Foreign-exchange trading is a world full of opportunities, but allocation of credit remains an obstacle, especially for smaller hedge funds.
Major banks such as Goldman Sachs and JPMorgan dominate the prime-broking market, but tend to focus on large clients. These banks are also now the only goliaths on the prime-broker street after the demise of Credit Suisse, and Nomura’s retreat after the Archegos saga.
With around 80% of the 8,200 hedge funds in 2024 managing less than $1 billion, and 40% managing less than $100 million, according to Hedge Fund Research, there's a substantial underserved market.
A more connected market would make it easier for smaller funds to access the credit they need
The evolving market structure, driven by the move to centralised clearing, uncleared margin rules and Basel III capital requirements, makes servicing these smaller funds less attractive for big banks. This has created an opportunity for non-bank prime brokers to step in, but the root problem of credit allocation remains.
At the heart of this longstanding issue is that credit in the FX market is not being distributed efficiently. Smaller hedge funds often can't get the credit they need at the right place and time, and there's a disconnection between the collateral they have and the credit they're being given. This creates a situation where not everyone can trade transparently.
How does the market go about fixing this predicament? A stronger connection between FX futures and the over-the-counter (OTC) markets is one potential solution. By doing so, market participants can benefit from more dynamic distribution of credit. Instead of having static limits, credit can be allocated based on real-time market conditions and the collateral available.
Stronger system
Futures can also provide a way to hedge against risks more effectively. Smaller funds can reduce their reliance on OTC credit lines by using futures to manage their exposures, making the entire system stronger. A more connected market would make it easier for smaller funds to access the credit they need. With the transparency and efficiency of futures, these funds can, in theory, trade more confidently and competitively.
The FX market's credit allocation problem has been a significant barrier to efficient trading for well over a decade now, particularly for smaller hedge funds. By creating a stronger connection between FX futures (for capital efficiency) and OTC markets (for price efficiency), market participants will be able to benefit from better management of FX exposures and improve access to capital efficiencies. This integrated approach could transform the FX ecosystem, making it more transparent, efficient and accessible for all market participants.
This article expresses the views of the author and not necessarily those of Euromoney