How Volatility Tested the Prime of Prime Model

Obviously it’s been a crazy first half of the year. Can you talk through how it has been from an LP’s point of view? 

It certainly has been. I can’t remember a period that has been as challenging and as rewarding simultaneously. The fact that we saw XAU appreciate over 60% within a 6-month period only to then have it give back much of those gains in quick time, including two single-day falls of over 12% is incredible, and let’s not even mention XAG…  

From our perspective, this year have forced several key areas into sharp relief. First among priorities has been capacity management and this, frankly, is where we have seen many providers of bilateral credit or NOP in the industry come up short. We’ve long discussed that capacity management and forward planning for the kinds of volatile periods we are continuing to experience is critical. NOP, like oxygen, is a rather boring topic until people feel it is in short supply. At that point, it becomes the only conversation in the room and during the volatility we observed in January, there were certainly some Prime of Primes and brokers feeling a little short of breath. 

Adequate capacity for hedge flows is not only crucial to a sustainable business, but it also underpins every client relationship, and while pricing often dominates headlines, conversations around NOP and capacity planning have become far more regular in recent months. We work with six prime brokers across our multi-asset product range, with four for FX and Precious Metals alone. It is this capacity, many years in the building, that stood us in very good stead when other LPs came up short as the precious metals markets gyrated earlier this year. Other LPs were forced to scramble to amend client conditions and secure additional capacity, and that’s not where you want to be when key markets are making 2-3 standard deviation moves.   

Alongside capacity, the other major focus has been price control. The rapid asset price appreciation in XAU and XAG and associated volatility presented a challenge for those LPs without the risk appetite or price tooling to moderate some of the more extreme spread widenings observed in interbank markets. Here again, several years of investment in proprietary price tooling, seamlessly integrated into our vendor hosted trading servers, proved invaluable in giving us more granular control over our price at a time where interbank markets were regularly showing signs of being increasingly erratic. 

More broadly, the moves in XAG and XAU has been a blessing in disguise as it has finally allowed many retail brokers to step back from the ‘race to the bottom’ pricing environment that had driven so much unsustainable pricing and encouraged arbitrage behaviours. At its peak, we saw the yield on 1 cent of price improvement in XAU fall below USD 2 per million. For internalising retail brokers looking to capture spread while showing a competitive price, yields were falling into single digit territory and that is simply not sustainable for anyone long term. As we witnessed, it turns out not to have been sustainable for many LPs too…  

If you look across the prime space, there are very few genuine PoPs with access to the range of investment banks / Non-bank LPs that 26 Degrees can access. Is your impression that the events of this year may have made people realise the value of those relationships? I get the sense that smaller ‘prime’ brands may have struggled to absorb / offload a lot of the flow coming their way properly. 

100%. Recent market conditions saw retail brokers having to manage rapidly increasing client and hedge exposures in Gold and Silver and when that rapid increase in hedging occurred across the street, some LPs realised they had simply extended too much NOP relative to their own hedge capacity. The response was that several pseudo PoPs revisit their risk frameworks – cutting NOPs or drastically increasing margins etc.  

The takeaway here is that it is not enough for an LP to say they have relationships with top-tier counterparties, clients should really interrogate this claim and if they don’t get a strong answer, look elsewhere.  

26 Degrees have spent years preparing for these scenarios, and our relationships prime brokers helped us to continue supporting clients during stressed market conditions, when they needed it most. You cannot create capacity, credit lines, operational trust and liquidity support during the dislocation itself, it takes years of quite building, and that’s what our client benefit from. 

Beyond having access to those counterparties, how are you set up to actually make sure you can execute with them as efficiently as possible and in turn give the best pricing possible to your broker-dealer clients? 

First and foremost, that comes down to our technology stack. Advanced order routing configuration for our own hedge trades ensure these are executed against the most appropriate liquidity pool for the flow profile. That diversity of LP pools is facilitated by our expansive Prime Broking relationships. So while we pride ourselves on being able to provide bespoke pricing for our broker clients, we take the same approach with our own LP hedge feeds.  

There is also a lot that could be said about quote filtration but without opening a pandoras box, precise benchmarking, mid-rate monitoring and outlier quote detection are crucial to ensure we show our clients the best possible reflection of the market but also aggress our LPs in a sustainable way.

Something you offer is quote-book optimisation for brokers. This seems to be becoming a more prominent USP for some LPs. Can you explain what this does in tangible terms and how it helps brokers?  

A broker receiving a tight spread via a feed with poor quote book construction or which does not accurately reflect the current market mid-rate, may suffer a significant degradation in their internalisation performance. This is something that is not always easy to spot at first but reveals itself over time or with careful analysis.  

Quote book optimisation is simply about finding the right fit for that particular brokers’ client base, flow profile(s) and technology stack. Optimisations may include adjusting quote quantities, spread variability, and degrees of quote filtration or throttling. It may seem counter intuitive at first but for retail brokers showing the tightest price at the wrong time can be a recipe for losses on internalisation books. If a tight TOB price is delivered by LPs at the cost of a solid market mid-rate, its likely a poison chalice.  

The tangible outcome is not always a tighter spread, it may be a more stable book, better execution at size, lower reject rates, lower market impact, or more consistent pricing around opens, closes and news. 

A theory I have is that certain dynamics in the industry mean that more and more brokers are in a position to only send their ‘exhaust pipe’ flow to LPs. Obviously there is some flow that no one – even investment banks – will take on. But does that set up mean you have to work harder to manage the hedging activity you do see? 

I wouldn’t necessarily say that all residual broker flow is overtly toxic, but it is fair to say that flows have become more concentrated, more directional, more correlated and often more impactful if not handled carefully. Facing a wide array of flow types and trading styles is part and parcel of the segment of the industry we’re in, and it’s becoming more crucial for PoP’s like ourselves to effectively handle sharper flow from brokers. Once again, flexibility is key, and ultimately, there is a price for almost every flow profile. It’s just a question of whether the PoP has access to the appropriate liquidity pools and the smarts to route accordingly. If you attempt to push a wide array of flow types through the same pool, sharper or more correlated flow will quickly degrade outcomes for the whole book.  

The job of a Prime of Prime is to segment that activity properly, build dedicated liquidity workflows around it, and manage the interaction with the broader market so brokers are not forced to carry that operational burden themselves. It does take time and effort, but that’s the job and we love it and if systems and workflows are properly set-up and optimised, it doesn’t necessarily mean you need to work harder.  

Another feature 26 Degrees offers to broker-dealers is risk and trade analysis. This is a growing theme we’ve seen over the last couple of years. Are you seeing more uptake for those solutions and can you say if there are any specific use cases that are proving particularly popular among brokers? 

It is, and there is more that we will be looking to bring to market in the coming months in this area. 

The way brokers use risk and trade analysis has changed quite a bit. A few years ago, a lot of this work was post-trade review. Today, it is becoming much more embedded in the day-to-day decision-making of dealing and risk teams. Brokers want to identify changes in client flow profile before they become a pricing, hedging or exposure problem. 

That is the key use case we are seeing. Is concentration building in one instrument? Is a particular client cohort becoming more directional? Is flow becoming more impactful at certain times of day? Are hedge requirements increasing in market conditions where liquidity is thinner? Those are not abstract analytics questions. They feed directly into how brokers manage limits, book settings, hedging workflows and internal escalation. 

The more specific analysis sits underneath that. Brokers want to measure market impact by client, symbol, order size, order type, time of day and market condition. They want to compare effective spread with post-trade mark-out, and understand whether execution outcomes are changing as conditions shift. But the real value is in turning that information into an operational decision quickly. 

Brokers do not need another dashboard that explains a problem after the fact. They need analysis that helps the dealing desk see what is changing while there is still time to act.