Refco demise highlights prime brokerage risk

2005 has generally been a good year for the foreign exchange industry. Banks have seen profits soaring despite ever-narrowing margins thanks to the increased interest in the asset class from a wider range of investors. We have seen the launch of a number of funds and indexes that demonstrate the increased demand financial institutions are experiencing from clients looking for returns in an otherwise flat market.

This increased confidence in the asset class as a safe haven for investors looking to diversify their portfolio is, however, a fragile one. The demise of Refco has highlighted to investors and those who are considering parting with their cash that there is a risk attached to the foreign exchange market.

While the losses were essentially down to the mistakes of one individual, and nothing to with any inherent risk associated with foreign exchange, the incident should nonetheless put a fierce spotlight on risk.

Prime brokerage has become increasingly important to the foreign exchange market, with banks devoting more resources and platforms such as EBS offering a new business line to attract prime brokerage flows. The guidelines inroduced by the FX committee are to be welcomed on a more fundamental level. However, some have questioned whether prime brokerage as it is currently priced can be sustainable for many banks who offer it. Refco’s demise highlights credit risk, which banks are charging for covering.

Where fees are at levels that some would argue are artificially low, how can this credit risk be paid for?

There is a danger that if banks continue to aggressively price prime brokerage in a bid to build flows, they will almost entirely cease to charge for what will, in many cases, be a fairly substantial risk. If this happens, prime brokerage will be a ticking time bomb, with the next significant corporate melt-down having a knock-on effect on the foreign exchange industry as a bank finds it has put a substantial amount of credit the way of a third-party that has gone bankrupt.

Of course, this may be an overly negative prognosis. Prime brokerage has yet to cause serious problems to banks, and it has succeeded in driving large flows of business that would otherwise have not added to the liquidity that benefits the system as a whole. But the market needs to be careful that in its eagerness to attract new business it doesn’t forget that there is always a risk in offering credit lines.