The need to teach old dogs new tricks
Marco Baggioli, Executive Managing Director—Global Head of Brokerage at ADS Securities highlights the prospects in the region and urges the global brokerage industry to adapt to technological advancements, focus on value.
The brokerage business is a relatively new market in the UAE’s financial system. It stemmed from the fact that the country is strategically positioned between the trading hubs of South East Asia and Europe to play an important role in global financial markets. ADS Securities spotted this opportunity and decided to step in to service this market segment.
“The global brokerage industry has gone through tough but interesting times, with multiple major changes. A few years ago, one such change was the emergence of electronics where the market moved from voice to e-trading, which was arguably the first major shift for the industry. Cost of trading dramatically decreased which also made the average size of the trades much smaller. It was previously not un-common for trades to be worth the equivalent of hundreds of millions of US Dollars. However, now the average trade on an e-platform is only around one million,” said Marco Baggioli, Executive Managing Director—Global Head of Brokerage.
As a result, the profitability of each trade has narrowed significantly. Trading foreign exchange today is fast, easy and is extremely cheap. However because each trade is small, it is not generating as much revenue as it previously did. These changes were nevertheless still acceptable as the sector is growing and there is market share for everybody to compete.
Another more recent challenge Baggioli highlighted was Swiss National Bank’s de-pegging of the Swiss franc in January last year, which came as another major shock for the industry. This highlighted the lack of prudent risk management capabilities by some parties.
“Quite a few players in the industry [the least-capitalised ones] went out of business and the banks that were servicing these people through the prime brokerage services realised that some of their clients were not healthy or solid and did not have enough capital to cover the risk they were taking. Thus, most of them decided that they would only be prime brokers to larger institutions. So a lot of people lost access to the market and access to credit lines which, as a consequence, caused a struggle in the market segment,” explained Baggioli.
One of the reasons that the banks curtailed their prime brokerage offering and credit offering to foreign exchange players was the cost of capital. These past two years have been challenging for the banks as Basel III kicked in and their capital requirements were increased dramatically. Money that historically would have been invested – potentially through prime brokerage credit lines - now has to be held as cash, increasing the cost of capital, which is an expense that has to be passed on to the banks’ clients. This left the forex brokerage industry in a position where many banks simply withdrew their support – but this is a highly innovative industry and it paved the way for forward-thinking businesses like ADS Securities to step in and fill the gap. A new service known as prime of prime emerged, providing credit intermediation to clients who either no longer had access to a prime broker, or needed additional credit lines to access either their own or external liquidity, to execute anywhere in the market.
“We have always had shocks to the financial industry. There are times when everything is fine and times where everybody is panicking and worried. Lehman, for example, was a clear shock where we saw one of the giants of the industry collapse, which people thought was ‘too big to fail’. This concept has disappeared and people now recognise that nobody is too big to fail. Swiss National Bank is another example of a black swan event as people were extremely surprised and were not expecting such a bomb to drop,” explained Baggioli.
He continued, “This was a severe shock to the system and a lot of people, and institutions, lost tremendous amounts of money. This incident is like living in an earthquake-free zone and suddenly an earthquake happens. All these incidents tell us that the market clearly needs to change. The SNB event tells us that we need to manage risk better.”
There is also an imbalance in the value chain of foreign exchange. This needs rebalancing and ADS Securities has been engaging this issue in forums with regulators and with industry peers by educating clients and market about the need to change. According to Baggioli, credit and capital are the most important elements of a foreign exchange transaction today. After that comes pricing, which needs to reflect the service that the customer buys in terms of credit and capital. The third element is technology, where the industry focuses a lot of their capital, which in turn directly causes them to neglect credit. In this context, technology should not cost too much as it can now be acquired from a broad selection of vendors as opposed to previously when it was a niche market that was specifically region-oriented and expensive.
“There are a lot of variables at play when evaluating global markets and there are no specific pre-emptive measures that could be taken. However going through each of these events teaches the market to better prepare themselves for the next event so we can only be vigilant and have the right systems to manage credit and risks, having the right collateral from the clients and specifically adjusting from what we have learned,” said Baggioli.
“We basically have a clear vision of how the foreign exchange industry is changing and we see an opportunity to be in the front line of the global market. We are adapting dramatically by changing our business model by being a value-adding focused organisation as compared to the traditional pure broker concept. We have working clients who have specific needs like credit, execution and price. These are needs where we can demonstrate value and clients will pay for it, whether through our market making capabilities and our prime brokerage services,” said Baggioli.
“The foreign exchange industry is huge and the problem is that many players are still set in their ways, carrying out the business in an outdated manner and refusing to keep pace with the changes that technology bring,” he added.
Prime brokers, banks, creditors and clients need to be part of a positive value chain and understand that brokers are now paid for the added value they bring to the transaction. ADS’ focus is on private clients in the GCC region, growing steadily in South East Asia and Europe.
With institutional clients, ADS is refocusing their approach catering to end users of foreign exchange such as corporates, asset managers and smaller banks globally, as well as family offices that choose to be treated as institutional and non-privates to deliver them value.
Baggioli further explained, “We are evolving our model. Currently we provide indirect access between two parties that do not want to work together, so we need to start making our own price. Not only are we talking prices and redistribution to our clients, but also starting market making ourselves. And to this end we have been working on algorithmic market making technology which is currently in testing and has shown very positive results. This will bring to the region something new representing an important step for the region as a sophisticated financial centre.”
Baggioli believes that the financial industry—particularly across Europe and Asia—will provide an opportunity for local banks and institutions from the GCC to play a more global role. This is because the rest of the financial industry now lacks the capital and regulatory environment they previously had that allowed them to play a leading role in the market for the past 20-25 years. New players from the GCC will be able to come on board as the region’s present aim to diversify from an oil-based industry to other economic sectors.
“Next year is a year of reckoning for the market as there are big regulatory changes, from capital requirements to bilateral margining of non-clear transactions. These are all coming together alongside some shocks that the markets need to understand and adapt to. Some big players may decide to exit certain business lines because they cannot afford it anymore or simply because it does not make economic sense. It will therefore be a year of regulatory adjustments where you may find certain banks being in trouble and in need of bailouts, especially in Europe,” said Baggioli.