Why does an established liquidity provider need a £40 million loan? Op Ed - FinanceFeeds

Why does an established liquidity provider need a £40 million loan? Op Ed

Andrew Saks

There is a company in London that has been in business for over ten years, markets itself as a MTF, an exchange and a no last look liquidity provider. How can this be, if it operates a retail brokerage and keeps borrowing money? Would your brokerage be comfortable sending client trades to a triumph of marketing over substance?

Back in 2012, the airwaves were full with euphoria across the FX industry as the management team at one particular London-based provider of ‘liquidity’ to retail FX brokers had bound together and raised enough capital to purchase the brand from its originator.

At the time, this particular company stated that its originator, which is actually in the online gaming industry rather than financial services or technology, retained a 33% stake in the company while the management team that had operated it under its gaming industry background became owners of a majority stake. The buyout coincided with a decision by its founder’s management to streamline the group and focus on its core competencies.

Rather unlike almost every bona fide prime of prime brokerage, of which there are only a handful in the world, that company hails from a gambling background rather than a financial markets, institutional trading or banking technology background.

Last week, that particular company made what can best be described as a loud noise about its latest development, that being a £40 million loan from a bank in California which has doubled the company’s credit facility.

An important question that perhaps should be asked when approaching a company that sells trade execution services to retail brokerages should be why a company with a need for this level of debt is purporting to be a prime of prime broker with direct access to live markets.

Extensive research by FinanceFeeds over several years, including meetings with senior executives within some of the world’s largest interbank prime brokerage divisions with which prime of primes would need to have a counterparty credit agreement has deduced that it is absolutely impossible to obtain or maintain a counterparty credit agreement with any major Tier 1 bank for the purposes of trade execution if the prime of prime broker has a balance sheet of less than $50 million.

Losses at banks and an extremely conservative approach to extending any form of counterparty agreement to the OTC derivatives world has meant that for the past 5 years, ever since Citigroup released a report that predicted the potential default ratio of counterparty credit in OTC derivatives firms to be 57%, it has been almost impossible to be in a position to process trades to Tier 1 FX dealers unless debt-free and in massive credit.

A counterparty with a balance sheet of more than $50 million would ordinarily not seek to pay vast sums of interest to banks by taking bank loans, nor would have the requirement to take them. In addition, a vendor selling liquidity in any form to retail brokers that has substantial debt would bring into question the execution model of the firm, and with whom it is trading, if with any counterparty at all.

Bearing this in mind, how can a firm that purports to be an institutional provider of liquidity issue a blustering press release stating that the new borrowing facility will be available for a four-year period, and that the company and the bank have agreed on ‘investment-grade terms’ on the upgraded loan?

What are those ambitions? Marketing perhaps.

In January this year, the London-based company which purports to operate multiple institutional execution venues for electronic foreign exchange trading and has since inception marketed itself as the world’s only multilateral trading facility (MTF) for electronically traded FX, established a b-book retail brokerage, offering 200:1 leverage, in New Zealand from which to directly approach retail clients in mainland China.

Indeed, diversification is vital in this rapidly evolving industry, and in order to offer a range of good quality products to a wider audience than the one that has become completely over-targeted by so many also-rans, however the firm is perceived by many to have begun its business ten years ago as a highly sophisticated provider of Tier 1 liquidity to brokerages and positions itself among prime of prime brokerages, meaning that its target audience is retail brokerages and its product range is marketed as a ‘no last look’ execution based MTF, and an ‘exchange’ from which brokerages can source Tier 1 liquidity.

By operating a retail brokerage with 200:1 leverage and fixed trading terms, the company demonstrates that not only is this a b-book retail brokerage rather than an exchange model that provides directly sourced and aggregated tier 1 liquidity, but it also competes against its own broker clients, especially given that direct retail order flow is a core business activity of the company.

In the past, I have personally confronted companies at trade exhibitions in mainland China that use the words ‘prime’ or ‘exchange’ or even in some cases ‘venue’ in order to align themselves at a level that extends only as far as marketing materials with bona fide prime of primes and non-bank market makers, in some cases I have asked who their prime broker is, to be told Goldman Sachs, Societe Generale, Credit Suisse along with non-bank execution at XTX Markets or Hotspot, all of which has turned out to be far from reality, when actually the ‘prime’ is a MetaTrader 4 white label brokerage executing its trades on its own desk.

Basically, a retail brokerage which operates a b-book, yet is onboarding brokerages rather than retail clients and then b-booking their trades when the broker thinks that its clients are accessing a combination of tier 1 bank liquidity and non-bank ECNs.

Don’t get me wrong, there is absolutely no harm whatsoever in b-book execution if it is correctly marketed as a retail market making service, and there is nothing wrong with conducting risk management according to a price feed by b-booking trades as many top quality retail FX and CFD firms with public listings and 30 years in operation do.

The difference is that, as an example, IG Group is a retail firm, calls itself a retail firm, and openly onboards retail clients without approaching brokerages to attempt to sell them ‘institutional’ liquidity via their own retail b-book and then compete with their own customers.

In January, I contacted the Asia Pacific division of the company which took this recent loan to ask their opinion on this, my question having been received by a senior executive at the firm, who did not reply.

If this is the case, P&L rather than agency execution should be a major question to ask.

The heated debate relating to RTS28 rulings this week, investigated in detail by FinanceFeeds, demonstrates how much of a moot point the method of execution is among prime of prime brokerages today, yet never does a b-book broker which has managed to convince retail firms that it is an MTF become a subject of finger pointing.

How does a firm that sells ‘institutional’ liquidity to brokerages and has the facility to hedge to its New Zealand based b-book operation, comply?

A company which purports to operate multiple institutional execution venues for electronic foreign exchange trading and has since inception marketed itself as the world’s only multilateral trading facility (MTF) for electronically traded FX, has established a b-book retail brokerage, offering 200:1 leverage, in New Zealand from which to directly approach retail clients in mainland China.

Indeed, diversification is vital in this rapidly evolving industry, and in order to offer a range of good quality products to a wider audience than the one that has become completely over-targeted by so many also-rans, however the London-based company began its business as a highly-sophisticated provider of Tier 1 liquidity to brokerages and positions itself among prime of prime brokerages, meaning that its target audience is retail brokerages and its product range is marketed as a ‘no last look’ execution based MTF, and an ‘exchange’ from which brokerages can source Tier 1 liquidity.

Basically, a retail brokerage which operates a b-book, yet is onboarding brokerages rather than retail clients and then b-booking their trades when the broker thinks that its clients are accessing a combination of tier 1 bank liquidity and non-bank ECNs.

Don’t get me wrong, there is absolutely no harm whatsoever in b-book execution if it is correctly marketed as a retail market making service, and there is nothing wrong with conducting risk management according to a price feed by b-booking trades as many top quality retail FX and CFD firms with public listings and 30 years in operation do.

The difference is that, as an example, IG Group is a retail firm, calls itself a retail firm, and openly onboards retail clients without approaching brokerages to attempt to sell them ‘institutional’ liquidity via their own retail b-book and then compete with their own customers.

I contacted the Asia Pacific division of the firm which conducts this activity to ask their opinion on this, my question having been received by a senior executive at the firm, who did not reply.

Companies in the past that have raised loans and operated retail brokerages whilst also selling ‘institutional’ liquidity on a B2B basis include Fortress Prime, AFX Group, and Boston Technologies. All three collapsed, taking client money with them, and had been engaging in profit sharing and b-booking which left brokers which had entrusted them as a ‘prime of prime’ high and dry, unable to return funds to their clients, because these firms had been internalizing trades and living from a profit/loss model.

One such firm faces a lawsuit for alleged $13 million earned as commission as reported by the Daily Telegraph, a matter which the firm in question denies, however its former parent company was very much under the microscope within FX industry circles a few years ago over its $100 million investment, the source of which was not disclosed.

FinanceFeeds at the time researched this in detail and was told that it was in regulatory process, and would eventually materialize on the FCA register because the investment had to be disclosed, however this has never appeared and remains a mystery. The firm’s CEO left the company very soon after this transaction took place and now operates a bank which provides solutions to the electronic trading industry.

The ‘MTF’ for the FX industry has been extremely clever with its positioning and marketing. It is a very highly polished brand, and its image is absolutely remarkable.

Aside from the branding exercises which range from yacht racing to use of technological terminology such as MTF, and no last-look exchange, the company has stood firm in taking the Tier 1 banks to task (quite rightly) for their last look practices.

In 2016, this particular institutional provider which states that its service differs somewhat from the norm as its open order book is driven by streaming non ‘last look’ limit orders supplied by top tier banks and institutional liquidity providers, challenged the accepted and widely practiced execution model that is in use by the vast majority of major banks, particularly the procedure of ‘last look.’

Last Look simply refers to the ability that liquidity providers have to reject an order even when the order matches the liquidity provider quoted price. Essentially, the liquidity provider gets one last chance or look to decide whether it wants to take the other side of an order.

Despite the practice being widely accepted and used by most institutions, the firm in question has been championing the cause, relatively quietly, of operating a no-last look execution model since its establishment at the beginning of this decade, and has explored how to further this in detail.

At the time, it majored on this by including it as part of its anonymous FX market survey which cites the perspectives of the Bank for International Settlements Foreign Exchange Working Group (FXWG) new Global Code of Conduct, which in 2016 was in its first-phase.

The CEO of the firm we refer to considered at the time that the working group’s Fair and Effective Makets Review (FEMR) was full of sound ideas and appropriate sentiments, however he also believed that the code of conduct set out by the FXWG was too narrow in focus and impossible to enforce.

Bearing in mind that 70% of global FX trading is conducted electronically, the CEO said at the time that there was a central importance required in restoring trust in FX and as the adherence mechanism to enforce the code is was due to be completed until 2017’s second phase, his opinion is that the industry could not afford to wait another 12 months for the code to be completed.

Here we are in 2020, and this is a non-issue.

The ‘MTF’ maintained at the time that it would be particularly important that the industry moves to combat market practices that are undermining trust in FX. Foremost among these is the use of ‘last look’, which the company has frequently said the market should abolish.

Controversially, its management team states that it conducted a survey into this and one of the top matters that respondents state should be abolished is the practice of last look execution.

“Depressingly, those who are shaping the code seem to advocate standardisation of this badly broken and opaque market practice” said the CEO 2016.

From an internal perspective within the brokerage, the practice of ‘last look’ is at the heart of fairness and transparency in the FX market. At best, it is an anachronism, designed to protect market makers in a way that today’s technology has now made unnecessary. At worst, the company’s management thinks that it feels to some traders like a market practice that fundamentally and unfairly balances trade execution against them.

Aside from this, its CEO touched on b-book execution, stating that 58% of its survey respondents were not happy to trade with a b-book brokerage, whereas 66% stated that every transaction that takes place via a b-book broker should be disclosed, and 71% concurred that FX trading will eventually move to execution-only venues.

It would be interesting to know how many brokerages are able to ascertain which of the trades they process to the ‘MTF’ are disclosed as internally warehoused, given this perspective four years ago, and the subsequent establishment of retail brokerages by the company that purports to be a prime of prime brokerage.

RTS28 itself is a bureaucratic folly. The regulatory authorities do not understand it properly, and if firms like FXCM in the United States can be banned by the NFA, perhaps the world’s only truly astute FX industry regulator, and its founder who was also banned, remains a wealthy and free man who has returned to the FX industry, and who regularly speaks on panels faced absolutely no consequences for what the NFA alleged was publicly reporting that FXCM’s US division was an agency broker, processing all trades to a live market yet processing a large proportion of its trades to EFFEX Capital and taking kick backs for doing so, then there is not much likelihood of the FCA or ESMA, or any regulators in the APAC region understanding this properly and doing anything about it.

Even if they do, it will be a minor matter. The FCA, for example, would have to have this spelled out to them. I have attempted many times to do so, and execution practice is never understood by the FCA. Perhaps that is why global authorities are planning to scrap ‘best execution’ guidelines after spending a fortune creating them.

It is widely known that if a prime of prime broker in the UK or Europe, and perhaps APAC or Australia kept its client money safe and didn’t go bankrupt, but engaged in profit sharing, b-booking or executing brokers’ trades through its own retail brokerage whilst purporting to be a prime of prime, and then subsequently was reported to the authorities for it, there would be a few officials pretending to understand what had happened, and it would be a case of carry on as usual, chaps.

Given this level of incompetence, it is down to brokers themselves to do their own due diligence.

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