What Is Prime of Prime (PoP)?
Prime of Prime, or PoP, is a firm that provides a retail broker (often forex brokers) with access to the trading liquidity pool of the bigger banks. These big banks are referred to as tier 1 banks, and not just anyone can trade directly with them.
- A Prime of Prime (PoP) broker is one that has an account with a tier 1 bank, and lets retail brokers trade through that account so the retail broker can access the tier one bank's liquidity.
- Trading directly with a tier 1 bank and accessing its liquidity is difficult for individuals and small firms, so the PoP bridges the gap and provides the smaller player with access.
- In order to attract business, PoP brokerages and their associated retail brokers typically offer higher leverage and smaller trade sizes than a prime broker.
Understanding Prime of Prime (PoP)
Prime of Prime (PoP) are classified as tier 2 brokerage firms. Tier 1 is the brokerage arm of large banks that allow institutional traders and customers to trade with the bank. Tier 2, or PoP, can best be described as a brokerage firm that has an account with the tier 1 brokerage firm and allows its customers to trade with them.
PoP leverages their access to tier 1 banks to set up access for the retail broker, which can connect their smaller retail client orders with the larger orders of the tier 1 bank. However, most PoPs will not deal directly with individuals—the retail brokers do that. The retail broker handles individual clients and tries to attract more business.
Tier 1 banks tend to be risk-averse, and therefore demand strict financial protocols and risk management from their clients. A retail broker may not meet these rigid standards and therefore may not be able to trade directly with the tier 1 bank. PoP does meet these standards, is a client or partner with the tier one banks, and allows the retail broker to trade through them with the tier 1 bank.
Since the PoP already meets the standards the big banks are looking for, the retail broker using the PoP will typically offer higher leverage to its traders, and allow them to place smaller sized trades than what would be available if trading directly with a tier 1 bank. They do this primarily to attract business since their retail clients may not have the funds to place the larger transactions that tier 1 banks require. However, the bid-ask spreads may be wider than what tier 1 banks offer. The main reason for this is that this is one of the main ways that PoPs make money.
One of the reasons that tier 1 banks and prime brokers don't provide the services that PoPs do is that there is a smaller profit margin in the smaller trades which typically come from a retail client and their broker. Additionally, their systems often don't support a cost-effective way to complete smaller trades. PoP brokerages are also equipped to deal with increasing regulatory requirements for highly leveraged trades.
Prime of Prime Brokers in Action
Clients will use a PoP service for a number of reasons. Firstly, it provides access to more liquidity, which is important for traders. Secondly, PoP gives traders access to products that standard prime brokerage accounts don't offer such as non-deliverable forwards (NDF).
The PoP structure came under scrutiny in January 2015, when the Swiss National Bank (SNB) removed its three-year-old peg of 1.20 Swiss francs per euro. As a result, the euro and Swiss Franc currency pair (EUR/CHF) dropped from 1.20 to an intraday low of 0.85, a roughly 41% drop. Many of these clients were leveraged in their positions; considering the pair dropped 41% after the announcement, this resulted in major losses for many clients.
This event saw PoPs lift the amount of funds needed in its customer's accounts for capital requirements, along with other risk management protocols being enforced.
Retail forex brokers tend to be clients of PoP. When these entities start out they are too small to deal directly with the big banks and access their liquidity. For this reason, they will seek out a PoP broker that will link them up with the big banks.
By linking to the big banks, the retail broker is able to access live price quotes from the major banks which they then offer, after widening the spread, to their clients. These retail clients can then trade on these prices. This would not be possible if the broker didn't link up with the tier 1 firms.
The retail broker may mark up the spread that they receive from the tier 1 banks. For example, the raw tier 1 spread on the EUR/USD may be 1.12565 (bid) / 1.12567 (ask), but the rate Pop clients may be is 1.12563 / 1.12569. The added 0.00002 on either side of the tier 1 spread generates revenue for the PoP. This is offered to their clients, like the retail forex broker, who then add a further markup on to this and offer it to their clients. So, the retail client may see a EUR/USD quote of 1.1256 /1.12572.
This markup in the spread is one way that PoPs and retail forex brokers make their money. Other ways include charging a commission on each trade.
Typically, the more PoP accounts or links to the big banks a retail broker can get, the better. Liquidity from five big banks is much better than liquidity from only one. The more tier 1 banks providing the retail broker with quotes and volume, the lower the retail broker's spreads will be, all else being equal. This is why forex brokers advertise how much liquidity they have access to and which big banks are providing it.