Margin squeeze by liquidity providers – “Giving in is not an option”

These days, the entire landscape of OTC derivatives trading has changed immeasurably following the Meme stock situation. How do you ensure that your brokerage is able to provide a wide range of instruments and not be curtailed by margin increases by liquidity providers?

It had to happen in the end.

Taboo subjects are only taboo because they are perpetrated by people or organizations that know very well that they are wrong or immoral, yet if they are a mainstay of everyday business, they are often skirted around or ignored so as not to draw attention.

Once again, FX Brokerages are facing the need to review their risk management models, and unfortunately, we may see some more businesses either consolidating or moving away from their core OTC spot FX and CFD model as a result of the crunch that has come about following the Meme stock situation which took place in January.

Many firms, according to one FX industry insider “were offering lucrative profit sharing with no downside, choice spreads and generous credit lines effectively feeding the turmoil”, which has now resulted in some retail CFD and spread betting companies retracting a number of OTC stocks.

Last week, as an example, IG Group withdrew leveraged share bets on hundreds of firms as the London-based company reacts to the day-trading trend gripping financial markets.

At that time, the company stated that it was pulling the leveraged products it had been offering as part of an initiative to allocate its resources after rising market demand following the GameStop saga.

What was particularly interesting is that some of the London-listed shares affected included Saga, Mulberry and Hikma Pharmaceuticals, which perhaps could be regarded as far bigger than the ‘small cap’ stocks the firm said it was moving away from.

Ultimately, this model proved itself to be non-viable within a very short time. Falling for the lure of easy money, industry participants were misled once again. Now, with this year-end fast approaching, retail traders are attempting to make withdrawals for the holidays only to find that many brokers face a difficult situation as their own troubled counterparties haven’t honoured pending liabilities.

There has been substantial discussion among FX industry executives this week regarding the way ahead of that this is paving, and that perhaps one of the reasons for curtailment of certain instruments is that liquidity providers may seek to increase the margin requirement for stocks, meaning that firms would seek to remove the facility to trade these instruments rather than pass on the increased margin requirement to retail traders, or perhaps seek to shift low cap stocks into physical delivery which frees money on balance sheets.

No company has confirmed any such line of thinking thus far, however it was definitely prudent to extend this question to industry executives to see their perspective should a margin increase take place, and whether brokers should internalize the increase or pass it onto their clients, or indeed find a different method of offering market access to stocks.

This morning, Natalia Zakharova, Global Head of Sales at FXOpen, a large retail brokerage with offices in many first tier jurisdictions including Cyprus and the UK, and a global client base, explained her perspective.

“The brokers are put in a difficult position should the liquidity provider increase the margin requirements for stocks,” said Ms Zakharova.

“But giving in is not an option. Brokers might consider passing it on to the clients, however, the clients might refuse to accept it. In my opinion, the best way would be to look for another liquidity provider or swallow the margin requirements themselves. It is not the easiest solution, but is definitely worth it when it comes to new client acquisition” said Ms Zakharova.

Indeed, that is certainly an option for a large, well-capitalized brokerage with very good relationships with its liquidity providers.

This direction is currently in its early stages, and reactive measures are what are being seen thus far, however it most certainly is very true, exactly as Ms Zakharova said, brokers are put in a difficult position should margin requirements for stocks be increased, given that the OTC market has little room for movement as it is so competitive.

Is giving in an option and stopping these products, thus making the retrograde step of offering fewer instruments to traders that continually are looking for more asset classes, or should brokers go for a solution that allows them to access multiple channels of liquidity, therefore in these constantly changing times when traders are very astute and know how this works brokers can constantly
offer direct market access to multi-asset venues and liquidity without blocking clients or being forced to offer a smaller product range?

Given that some clients may refuse to accept these increases, it could perhaps be that the best way would be to look for another liquidity source. It is not the easiest solution but is definitely worth it when it comes to new client acquisition and in this respect a genuine multi-asset platform allows brokers to have multiple sources.

Some degree of opinion within the industry is that most of the brokers were in the same situation and alternative liquidity sources most likely will not help because separate LP will have the same margin requirements, as allocating money to a few different liquidity providers is very costly scenario.

It could perhaps be considered that putting a full multi-asset solution in place would remedy this, however, in North America, where most of the exchange-traded volume takes place, the structure is different and brokers are connected through the clearing houses if they are not a self-clearing broker.

At some scale it becomes a reasonable proposition to become a clearing member at some of the large venues in Chicago, however, it is well worth going into detail with prime brokers that provide execution services for exchange-traded products to gauge the cost and logistical viability of this.

One particular company that is leading the way ahead with the full multi-asset structure at the moment is TraderEvolution Global, whose CEO Roman Nalivayko made his point clear on this matter today.

“One of the core components of our platform is the module responsible for the connectivity to markets. Currently, there are more than 60 ready-to-go integrations available for our clients” said Mr Nalivayko.

“Also, our clients taking advantage of being able to request from us any integration they need. In this way, our clients can solve a few issues, one of them is widening their offering, decreasing dependency on a single counterparty, possibly getting a better offering from an alternative counterparty” he said.

In terms of background, the traders behind the class action which is being prepared against IG Group invested in 12 stocks, one of which was the infamous GameStop, and are accusing the market makers of acquiring short positions, exposing them to huge losses running into the billions of dollars collectively. According to the litigation, 35 firms conspired to prevent retail traders from buying any further stock and forcing them to sell their stocks to artificially suppress stock prices of the stocks. On January 27, 2021, after the close of the stock market and before the open of the market the next day, the brokers and hedge funds in the suit coordinated and planned increased short volumes in anticipation of short calls on the following day.

This should demonstrate the gravity of such a situation for brokers should they take this approach and block traders from accessing their accounts, and subsequently drop several instruments from their product line up.

In my opinion, such flexibility is a must-have option in a constantly changing market.

Some of those at the top are beginning to speak out. Alexander Gerko wrote a piece on LinkedIn recently highlighting the fiasco with Robinhood and making important points that are of wider interest to the electronic trading industry. FinanceFeeds reached out to Mr Gerko for more views on this matter, and we would most certainly appeal to Mr Gerko to send his message to a broader audience.

Mr Gerko founded XTX Markets in 2015, and by 2019, the firm had garnered so much respect within the Tier 1 market-making sector that his company is now ahead of Citigroup in terms of Tier 1 dealing, after 17-year domination by Citigroup.

“Retail flow, in aggregate, in the long run, loses money, not because the retail flow is “misinformed” but because the retail flow is “random” and loses exactly the sum of spread and commissions,” said Mr Gerko.

He continued “Retail flow is useful to the trading process to the extent that fundamental investors are able to interact with this liquidity, at least some of these losses on retail side propagate back into their 401(k)’s.”

“This connection between retail flow and fundamental investors is completely broken in the U.S., as losses of retail are fully offset by gains of wholesale market makers. “PFOF” is horrible because it creates incentives for retail brokers to ensure trading through their platform is as uninformed as possible to maximize how “valuable” flow is to the market makers. There is a reason why Robinhood flow historically attracted the highest PFOF” said Mr Gerko.

And now we see Jannick Malling’s new Public app using 1980s rock star Michael Bolton to lambast PFOF for what it is … or rather what it was, as it is now dead.

He continued “Free trading is a silly gimmick which just turns transparent costs into opaque ones, and incentivizes more noisy trading to the benefit of retail brokers and wholesale market makers. “Gamification” of a valuable function of asset pricing and capital allocation is even more disruptive to true price discovery and capital formation. “Price improvement” vs market that is artificially wide due to badly broken market structure is just disingenuous marketing. The way to get actual price improvement is to put retail flow on the exchange where multiple trading firms and institutional investors and other retail orders would compete for it” said Mr Gerko.

Mr Gerko considers that the potential solutions are indeed to force all retail flow on the exchange, to allow it to interact with other retail and institutional flow, remove the notion of quote protection. It is an extremely ineffective tool to prevent tradethroughs and stifles innovation while promoting market fragmentation, and allow exchanges to charge whatever they want for trading, mostly to move away from nonsensical “cents per share” pricing.

Interestingly, Mr Gerko also advocates the banning of any kind of rebates or PFOF. He stated that force exchanges to compete on innovative market models, not on minuscule price differences. Put pressure on excessive fragmentation of lit liquidity which costs investors billions

He also confers that it would be good practice to redesign minimum price increments, MIFID II style, to allow tick sizes to change as a function of liquidity and price level. Currently, a lot of stocks have either artificially widespread allowing for excess profits to market makers, while other stocks have spreads of hundreds of ticks, completely killing liquidity on top of the book.

One thing is for sure, and that is the need for the electronic brokerage sector to begin to look closely at where and how to diversify its liquidity, especially at a time during which traders on forums can cause the success or demise of a retail firm.

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