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Is waiting for a ‘client drop’ really the best way to manage P&L and risk? Jeff Wilkins speaks



LeapRate interview… Retail brokers generally state that around 75% of retail investors lose money – the majority of these losses are in the spread value of their trades (because they are trading on wide spreads) rather than because they call the market wrong.  However, studies have shown that over the long-term (if you take out transaction costs and spreads), clients’ trading P&L is generally no better or worse than that of their brokers. LeapRate spoke to Jeff Wilkins, Managing Director of IS Risk Analytics (ISRA), to explore this topic further.

Jeff Wilkins
Jeff Wilkins

LR: What is your view on a B-book risk management strategies which focus on profiting from client losses?

Jeff: We see many B-book brokers whose goal is to capture 100% of ‘client drop’ when it occurs.

Sometimes this approach can work. The market volatility during March and early April this year – the highest we’ve seen since 2008 – was generally good news for such brokers, who were no doubt congratulating themselves on being able to profit from their clients’ losses.

But waiting every 12 years or so to make a killing from unprecedented market events is not the optimum way to run a business, particularly when it comes to managing P&L and risk.

Rather than just hoping for the best and getting lucky from time to time, brokers need to take a more systematic and calculated approach to risk, putting themselves in a much stronger position.

LR: What does this systematic approach to risk consist of?

Jeff: Brokers need to break down and accurately measure all revenue components, rather than viewing it as a sort of ‘P&L soup’. By analysing what constitutes risk revenue (from B-booking their clients’ trades), versus risk-free revenue components (from things like spreads, swap mark-ups and commissions), brokers can better predict what their month-on-month revenues are likely to be, gain a better understanding of how to set up a cost basis against that, lock in consistent revenue streams over time and budget for the future.

At ISRA, we’ve been helping our clients in the retail broking community do exactly that. And what we’ve been able to show them has been quite enlightening.

Is waiting for a ‘client drop’ really the best way to manage P&L and risk?

LR: What are the biggest trends you have been seeing?

Jeff: First of all, it’s clear that in many cases, the money that brokers make from their B-book is actually just a small proportion of their overall revenue but it comes with a very high proportion of risk, which means that their P&L is extremely volatile. Brokers often don’t realise how small the risk revenue component causing the massive variability in their monthly P&L is at any given time.

Their risk-free revenues on the other hand are much more linear with their clients’ trading volumes. And by deconstructing each transaction, we are able to show brokers how much revenue they could be locking in risk-free.

LR: Are you suggesting that a B-book model shouldn’t be used by FX brokers?

Jeff: With the B-book model, in any typical year in there is likely to be six fairly average months, three very poor months and three very good months. So is it worth the stress, the aggravation and most of all the risk that these high-percentage swings in revenue cause? Is it worth sacrificing the ability to grow a consistent, sustainable business for the hope that clients have a “large drop”?

Only the brokers themselves can answer those questions. But a brokerage is a business. And any investor looking to inject money into that business will want to see consistent revenue streams rather than highly variable month-on-month P&L that devalues the business.

LR: How can ISRA help?

Jeff: We can help by providing and implementing models that give brokers full visibility into their revenue, P&L and risk on a transactional, day-to-day, week-to-week and month-to-month basis. The net result is that they can take a more informed approach to risk, adapt their business models accordingly and monetise their flow on a more consistent basis.

There are clearly identifiable revenue components and ISRA can help brokers recognise them, to help facilitate more sustainable business models.

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Is waiting for a ‘client drop’ really the best way to manage P&L and risk? Jeff Wilkins speaks

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