Foreign exchange prime brokerage is a credit intermediation service whereby, in its simplest form, a prime broker enables its clients to seek liquidity in foreign exchange (“FX”) transactions from any one of a number of executing dealers with whom the prime broker has “give-up” relationships, such that once the client and executing dealer have committed to a transaction’s terms and the trade is given up to and accepted by the prime broker, corresponding offsetting transactions result between the prime broker and its client, on the one hand, and the prime broker and executing dealer, on the other, with the executing dealer consequently bearing no credit risk exposure to the prime broker’s client. Because of the tandem roles of the prime broker and executing dealer in the execution and give-up process, prime brokerage does not fit precisely into many of the new regulatory paradigms affecting the execution of derivatives transactions, and the prime brokerage market has had to develop special procedures to facilitate compliance.1
The latest market reform measure (albeit a voluntary one rather than a regulatory mandate) to impinge on FX prime brokerage is the FX Global Code (Code),2 a set of “principles of good practice” produced through a collaborative effort between central banks and private market participants and released on May 25, 2017, by the Global Foreign Exchange Committee (GFXC), a newly formed global association of central bank-sponsored FX committees that will maintain and update the Code.3 This Legal Update highlights several principles of the Code that expressly address FX prime brokerage.
The FX Global Code
The aim of the Code is to promote the integrity and effective functioning of the wholesale FX market. The Code is intended to apply to “Market Participants,”4 a term defined to encompass most categories of participants that are active in the wholesale FX market as a regular part of their businesses, and generally expected to include financial institutions, asset managers, sovereign wealth funds, hedge funds, pension funds, insurance companies, corporate treasury departments, non-bank liquidity providers, execution facilities, brokers, aggregators, e-trading platforms and, except where it would inhibit discharge of their legal duties or policy mandates, central banks and supranational organizations.
Among the measures to encourage voluntary commitments by Market Participants to conduct their FX activities consistently with the Code’s principles, a working group of central bank officials has announced that their central banks intend to adhere, and will expect their regular FX trading counterparties to adhere, to the Code’s principles except where this would inhibit the discharge of the central banks’ legal duties and policy functions.5 In addition, an annex to the Code sets forth a Statement of Commitment, which Market Participants may choose to adopt and furnish, either publicly or individually to other Market Participants, to signal their commitment to following good practice. The Statement of Commitment includes an affirmation that the institution has taken “appropriate steps, based on the size and complexity of its Activities, and the nature of its engagement in the FX Market, to align its Activities with the principles of the Code.” Based on participant feedback, the GFXC anticipates that most Market Participants will need approximately 6 to 12 months to implement appropriate steps to support their adoption of the Statement of Commitment.
The Code states that it does not impose legal or regulatory obligations, modify applicable law, bind any regulator or provide a legal defense to a violation of applicable law.6
Principles of the FX Global Code That Expressly Address FX Prime Brokerage
As defined in the Code, a “Prime Broker” is:
An entity that provides credit intermediation to one or more parties to a trade based on pre-agreed terms and conditions governing the provision of such credit. The Prime Broker can also offer subsidiary or allied offerings, including operational and technology services.
A “Prime Brokerage Participant” is:
A Market Participant that is either (i) a Prime Broker, (ii) a Client using the services of a Prime Broker, or (iii) a Market Participant acting as an executing dealer (price maker) or execution intermediary (such as an Agent or platform) between the Prime Brokerage Client and the Prime Broker.
Principle 41 of the Code is devoted to fostering real-time monitoring by all Prime Brokerage Participants of trading and credit permissions for prime brokered trades.
Principle 41 states:
Prime Brokerage Participants should strive to monitor and control trading permissions and credit provision in Real Time7 at all stages of transactions in a manner consistent with the profile of their activity in the market to reduce risk to all parties.
The Code articulates the contribution expected from each category of Prime Brokerage Participant with regard to this principle:
- Prime Brokerage Clients should strive for Real-Time monitoring of their available lines and permitted transaction types and tenors so that only trades within permitted parameters are executed.
- Executing dealers should strive for Real-Time monitoring of designation limits to validate trade requests prior to execution.
- Prime Brokers should (i) have systems reasonably designed to monitor trading activity and applicable limits upon receiving give-up trades, (ii) be in a position to accept trades in accordance with terms and conditions within Prime Brokerage agreements and designation notices and (iii) have policies and procedures reasonably designed to address limit breach exceptions, limit changes, amendments and novations.
Several other Code principles, while not limited to prime brokerage, expressly discuss how they apply in that context.
Principle 26 (risk management framework): Market Participants’ risk management and compliance frameworks should take prime brokerage activity into account. Prime Brokers are “encouraged to engage in ongoing dialogue with those for whom they are providing credit intermediation … to underscore expectations regarding appropriate behaviour in the market.”
Principle 15 (resolution of trade discrepancies): Where their identities are known to each other, the Code allocates responsibility to prime brokerage Clients and executing dealers for resolving trade discrepancies to achieve timely amendments and matching of trade terms through the Prime Broker. When anonymous market access is provided, the access provider should assist in the resolution of trade discrepancies.
Principle 19 (identify and appropriately limit access to confidential information): Prime Brokers should have an appropriate level of separation between their prime brokerage business and their other sales and trading business, including appropriate information barriers, and should be transparent as to the standards they require and adopt.
Because the Code sweeps broadly into nearly all aspects of a Market Participant’s involvement in the wholesale FX markets—viz., in the areas of ethics, governance, execution, information sharing, risk management and compliance, and confirmation and settlement—even Code Principles that do not specifically target prime brokerage could have an impact on prime brokerage operations, and prime brokerage participants will want to assess the effects of the Code in its entirety. Topics of potential interest not dealt with in this Legal Update include, among others, markups, order handling, clear communication of the capacity in which a participant is acting, treatment of confidential information, pre-hedging, and “last look,” a topic on which the GFXC is currently seeking feedback.8
*****1 See, for example, the ISDA Derivatives/FX PB Business Conduct Allocation Protocol (May 6, 2013), available at http://www2.isda.org/functional-areas/protocol-management/protocol/13.
2 FX Global Code, available at http://www.globalfxc.org/fx_global_code.htm.
3 Further information about the FX Global Code and the GFXC is available on the GFXC website: www.globalfxc.org.
4 A “Market Participant” is a person or organization (regardless of legal form) that: (i) is active in FX Markets as a regular part of its business and is engaged in the activity of the purchase or sale of one currency against another, or in transactions designed to result in gains or losses based upon the change in one or more FX rates, such as derivatives, whether deliverable or non-deliverable, either directly or indirectly through other market participants; or (ii) operates a facility, system, platform, or organization through which participants have the ability to execute the type of transactions described in (i); or (iii) provides FX benchmark execution services; and (iv) is not considered a retail market participant in the relevant jurisdiction(s). Where consistent with context, the term includes personnel who conduct the foregoing on behalf of a Market Participant. FX Global Code at 3.
5 Foreign Exchange Working Group, Report on Adherence to the FX Global Code (May 2017) at 4, available at http://www.bis.org/mktc/fxwg/adherence_report.pdf.
6 This statement is, of course, not dispositive of the legal effects of the Code, or of a Market Participant’s adoption of the Statement of Commitment, in any jurisdiction. Market Participants will no doubt wish to evaluate independently to what extent, if any, the Code, and the adoption or not of the Statement of Commitment, could affect the legal, business, reputational and other risks inherent in their FX market activities.
7 The Code defines “Real Time” to mean “[n]ear, or close to, the actual time during which a process or event occurs.” Global FX Code at 71.
8 See GFXC Request for Feedback on Last Look practices in the Foreign Exchange Market (May 25, 2017), available at http://www.globalfxc.org/docs/consultation_process.pdf.