What if you tried to do everything yourself? – Op Ed

We take an analytical look – with facts and figures – as to why so many retail brokerages do not want to go it alone.

Imitation is the greatest form of flattery. Or is it??

Research that FinanceFeeds conducted with regard to opening a client deposit account for FX brokerages demonstrated not only the variation between large, Tier 1 banks and their criteria, but also the commercial attitude toward retail FX brokerages.

NatWest, part of the RBS group, as well as RBS’ corporate division itself, stipulate no minimum deposit and no required minimum daily balance for client money holding accounts, however when I enquired as to whether this service was available for small retail FX brokerages, the answer was a resounding no.

Law firms and insurance agents, yes, but FX companies serving retail clients, no.

Chase Private Client, the client money holding account offered by Chase, will accept certain FX brokerages according to very stringent conditions but expects a $250,000 average ledger balance to be maintained at all times (made up of either cash or qualifying deposits and investments linked with the account – ie collateral) and a minimum daily balance of
$15,000 or more.

Bearing in mind that this is a separate matter from operating capital requirements and operating costs, and a separate matter from regulatory capital requirements, it is clear that banks have a strict risk management profile.

How brokers are looking to mitigate risk, yet offer modern and attractive services Smaller brokerages which transfer their entire order flow to their liquidity providers, and white label partners of retail brokerages should bear in mind that if they are operating a pure A-book (which is very very rare) the chances of being outside these parameters is
high, and therefore at the end of the liquidity chain, the banks will intervene, ultimately limiting the activities of smaller, less capitalized firms.

It is possible for all brokerages to assess this carefully by using online services such as the S&P Global Market Intelligence Platform, which is designed to help firms measure and manage their credit risk exposure by screening benchmark relative financial and credit metrics.

Companies such as Traiana, which is the post-trade clearing, risk management and settlement division of British interdealer brokerage ICAP, provide services including automated post-trade processing for giveups, allocations and clearing of CFDs, which have become very popular since the Swiss National Bank event in January 2015 as a
form of OTC futures contract which many brokerages are viewing as a means of lowering the risk of negative balance exposure which may ensue from high volatility.

Britain’s electronic trading sector has, for many years, been centered on CFD trading and spread betting, necessitating the development and maintenance of proprietary platforms by London’s long-established retail FX giants.

During the last two years, there has been a distinct drive toward taking the CFD product to an international audience, and some very significant mergers and acquisitions have come about as a result, a notable example being the purchase of City Index by GAIN Capital for a sum that was at the time reported to be $118 million in October 2014.

Subsequently, it emerged that the net purchase price was actually $82 million, which included $36 million in cash.

The drive toward adding CFDs to global product ranges was relatively short lived, and has now become a very quiet and somewhat distant dynamic. It may well be that the reason for this is the inability to clear currency-based CFDs, despite certain services being available to clear equity CFDs as per the Traiana Harmony network, and also the very wide spreads which can ensue due to the OTC nature of a futures contract being intrinsically difficult to assess from a buy-side perspective.

Today’s new dynamic is hailing from North America, where the institutional exchange technology providers and exchange-traded futures and equities platform developers are looking closely toward a retail audience, which sets a centralized exchange in position.

It will be interesting to monitor the approach to risk management and how much counterparty credit ratios differ should this be adopted on a widespread basis in the United States. FinanceFeeds has committed considerable resources to working with major exchange providers in Chicago in order to monitor this as it develops, and indeed retail progress has been made

In these days of very low profit margins within retail FX brokerages, countered by demand from traders for extremely fast and priceaccurate execution, attention is being paid to how the execution cycle works at a higher level than any other time since the rise to prominence of retail FX.

Brokers in the retail sector are now able to emulate an institutional trading experience, however there are factors that have arisen at an equally rapid pace as the proliferation of direct market access brokerages, such as the relunctance by Tier 1 bank to extend credit to prime brokerages, which has hampered the ability for brokerages which attract retail clients to access top quality liquidity.

That in itself has led to some of the more astute and avantgarde brokerage technology providers to generate innovative solutions to foster better prime of prime relationships and continue to provide best market liquidity to a retail audience despite Citigroup’s research in 2016 having indicated that extending credit to OTC derivatives firms has a potential 56% default rate.

It is remarkable that the major hosting and integration companies in this industry have come up with solutions that provide comprehensive connectivity in what has become an expensive and rarified business.

In order to demonstrate this, it is important to consider what would occur if a small to medium sized retail brokerage attempted to establish connectivity on an individual basis.

Indeed, back in 1991 the connectivity that was provided for the interbank sector, serving Tier 1 banks – the highest level of the liquidity hierarchy, all of which was connected by 10-bit 2 bayonet connectors and had software which killed errant packets that served to block the transfer of data that, even unhindered, is very slow.

It was expensive, too. Consultancy rates for outsourced professional services providers in Britain back in 1991 (such as British Telecom or MITEL – back then it was the telecoms providers that dominated rather than the big four professional services firms that have now extended their services to technology) were approximately £1600 per day, which, accounting for appreciation and inflation, is akin to £4,000 per day today.

Shortly after that period, retail FX trading began to emerge, Matchbook FX being one of the pioneers.

By the late 1990s, EBS [now the electronic brokerage division of British interdealer brokerage ICAP] was just beginning to emerge as the mainstay of liquidity but only for certain pairs. The Reuters Dealing system had a dominion over certain other pairs, and certain voice brokers controlled others.

The sea-change transition from voice to electronic systems accelerated with the late 1990s / early 2000’s internet and e-commerce explosion.

In the late 1990’s the Asian currencies melted down – specifically the Thai Baht, Malaysian Ringett and Indonesian Rupiah, which helped propel USDJPY from the mid 80’s up to the mid 140s and then back down again amidst volatility that the FX markets have not seen since. Shortly thereafter, the Nasdaq and related equity markets exploded reaching their infamous apex in the spring of 2000.

“The whole game changed” said Mr. Levy. And amidst it all, firms such as Matchbook FX, as well as a few other pioneers such as CMC, GFT, Money-Garden (also known as MG Forex) Shalish Capital (now known as FXCM) and Midas (now known as Saxo Bank) where there at the very beginning.

Technology has evolved in leaps and bounds – however let’s remember those who were there from the beginning.

It is very likely that at least half of those are white label license holders, which had paid $5,000 to MetaQuotes for the license and then a monthly volume-based fee to capitalize the platform and its hosting.

If this was bypassed, and a brokerage approached Equinix for a colocation service on an individual basis, this would cost around 20 times more. Similarly, once having established a colocation provider, a separate relationship with a bank would be required, and the Tier 1 banks will either will no longer extend credit, or they will request much bigger balance sheets. $250,000 would easily get a Prime 5 years ago, we are now talking about minimum amounts in the $15 million if not between $25 million or $100 million within some of the main prime brokerages.

The end cost of all of this would be quite prohibitive and that is without considering licensing, regulatory capital adequacy requirements, office rental and salaries for staff.

Essentially, the efficiency of the pricing of connectivity to live markets and the continual innovation with regard to how to package liquidity and distribute it is down to three companies, those being PrimeXM, oneZero and Gold-i, all of which serve the majority of direct market access brokerages in today’s industry and have a solution which ensures cost-effective operation.

Much attention is focused on bridge provision, and how the MetaTrader 4 platform was adapted to be able to operate with real market liquidity, following its original design in which it was intended to operate via an internal dealing desk with fixed spreads.

There is far more to the provision offered by these companies, however, because the method by which liquidity is distributed, by which hosting is covered, colocation and data center presence becomes not the concern of brokerages, and the end cost a fraction of what it would be if a broker attempted to establish connectivity relationships with data center
providers directly for processing retail order flow.

In figurative terms, it is worth considering what the monthly cost would be if attempting to take on board the individual cost of colocation.

Research by FinanceFeeds has concluded that the cost of hosting at any of the major Equinix sites would average approximately $1700 per month for 20A or $2,200 per month with 40A, before bandwidth costs, if using a colocation expert such as Atlantic Metro or Radianz.

$1200 per month for a rack and $400 per month for 20A/120V is about right for Equinix NY4. It is worth remembering to include setup fees. Also, firms will need to consider the monthly recurring for the cross connects as well.

A senior executive within one particular firm in North America that I spoke to recently explained “We have a rack in NY4 and pay $1500/mo for a cabinet, $325 for fiber cross connect (each), $225 for copper (each), $450 for 20A 120v primary, $225 for 20A 120v secondary, + bandwidth which I might add I’ve found some places will charge you more per mbps in NY4 than they will NY2.”

It would require significant trading volume to make this viable, and even then, a dedicated team of technical support engineers to be able to liaise with the provider.

Speaking in June this year to Grant Foley, CFO of CMC Markets in London, FinanceFeeds was informed that the cost of the development of the company’s proprietary platform was over $100 million, and the operating costs per month are around $150,000. This includes the relationship that the company has with its hosting center, as the firm has in-house servers that need top quality connection to the live market.

Very few brokerages in the retail market can conceive such a cost. On this basis, the new ecosystem model that is being looked at by integration companies, with Andrew Ralich, CEO of oneZero having explained how $1 per million is achievable, dedicated to the retail sector is a welcome solution to access to prime of prime liquidity and fostering deeper relationships, as well as keeping the hosting costs down significantly.

The industry is quite clearly are on the road to a very interesting connectivity direction in the coming months which will improve the trading experience despite the reluctance of Tier 1 banks to extend credit, whilst at the same time ensuring low costs to small to medium sized brokers.

This is a very brief synpopsis of the original and very initial stage of planning a completely in-house brokerage – however it provides a clear insight as to why so many do not go the hard yards and think individually, and why now the pre-packaged easy path has created such a value proposition issue in which almost 1000 brokerages are almost identical right the way up from their trading platform to their uniform execution channels.

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