European rulings encouraging the b-book? CySec and BaFin go retrograde, whereas UK moves ahead

CySec’s rulings on client negative balance protection will encourage retail brokers to execute trades via their own internal dealing desk. Not really the stuff of progress…


In Europe, there is really only one financial center.

Whilst online financial instruments have the reach and connectivity solution to support every single individual and commercial entity that spans the entire length and breadth of the globe thanks to colocation facilities, specialist hosting services that ensure that trades from all over the world are processed via datacenters in major centers such as Hong Kong, New York and Tokyo, the product may be portable, but the epicenter is not.

London dominates the world’s financial markets economy.

Just one square mile produces 49% of all global interbank FX dealing, and generates 16% of the European Union’s tax receipts whilst its financial district employs just 0.00009% of the entire continent’s workforce.

In the same way that cars have been made all over the world and driven in many continents for a hundred years yet there is really only one Motown, that being Detroit, London not only powers the world’s markets, but its infrastructure is set up specifically for that purpose, plus those at the top really understand every aspect of the operational and technological methodologies that are critical to trade execution on a level that requires all firms in the world to look toward the capital.

Today, Cyprus’ financial markets regulatory authority CySec once again demonstrated good intent, that being an attempt to protect clients and brokerages from exposure to negative balances, however the end result of its ruling is likely to lead to an encouragement of brokers to internalize all order flow.

Of course, there are large brokerages in Cyprus which have strong liquidity partnerships with London’s Tier 1 banks, however out of the 159 retail FX brokerages which are in current operation on the island which itself is a hub for the FX industry, this likely amounts to just a handful, the remainder of which will fall under the MiFID II categorization of ‘systematic internalizers’ when the new pan-European rulings are implemented in full in January 2018.

At a time during which the top level prime of prime brokerages are keen to extend genuine aggregated liquidity to retail FX firms which can in turn confidently process their order flow directly to a live market with correct and accurate pricing, it is odd that CySec would implement a ruling which encourages execution on a b-book basis.

Today’s circular which was issued by CySec states that the negative balance protection referred to in CySec’s publication applies on an account basis and therefore Cyprus Investemnt Firms should take the necessary measures in order to ensure that the maximum loss for the clients on an account basis never exceeds the clients’ available funds in the specific account.

What measures can a small retail FX brokerage take to ensure that the maximum loss never exceeds the clients’ available funds? The answer is quite simple, that being that instead of sending trades to the liquidity partner, they will simply make their own market on an internal dealing desk, thus taking the entire MetaTrader 4 based retail FX industry back 15 years.

Indeed, the interests of CySec are to maintain Cyprus as a hub for the FX industry whilst at the same time ensuring its future development, as it is one of the island’s most prominent business sectors, and unlike other non-bank financial markets regulatory authorities, CySec really only has FX brokerages as its mainstay, whereas the FCA and ASIC for example, have a wide range of traditional financial services companies to regulate outside the electronic trading sector hence are more holistic.

This, however, does not guarantee a sensible approach outside of the major financial centers. Also within the MiFID II-encompassing European Union, Germany’s BaFIN is following a similar path of encouraging the b-book by proxy.

Shortly after the FCA released its plans to make changes to the means by which CFD products are sold, which was perceived by many senior executives to have been the result of lobbying efforts by the vast yet outmoded exchange sector which cannot hold a candle to the advanced nature of Britain’s now extremely well established OTC business, consulting groups were formed by London’s finest and the regulators listened carefully.

No attempt, however, was made by the FCA to encourage internalization of trades via proprietary dealing desks, as London’s powers that be fully understand how execution should take place, as they preside over a city which provides direct market access to the entire world.

Germany’s BaFin followed suit, however rather by the same means that CySec views it.

On the basis of the consultation paper issued in December last year, there are no other requirements from BaFin including no leverage limits, and where retail clients’ risk is limited to their deposits, there is no prohibition on marketing, distribution and sale of CFDs.

This really only leads to one important matter, that being the subject of how to mitigate negative client balances.

In its consultation paper, BaFin states that firms should insure their clients against exposure to negative balances, and therein lies the most peculiar byproduct of the regulator’s intentions.

The only way to avoid negative balances on leveraged retail trading accounts is to run a b-book execution model with an internal price generated by dealing desk market making, and that way if a stop loss is not set, the account can only go as low as zero. This is retrograde and takes the retail industry back to the darker days of ten years ago when many MetaTrader 4 brokers operated fixed spread accounts on a closed system and connectivity to liquidity from the live market was a pipe dream and the preserve of institutional desks only.

Given that absolutely no insurance company in the land will insure a leveraged FX or CFD account against exposure to negative balances, the only way to comply with BaFin’s proposals would be to go away from the now widely accepted agency execution model and back to the old fixed spread market maker model, which nobody, including most brokers, want.

London has become the home of Prime of Prime brokerages which offer their services to retail FX firms, and the entire OTC business has developed into a highly sophisticated emulation of the institutional world, so by taking this step, it would be likely that Germany’s customers would become disadvantaged and rather than acting in their best interest, BaFin would actually be causing them to become exposed to the you-against-me nature of a closed market operated by a broker’s dealing desk.

BaFin has in the past shown its lack of understanding with regard to the electronic trading business. Three years ago, the regulator considered imposing a ‘latency floor’ of a number of milliseconds on ECN platforms in order to avoid perceived advantages of using a faster system. EBS in anticipation considered implementing a self-imposed ‘wait time’ on execution.

In this case, whilst the FCA may well or may well not be acting in the interests of large listed venues or lobbyists, or acting in the wake of firm bankruptcies and client balances that are the wrong way up, it is clear which regulator understands the entire execution model of electronic trading and which do not.

No doubt the myopic regulators in the European Union will consider that these measures were introduced in order to maintain the best interest of the client. Yes, mitigating negative balance exposure is noble, but at the cost of creating a ‘me vs the house’ environment? Definitely not.


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