Let’s challenge the FX trading platform status quo: Revolution is easier than evolution – FinanceFeeds research
For what now certainly feels like many years, retail FX brokerages have stuck doggedly to the formula of obtaining a MetaTrader 4 license, then connecting it to an OTC prime brokerage which in some cases is engaged in the business of retail OTC FX itself, and then concentrate their efforts and (often limited) resources toward […]
For what now certainly feels like many years, retail FX brokerages have stuck doggedly to the formula of obtaining a MetaTrader 4 license, then connecting it to an OTC prime brokerage which in some cases is engaged in the business of retail OTC FX itself, and then concentrate their efforts and (often limited) resources toward marketing and onboarding clients.
This model dates back to the middle of the first decade of this Millenium, which, in this fast-paced, technologically advanced business, is a metaphorical lifetime.
The question is, why?
FinanceFeeds conducted research recently, using an equally highly technologically advanced system in order to decipher exactly how many active MetaTrader 4 brokerages are currently in service, the number being approximately 1,231 globally (includes anyone offering MT4), all of which are offering OTC FX, and do not differentiate their services very much from each other.
There are also the major British electronic trading companies, all of which are very highly regarded and long established, and all of which have proprietary platforms in order to accommodate the requirements of Britain’s spread betting and CFD orientated electronic trading landscape.
In some cases, the development costs of such end to end proprietary systems runs into very sizable figures. For example, last month, I met with Grant Foley, CFO of British spread betting giant CMC Markets, and marveled at the company’s next generation proprietary platform, which cost $100 million to develop, and is hosted and supported completely by CMC Markets.
It is absolutely a cutting edge system, and rather like Saxo Bank’s leaning toward FinTech and continual expenditure on platform development, the most recent of which is the firm’s OpenAPI-based device-neutral SaxoTraderGo solution, the emphasis is on maintaining flagship status.
However, the flagship status is very high quality, but does not challenge the status quo, nor does it begin to emulate the completely different systems that are used in the institutional sector, especially in North America where exchange-traded derivatives are the darling of the proprietary trading firms and algorithmic and HFT giants of the Mid West’s fiscal powerhouse – Chicago.
This evening, I will arrive in London, and one of the most poignant questions on my mind will be with regard to why the world’s global financial center still eschews the development of a trading environment which emulates the professional shops of the world’s largest economic superpower.
Retail FX firms with very highly polished reputations (which they have absolutely deservedly earned) have gained prominence in the Far East, which is regarded as the golden egg of the retail FX business, and newer firms which offer MetaTrader 4 are intent on committing marketing resources to venturing into mainland China, however is this really the be all and end all, and is it sustainable?
More thought provoking for many would be to consider whether anyone would go to the vast expense and effort required to enter the very closed Chinese market. Then to onboard retail accounts via IBs that know they are in a position of power and can demand very high remuneration packages.
Follow this up with having to continually ‘do the rounds’ of the IBs and partners in China to ensure that they remain loyal, due to China’s innate service-orientated culture and the value of face to face relationships. Moreover, the difficulties in transferring funds, language barriers, and internet firewall which requires full hosting of servers in mainland China, for something that can be moved to another retail provider overnight.
If retail firms thought that they could attract semi-professional and professional traders in America, Australia or Canada by emulating the model used by proprietary trading shops but adapting it for use at home.
Why are we still doing it this way?
MetaTrader 4 was designed to be the user interface from which retail customers access a completely closed system, which in its early years meant trader vs dealing room in many cases, with no live market connected to the entire system.
Since the adoption of third party technology which has adapted the MetaTrader 4 platform to be able to be connected to aggregated liquidity feeds, many brokers now seek to onboard sophisticated retail traders, with direct market access and very fast execution, however it is still a yardstick short of the institutional model used in both Wall Street and State Street.
Yes, exchange listed derivatives are expensive to clear, because the market maker has to become a clearing member, which usually has two costs – membership fees which are upwards of $500,000 per year, and clearing costs which are several hundred thousands of dollars per month depending on volume.
Quite clearly, lack of demand for the retail sector to emulate the professional and commercial model has not driven the cause for a similar ecosystem with much lower costs to enter the market and place a central order book between liquidity and broker. Imagine if a broker and its prime brokerage were on the same level.
There have been some incidents recently, particularly as a result of the Swiss National Bank’s removal of the 1.20 peg on the EURCHF pair in January 2015 which caused the insolvency of some prime brokerages, notably Boston Prime, which left brokerages unable to pay client withdrawals and soaked up client funds like a dry sponge in an oasis, with very little recourse except for waiting for the insolvency practitioner to set a cents-per-dollar settlement amount.
Yet still this model reigns supreme.
There are very few retail OTC prime brokerage firms that is absolutely not exposed to any risk if every trade is sent directly to market. Even the major banks which handle the vast majority of interbank FX order flow have now moved away from this model altogether – for example, Citigroup, the world’s largest interbank FX dealer, exited the retail sector altogether by offloading CitiFX Pro, its retail prime brokerage division, just 3 months after the SNB event.
Expert view from within London’s highly established institutional sector
Today, I spoke to a senior executive within the non-bank prime brokerage industry in London’s Square Mile who explained “I think it is fairly safe to say that operating a B book might be considered more profitable than running an A book model. However, post SNB there was a real push in the retail FX industry to switch to an A book model, whereby a broker automatically hedges all thier client trades with another counterparty.”
“Generally brokers were hedging trades using a number of Liquidity Providers whoes price feeds they are aggregating in order to obtain the best price. Traditionally this was top tier banks, who are the primary source of liquidity in the FX market” he continued.
“It was generally argued that this STP appraoch was better for clients since the broker was not directly profiting from clients losing money on the trade and so it could be argued that their interests are more aligned with their clients, and in addition by seeking pricing from a number of top providers a broker could argue that they were executing thier clients trades at a fair market price. Therefore, to clarify, they are hedging their clients orders using the best price from a number of liquidity providers.
This is particulary important becuase there is no central exchange that can be used as an independent reference price.”
This particular senior industry expert continued by explaining “”Many retail client latched onto this STP model becuase they bleieved it to be a better and fairer way to trade, and running an A book, STP brokerage also requires less money because firstly many regulators percieve the risk of running the business risk to be lower and require less regulatory capital and secondly becuase you do not need to have a buffer to cover negative B Book PnL when clients make money.”
“As a result we saw an explosion of new 100% STP brokers who took on the well known established names in the industry, who were mostly market makers. These brokers were not only able to offer a more transparent and fairer execution model, they were often able to undercut the traditional brokers on spreads and commissions.”
“The STP model, as it was a much lower margin business, required brokers to focus on high volume whilst trying to keep costs as low as possible, an approach often achieved through automating as much of the onboarding and service as possible. It was not impossible for a STP broker to trades tens of yards a month and only have an employee base in the 10s of people rather than hundreds.
As a result we saw spreads and commissions tumble in the industry and so it wasn’t long before some very big, established names started laying off staff and also switched to the STP model.
“A number of brokers had assumed, incorrectly, that the STP model was risk free that they hadn’t properly accounted for gap risk. All of sudden many retail brokers realized that they were unable to absorb large losses that might be inccurred from such events and so started looking at the B book model again given their perceived more beneficial risk to reward ratio.”
“I also suspect that many brokers also realised they had a lot more power to cancel trades in a B book model if it suited them. This of course might be completely unethical depending on the circumstances. In addition I have been told that many retail clients started demanding negative balance protection, which is only something a market making broker can realistically offer, the end result of all of this is that we have seen a shift away from the 100% STP to Top Tier banks model.
“Many STP brokers have started STPing trades to a B book broker, often in return for a share of the B book profits, or they have started their own B book business. This could be argued is to the detriment of retail clients, but is it?” asked the prime brokerage expert.
In answer, it could be that many B book brokers argue that if fairly and transparently run, a B book broker can actually offer a client better execution experience than an A Book broker. This leads us nicely to your comments regarding exchanges and why they have not really taken off in the retail FXspace, although there is not one centralized exchange for FX, there are many venues on which people can trade.
“I use Integral and Currenex to aggregate pricing from around 12 Top Tier banks plus a few major Non-Bank Liquidity Providers that are effectively hedge funds. We do this becuase by aggregating these LPs we can obtain better spreads, depth of liquidity and execution than by taking liquidity from just one counterparty” explained the executive.
“In addition the LPs we use are able to give us tighter spreads than they would want to offer in another venue becuase the flow we send them on these venues is more retail, thus retail clients generally see better spreads than on the venues the banks themselves use to to hedge, like EBS or Hotspot.”
“Thus, the reason an exchange model hasn’t really taken off is most likely because retail clients can generally get better spreads than on a venue that is shared with venues used by more professional market participants. The issue is more complicated than this, but essentially this is what it boils down to. There is a well know “exchange” that was set up in the UK that struggles to offer competitive spreads for exactly this reason.”
“So coming back to the A versus B book argument, the most important consideration for a retail broker, at least in a well regulated jurisdiction, should be ensuring best execution for their clients, and this is regardless of whether you adopt an A or B book model.”
“If a B book model can deliver better execution than A then I cannot see what is wrong with that, however, there is a big question mark. In the European Union, retail brokers are required to be able to prove best execution, and that can be difficult to do in a 100% B book environment” he concluded.
MiFID looks at execution
Questions and Answers Relating to the provision of CFDs and other speculative products to retail investors under MiFID, including an entire section on hedging models, are available by clicking here.
In summary, this MiFID directive details different execution models, including firms that take the other side of clients trades. The most important aspect of this is at the end, where the European authorities state “Such a conflict of interest in all likelihood cannot be managed and should therefore be avoided, by not adopting such a business model
This ESMA Q&A is a huge wake up call for B book brokers and this article is applicable to OTC FX as well as CFDs. It makes it very difficult for an EU regulated broker to justify best execution if they are 100% B Book.
Thats not to say it is impossible to justify, but it is much more difficult to prove best execution and I think as a result we are already witnessing a shift in how B book retail brokers are managing their execution and this is bound to continue given the approach ESMA appears to be taking in the article that is linked to above.
The software aspect
From a development point of view, technology expert James Glyde, Business Development Manager at Spotware Systems, which makes the cTrader platform explained to me today “The whole purpose of a retail broker is to extend the opportunity of trading financial markets to the common man, their service must fit their clients means therefore cost and minimum requirements must be reduced alongside presenting an inviting opportunity to their clients. Facilitating trading on the exchanges simply does not fit in with that program.”
“There have been a lot of whispers recently about exchanges taking initiatives to become more accessible, but it hasn’t happened yet. Despite platforms like cTrader being more than equipped to facilitate connection to any and as many exchanges as a broker desires for pricing and execution via FIX API, the benefits just don’t fall into place when lined up with FX, Equities and Indices CFDs which can be obtained with far more attractive commercial terms for the broker and this fits nicely with their objective. For this reason, a significant amount of our attention has gone towards creating the number one solution for offering thousands of Equities CFDs” – James Glyde, Spotware Systems
This moves on to the need to expand on the reasons why in London’s institutional heartlands, this is the model of choice.
CFD, or de facto futures contracts?
The continued expansion of CFD trading as a means of brokers offsetting risk and offering a type of OTC futures contract is perplexing, as spreads are very wide and there is no means of clearing CFDs at all, whereas executing FX contracts on exchanges means much lower spreads and ability to see market depth because the brokerage cannot mask any of it, as all clearing members (FCMs in America) can by default see specific data and have access to pre-determined parameters for this.
For example, CME Group’s DataMine provides market depth and displays market data messages required to recreate the order book which are five to ten orders deep in futures markets and three orders deep in options markets.
Globex, which is CME Group’s proprietary electronic trading platform that lists financial derivatives, one of which is FX, displays “Top-of-Book” which contains all top bid, bid size, top ask, ask size, last trade, trade volume, and time-stamp data. This exemplifies the reasons that counterparties and traders which use exchanges are in a different position with regard to information than their OTC peers, and have not only a vast array of information from an impartial entity at their disposal, but also are aligned with their provider completely.
The question is, who will take the first step toward founding a retail FX orientated trading venue? Now THAT would be interesting….
Featured photograph at Google Campus, Tel Aviv. All photography copyright FinanceFeeds