manually) or to an API (application program interface) for automated trading.

How is a trade made? If Alpari sees a favorable price at Bank 2, it sends a request to buy. Bank 2 executes the request and sends the confirmation back to Alpari. Alpari then sends its PB a record of the transaction (date filled, volume, etc.). Bank 2 also sends a record to the PB. The PB, having received a record of the transaction from both parties can then compare. If everything matches up, the transaction is considered to have gone through. At this point, Alpari sees this transaction on its account at PB. A certain percentage of the funds on Alparis account serve as margin for leveraged trades.

Lets then assume we are ready to close the position and we see that Bank 1 is displaying a more favorable price. Alpari can close the trade with Bank 1, but as before, the trade is given-up to the PB and will show up on Alparis ledger at the PB. What actually happened is that Alpari made the purchase from its PB who simultaneously bought from Bank 2 and sold to Alpari.

So whats in it for the participants of such a system? First and foremost, the PB makes a commission from the transaction (the size of the commission depends on a number of factors including the trading volume of the company). The PB also can put the funds on Alparis account to productive use in the same way that any other bank uses a customers balance. Alpari, for its part, gains access to more banks meaning a more liquid market and can open and close positions in different banks without having to move money around among different accounts. Furthermore, Alpari can make trades with the PB without paying extra commission. Bank 1 and 2 get trading volume from the PB without having to incur the risk associated with the trades (the PB is on the hook for positions exposed to market risk).

This arrangement is advantageous for any sufficiently well-established and well-capitalized broker.

Many people dont know what Currenex is and where their pricing comes from. There are a lot of versions floating around about what Currenex actually is some people even think its an exchange. Actually, Currenex is just a technology provider they simply provide access to an ECN through their servers and trading platform.

Lets take a step-by-step look at how it works. Lets say Alpari reaches an agreement with Currenex. Currenex then gets in touch with Alparis PB and sets up an arrangement to have transaction confirmations automatically sent to Alparis PB. Alpari then provides Currenex with a list of banks that it works with and these banks are hooked up to the Currenex system.

Banks feed quotes into the system according to the FIX protocol. The quotes are formulated from several different prices, depending on volume.

It looks like this, for example: Bank 1 says that it is willing to buy between 0 and 1 million EURUSD at a price of 1.5000 and sell at 1.5001 and is willing to buy between 1 and 3 million EURUSD at 1.4999 and sell at 1.5002. Because its harder to move large volumes, however, between 3 and 10 million the buy price may, for example, remain at 1.4999, whereas the sell price will be larger, for example 1.5003. In other words, unlike in everyday life where higher volumes are sold at a discount, banks will not provide a better price for a higher volume due to the difficulty in processing high volumes. Smaller volumes, on the other hand, are easier for the bank to process internally.

Naturally, higher volumes entail greater risk for the bank, a fact which compels it to distribute large volumes among other banks. This tends to be disadvantageous for the bank because it can move the market price against the bank. This is where there are higher prices for larger volumes. The model is the same everywhere for large and small banks alike with the only difference being the level of risk. Its also the case that most brokers either charge a higher spread or offer less favorable execution for large orders. It should be mentioned that if a broker doesnt do either of the above, it means client positions are not being hedged a practice that could lead to client gains not being honored by the broker, or even to the bankruptcy of the broker.

As a result, the more banks that are involved, the higher the liquidity in the system, and the better the price for the client.

A broker that uses the method described above pays a commission that actually consists of two separate commissions: the prime brokers commission and Currenexs. This commission is subsequently passed on to clients. As a general rule, clients who work with Currenex pay a higher commission but trade with lower spreads. The company in turn pays a small commission because its volume is comprised of the sum total of all client trades. The difference between what the company pays and what the client pays is the companys profit. The difference, of course, is not large but does add up when large numbers of transactions (and high volumes) are involved.

It is therefore in the brokers interest that the client be successful; the more the client trades, both in terms of volume and quantity of transactions, the more the broker earns from the client in commission. In other words, a clients longevity is beneficial to the broker. By the same token, poor traders tend not to last long in the market and therefore provide less income to the broker. This serves as a good stimulus for the broker to improve trading conditions and explains why deep-pocketed institutional clients tend to be offered reduced commissions and other favorable conditions.

More than anything, the prime brokerage and ECN models are proving to be the future of dealing. Older models based on the unsavory conflict of interest between broker and client where client winnings come out of the brokers pocketare dying off. With prime brokerage, successful clients, far from being a threat, serve as a steady source of income for their broker.

Clearly not every broker meets the requirements to use such a brokerage system – licensing, capitalization and a sufficient client base represent a high barrier to entry for many. This explains why the list of brokers that Currenex works with is not extensive. And most of the masses of second-tier brokers dont have a chance of making it onto that list. For them there is an alternative, albeit a less attractive one: partnership with a broker that already works with a prime broker. But this adds another go-between, a fact which necessarily entails less favorable trading for the client.

I would like to dispel one more myth about ECN: minimum trading volumes. By default, Currenex does have a volume requirement: 40,000 units of the base currency. Banks, however, are often willing to process orders of as little as 1,000 units. We negotiated with our banks a minimum volume of 10,000 units and requested that Currenex reduce its requirement to 10,000. A series of test transactions using these parameters demonstrated that everything works fine, both for the banks and Currenex. Its very possible that we will be able to reduce our trading volume requirements to this level for ECN clients. Due to the automated nature of currency transactions (there is an established mini forex on the interbank market) banks lose nothing by being willing to work with smaller volumes.

This site is operated by AI Accept Solutions Limited (registered at 17 Ensign House, Admirals Way, Canary Wharf, London), a subsidiary of Alpari Limited.

Alpari Limited, Suite 305, Griffith Corporate Centre, Kingstown, Saint Vincent and the Grenadines, is incorporated under registered number20389 IBC 2012by the Registrar of International Business Companies, registered by the Financial Services Authority of Saint Vincent and the Grenadines.

Alpari is a member ofThe Financial Commission, an international organizationengaged in the resolution of disputeswithin the financial services industry in the Forex market.

Risk disclaimer:Before trading, you should ensure that youve undergone sufficient preparation and fully understand the risks involved in margin trading.

This site is operated by AI Accept Solutions Limited (registered at 17 Ensign House, Admirals Way, Canary Wharf, London), a subsidiary of Alpari Limited.