B-book P&L is rife among many brokers but is very shortsighted. Why don't retail FX firms execute like Tier 1 banks? - FinanceFeeds

B-book P&L is rife among many brokers but is very shortsighted. Why don’t retail FX firms execute like Tier 1 banks?

The sooner the peripheral element of the retail FX industry embodies this ethos and begins to populate its offices with professionals with institutional and interbank experience on the technological, execution and relationship side, as well as customer facing staff who understand the means by which the market infrastructure of London and New York operates, the better for everyone, including themselves.

A leopard cannot change its spots, says the well worn adage.

The innate nature of the human condition in some cases runs counter to the ever changing and rapidly advancing world of FX industry execution methodology and market infrastructure topography.

Nowadays, there is a clear distinction between the electronic trading companies that operate their entire corporate entities with aplomb, delivering services that range from prime of prime brokerage with genuine market connectivity, alongside proprietary platforms, specialist integration and matching engines to a host of risk management tools.

Alongside these top tier companies which include longstanding stalwarts such as Saxo Bank, CMC Markets, Invast Global and Interactive Brokers, are 1231 active MetaTrader 4 licenses, meaning that 1231 other retail FX companies are operating across the world, mostly offering the same white label MetaTrader 4 system with a retail feed to another retail firm’s dealing desk where order flow is then internalized, or no connectivity at all, with the entire flow being internalized at the dealing desk of said white label.

Cyprus, home to over 155 retail FX brokerages, is well recognized to be the retail FX center for the entire world, however it is possible to count on one hand the number of companies based there that actually operate their execution according to Tier 1 bank price aggregation from prime of prime brokerage and who send their orders to market in accordance with the prices.

The vast majority of firms there simply operate a B book. The knowledge is there, the resources are there, but the conditioning and habit is to run a sort of ‘me against the house’ environment for retail customers. Indeed, the vast majority of firms in Cyprus, whilst residing there in order to gain ease of access to MiFID compliance and pan-European regulation, do not have any customers at all in Europe.

Most of the customers of retail FX firms in Cyprus are in Russia and the CIS countries, the Middle East, Africa, the Indian subcontinent and South East Asia. In effect, regions with no FX industry regulatory structure and in which many clients expect to be trading against a ‘house’.

What few European retail clients that actually do exist are based in France and Germany, almost all of which are loyal to British CFD firms such as IG Group, CMC Markets (both have around 25% of their retail client bases in Germany and France, the rest is in the domestic British market), Saxo Bank and until recently FXCM UK. In short, French and German traders do not trade with Cyprus brokers.

Many operators of brokerages in Cyprus also do not come from the electronic trading sector.

Unlike in London, Sydney and New York, where most senior executives have spent their years in an internship at a major bank whether it be on the trading desks or in the technological development and infrastructure divisions, before moving to senior management level at large institutional non-bank companies such as Currenex or FXall (now part of Thomson Reuters), and then to senior executive positions at large established companies.

By the time the career of these executives reaches that level, they are highly experienced in how to operate and structure a brokerage with intricate knowledge of netting, counterparty credit risk, are able to maintain relationships with Tier 1 bank eFX liquidity divisions and run the companies as though they were running an institutional desk within a bank, right the way from the means by which the counterparty agreements are structured, to the execution and range of products available to clients.

When approached, many firms which continue to operate a complete b-book will perhaps state that it is so expensive nowadays to run a genuine and transparent business that with the margins allowing little room for profit, there is no point.

This, however is not the case. Comparing the career paths of the aforementioned executives to those operating b-book firms outside the major global financial centers reveals the reason – most of them come from the affiliate marketing and gaming industry, where lead selling and client churn is key.

It is entirely possible to attend the offices of said firms, and they will not be able to hold a conversation about execution of trades, even though MiFID II will soon require what the European authorities call Systematic Internalizers (b-book operators) to report and account for every trade that takes place.

Most of the operators of the firms concerned concentrate their resources on marketing, client acquisition – a very expensive business when no value proposition exists – and lead purchasing.

Looking at how much banks pay their counterparty credit risk analysts in major centers such as New York or London, it is even more clear that the barrier is mentality rather than cost.

In London, a Credit Risk Analyst at a Tier 1 bank such as Barclays, who would work within the division of the company that operates the BARX single dealer platform which extends its liquidity to prime of primes globally, would earn according to May 2017’s employment statistics approximately $67,000 per annum.

In New York, a Risk Analyst within a major electronic trading desk at a Tier 1 bank would earn between $80,000 and $96,000 according to employment statistics for May 2017.

These figures are not outlandish at all and pale into complete insignificance compared to the amounts paid to compliance officers in the same regions, which total in some cases $1200 per day.

Should retail brokerages in various regions employ professionals from the Tier 1 bank desks for this salary rather than former gambling company ‘house’ operatives who work the dealing room desk and internalize trades or trade against their customers, the entire retail FX sector, especially within the MT4 white label brokerage sector, would elevate itself immediately to the level of the institutional world, by adopting genuine, institutional level talent.

Individuals such as this also have experience and connections within the top level banks, and know their responsibilies very clearly, hence it may also go some way toward rectifying the adverse perspective that many eFX divisions of banks hold toward the OTC derivatives sector in terms of credit default risk. Citigroup, the world’s largest FX dealer by volume (16% of the world’s interbank FX market share) considers OTC derivatives to be the source of a 56% potential default risk if extending counterparty credit.

Occupying the dealing rooms of many brokers outside the main financial centers are dealers who are used to dealing poker or gaming odds rather than maintaining relations with risk divisions of major banks or keeping their knowledge of bank execution infrastructure at the forefront of their minds.

FinanceFeeds is aware of several cases of this being applied to what is intended to be – and regulated as – a financial markets segment, including intentional slippage and order filling done locally by a ‘you against me’ dealing desk, instead of doing things the right way.

This is limiting in itself.

When taking Cyprus as an example, there are over 150 brokerages on the island, and according to extensive research by FinanceFeeds, the entire sum of those brokerages only have 10,500 clients between them, pretty much all of which have an average deposit size of $600 (global average is $3800 and $6600 in the United States) and a client lifetime value of less than six months.

By onboarding small ticket clients and then ‘turning the handle’ to make the deposit into brokerage revenue, clients are gone within six months, the cost of replacing them often higher than their initial deposit (approximately $1300) and the ability to join the ranks of the institutional sector and bring in clients from major capital markets centers on a long term basis (average client lifetime value at Hargreaves Lansdown in Britain is six years).

In China, where vast introducing brokers provide giant order flow to Saxo Bank, AxiTrader, Blackwell Global, BMFN, FXCM, Vantage FX and IC Markets, as well as having some direct relationships with prime of primes due to their ability to show vast balance sheets, absolutely no order flow is going to Cyprus brokers, or offshore firms.

This means that it is impossible to gain a steady and well organized stream of high volume, high net worth customers with managed accounts held by IBs responsible for over $300 million per firm in assets under management across the entire country’s provincial towns, as Chinese companies will only operate with those that can provide them with a correct market structure for their clients – especially post IronFX debacle.

Bearing in mind the tell-all metrics in which it is clear that the average length of time that a new trader spends in retail FX is six months, and the average cost of acquiring such a client is between $1,200 and $1,500, unless you are Plus500 which has got acquisition efficiency down to a fine art, in which case it is between $800 and $1,000 per new client, the bottom line is very relevant here, not just the reputation and value proposition of operating a clear business with a good prime brokerage relationship.

The costs of operating a facility which houses sales and retention staff, requires the payment of per-square-meter office rent and business rates, plus salaries, which FinanceFeeds calculated recently, are all vital considerations when operating a retail FX firm.

Remuneration of IBs, supporting partners and customers, and maintaining a proprietary platform (approximately $150,000 per month excluding development costs) or paying volume costs to MetaQuotes or a white label solutions provider whilst taking into account the very low spreads on the major currencies and keen commissions that IBs and traders demand, all make for a business in which even the least astute accountant would spend all day nickel-and-diming the company’s executive team.

In Chicago, the heart of the exchange traded futures sector, I met with Ryan Hansen, President of Tradovate who explained how the capitalization of futures platforms that are aimed at retail traders can be monetized. Mr. Hansen explained “We don’t charge a trade commission nor do we operate on a cost per million basis. Instead, we charge a monthly membership fee, rather like online portals such as Amazon Prime or Netflix.”

“There used to be a reason that this was done differently in the past, as used by firms that operate a commission model. The old way of doing business where a human touched every aspect of an order at multiple stages is no longer relevant, it went through a process in which a customer called a broker, then the broker called the trade desk, then the trade desk called the trading floor, the trading floor then transacted the order potentially with a market maker. The trade was then reported back. This required a lot of manual work” explained Mr. Hansen.

“With electronic trading, the costs created by the manual element are no longer the case.”

“For example, 1,000 contracts could be executed, or just 1 contract could be executed, and there would be no extra work for either scenario.

“Traditional brokers charge a commission on every single contract. What we are providing is a means by which we impact value the most for customers. We therefore charge a membership fee that covers the technology cost and the brokerage in one.”

In terms of connectivity to venues, Mr. Hansen confirmed that Tradovate is connected to CME Group (which includes CME, CBOT, NYMEX and COMEX), ICE US & Europe, and Eurex derivatives exchange.

With this in mind, the question began to surface among industry innovators as to how this model can be incorporated into MetaTrader 4, thus making matters very cheap and very effective for retail brokers wanting to attract a longer term client base with higher deposits and much less risk.

This also applies to certain companies that are now providing a multi-asset solution via the MetaTrader 4 platform itself, as is the case with DirectFX via its arrangement with CQG.

Speaking in Shanghai in January with Brankin, Business Development Director at Direct FX, FinanceFeeds investigated the company’s rational for beginning to offer a full multi-asset MetaTrader 4 platform, because of integrating futures and US equities on MT4 which are exchange traded on CME.

“We can also connect to regional exchanges around the world. We have a partnership with CQG which is a company that built several connections and the ‘plumbing’ to all the exchanges around the world. We have a partnership with oneZero as we needed to be able to develop bridging technology to take what CQG had built and integrate that for exchange trading on MT4 whilst allowing FX to be OTC” – Tim Brankin, Business Development Director, Direct FX

Mr. Brankin is a specialist with regard to developing integrated systems that allow exchange traded futures to be accessible to retail traders via MetaTrader 4 whilst allowing the FX instruments to be traded on an OTC basis from the same platform, as he spent three years as Managing Director at TradeToolsFX in Chicago, which, among other solutions, developed a fully integrated solution to connect the MetaTrader 4 platform to Chicago based binary options venue Cantor Exchange.

Mr. Brankin has a vast and extensive career background in the institutional and listed derivatives sector, having spent 7 years at TD Ameritrade and a significant period at E*TRADE before joining Velocity4X in January 2006.

Mr. Brankin understands that the general direction this year will be an evolution of business from that of standard OTC FX brokers.

Having a multi-product system helps attract institutional business in China because Chinese investors want access to other investments because the government restricts where they put their money which is generally limited to chinese stocks and property.

Direct FX has entered into a partnership with DriveWealth which has a relationship with ICBC which is now a NYSE member firm. Chinese investors can that way invest in US firms like Amazon, Apple, Google, alongside Chinese stocks like Baidu and Alibaba.

“My main focus is working with the institutional clients here in China to set up the connectivity and access to the US futures and equity markets for their money managers and their clients, therefore now our Chinese partners and clients have a truly diversified portfolio for the first time by being able to invest in US commodities, equities alongside the currency markets, so our aim is to become a comprehensive financial services provider similar to the companies I worked at in the past like TD Ameritrade and E*TRADE which have turned into global powerhouses for self-directed retail futures investors” concluded Mr. Brankin.

Saxo Bank is another case in point. At a private meeting in Hong Kong in February this year, FinanceFeeds investigated with Saxo Bank as to how retail firms MUST move on and that the future is API, multi-product wealth management, democratized prime brokerage and high tech execution.

During the meeting, Jennifer Hansen, Executive Director and Head of Institutional Business at Saxo Bank explained “We are at a tipping point at the moment across the industry. The type of conversations our sales people have across the world are more creative than they were five years ago, and commercial customers are getting much crisper about what part of the value chain they want to build themselves. They are asking themselves which piece they do not have and what providers to use in each area.”

“Additionally, keeping ahead of regulatory change is part and parcel of keeping abreast of technology. Diversification, fair dealing, best execution are forces that are here to stay and need to be built into strategy. It is not practical just to be known from an FX perspective, as electronic trading firms need to continually be able to change their own user experience to stay ahead of regulatory change” – Jennifer Hansen, Global Head of Institutional Business, Saxo Bank

“If i mention an example here, it should be the way that a real multi-asset solution should be designed and provided to customers” said Ms. Hansen. “For example when we launched our digital bond offering we got a lot of focus because digitizing bonds is a major task. Working in a traditional technology stack with a series of services built around it is problematic these days because it means that a simple change could create up to 30 touch points.

Back in December 2015 at Saxo Bank’s global head office in Hellerup, Denmark, FinanceFeeds met Saxo Bank Senior Director and Head of OpenAPI Benny Johansen who detailed how this works.

“What is new with OpenAPI is that it allows a third party client, client company or application developer to not only integrate into our infrastructure, but to essentially completely rewrite the front end trading application. So if you take a step back, I would say that OpenAPI is a complement, and additional piece in the puzzle in the ways you may work with Saxo Bank” said Mr. Johansen.

“OpenAPI is one part of the larger Open Bank Vision”: A quick screenshot of what Mr. Johansen explains as the Saxo Open Bank Vision. On the left screen you may discern the hub in the middle illustrating the Saxo Bank trading engine, and the boxes around it illustrating the various types of integration technologies available.

Thus, the sooner the peripheral element of the retail FX industry embodies this ethos and begins to populate its offices with professionals with institutional and interbank experience on the technological, execution and relationship side, as well as customer facing staff who understand the means by which the market infrastructure of London and New York operates, the better for everyone, including themselves.


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