MiFID II and the demise of the IB

Meir Velenski CEO of Velenski Financial Group is a market expert on FX and CFD trading and a consultant to firms in this market.

Markets in Financial instruments Directive (MiFiD) is probably the most draconian financial legislation to date that has hit the financial markets sector, yet probably one of the most ambiguous.

The implementation of the directive has passed, yet so many comapanies under its jurisdiction are struggling to apply it.

MiFID II requires that all firms have in depth programs for more detailed record keeping and for longer periods of time. There are reasons for this and rational behind it.

Let’s have a look.

What is the actual rationale?

The B Book problem

It all starts with the B book. The famous B Book is the way that some retail trading firms work with their customers which are largely private investors and traders.

In this model, brokerages take in the trade, take the risk and then there is a 95% certainty that the private investor or trader, mainly due to high leverage and poor experience will have all his money wiped out, resulting in 100% profit for the host firm.

B book companies that follow a particular price feed and choose to internalize their orders in a procedure to mitigate exposure to negative balances or losses, yet execute trades as per an aggregated price feed is one aspect, but sharing profit and loss between broker and client is not, and such brokerages range from small offshore ones to large companies like Plus 500, who have simply targeted every global corner digitally and got the man in the street to “bet” on the market, often losing all his initial deposit, and due to these deposits being from clients investing smaller amounts of money, there a likelihood that most will lose, hence no withdrawal will take place and thus it is banked by the brokerage. Eventually, the regulators got wind of this and began to make ‘best execution’ rulings, and to call it a day.

Why would a firm not like this model? It will drive the firm to attract more clients to try their luck and increase huge profits like as per the exxample above, with no client call centre or anyone to speak to. Other firms at least have a service desk.

The main driver behind the European directive is simple, that being consumer investor protection. If we are to look at the main background to this directive, it is clear on what the regulators want to achieve, that being to stop retail electronic trading firms exploiting the man in the street.

Too often, the investor, trader and consumer has had very little recourse with the might and power of the financial instructions. Too many times has the trader or investor turned to providers and financial houses to complain about being mishandled or trades being wrongly booked, or positions being erroneously closed to name but a few and nothing happens.

The investor simply does not know even what to ask and is fobbed off by a desk salesperson or the complaint / Enquiry is oases from Pillar to post with no case ownership. In all too many cases no records are kept or monitored by anyone.

Compensation (to give the client a placebo) often is “ free trade no spread “ wow that’s a major offer of compensation to a complaint!

The investor in the eyes of the regulator has been so badly done to over the years that they have take draconian action to right this wrong hence MiFiD II has now put the onus and responsibility on all providers for intense record keeping to correct something that really should have been dealt with by the firm.

Once financial firms demonstrate that their attitude to investors is simply to exploit and look to wipe out their account, as some of them have done, then the regulators, as late as they are, begin to take action.

The regulator now requires that retail clients are classified as either experienced, professional or new. This limits the firms to freely work as they have done so far.

What about IBs ( Introducing Broker) and MiFiD

The existing, soon to be previous model, has been such that, the introducing broker (IB) brings a client to the retail electronic trading firm and that client is then tagged under the IB relationship .

On going trades generate commissions, which are split with the IB for the life of the client.

The IB could be someone very active within the dealings of the client, he could even be trading for the client (which maybe constitutes a conflict of interest) or he could just be a simple IB that brings a client and has no further dealing or interaction.

This is all changing now. The rules and the interpretation of the rules will cause a fall out from the number of IBs in the market – why ?

The IB, revenue and The Chinese model

Until 2017, the IB as mentioned above can make significant lifetime revenues from an active client. In China some IBs are bigger then the host firms. The Chinese have refined this model to perfection .

Host firms, in Europe which now find themselves under the MiFID II rulings have scrambled in desperation for market share, some of which are MetaTrader 4-based firms which struggle to differentiate themselves on home market territory and some are sophisticated companies with their own proprietary platforms and a very good quality reputation, and have bent over backwards to sign up IBs in China.

Many of these firms, some of the most notable being FXCM, FXDD, GKFX and Saxo Bank have have spent millions on marketing in China and getting these large IB firms to sign up. The Chinese model differs slightly with other models in that the UK and global firms have offered exclusive terms to the Chinese poured millions into them to get their business.

MiFiD II will change all of this and could cause the Chinese IB firms to relook at their model. Take a typical UK firm that has spent time and money developing the large IB network and now needs to declare everything to the clients.

Mark up revenue

One of the styles of revenue is a mark up on the client account. This means that the IB agrees with CFD/FX firm to mark to the client account by a agreed amount say 1 or 2 full pips.

So if the market on the Dow is 25520-25521 the the mark up will show 25520-25523 ( 2 pip mark up ).

Example client opens $10 per point on the Dow. Normal spread paid = 25520-25521= $10 per point so $10 paid in spread

Mark up: 25520-25523 = 3 pip spread, and the client pays $10 per point pays $30 spread

Of the above $20 goes to the IB and $10 to the retail FX firm, hence my stipulation that those extra pips go to the IB.

Will the clients entertain that their accounts are marked up in order to pay the mark up to the IB. Not on MiFiD. This will cause a significant drop in revenue for the IB.

Spreads tight as they are will become tighter. In the real world it’s the false spread on the B- Book operators actually causes the client to lose. If the client is marked up the the chance of the Client losing is even greater.

All change

There will be no more trail commissions for IBs on any Client unless the IB can demonstrate interaction and active client management to the CFD/ Spread betting or FX firm. What the IB will get is an introducer commission of a one off or maybe 3 month payment.

This means that the IB revenue model in 2018 post MiFiD is over. The revenue will fall for the IB and will cause an exit for the CFD firms if IBs as the payments will not justify the effort or motivate the IBs.

What can the retail FX firms do?

There is no way that the large companies which form the mainstay of this industry and have striven to develop a vast and loyal network of large scale IBs in China will allow this to happen, as it is too big a revenue driver.

One of the things that could be done is to simply put all IBs into a salary, bonus package that make them all employees or sub-contractors, as was the case in the IT world in the 1990s.

The other option is to devise a compliant action plan, that demonstrates the IB has had active input with the said client.

China is a major market for all firms and MiFiD will not deter or dampen their enthusiasm to retain and grow this market. One way or another the firms will find a way around the rules until the chicken and egg situation arises again.

Let’s wait and see