The b-book is alive and well, even as volatility increases

Opinions across the industry vary on the practice of internalizing trades, a practice in which dealers execute trades in-house without passing them to the liquidity provider. This practice, known as operating a b-book, has, in the retail FX sector, morphed from a method associated with unregulated firms which rely on their clients’ losses for commercial success to a more sensible and measured means of stabilizing risk to client and company, at times when large changes in volatility occur.

Many traders have focused so much on keeping spread down to a very low level, especially those using automated execution devices such as expert advisers and algorithmic solutions which rely on executing trades without vast differences in spread which could cause the system not to work in the interest of its user, that firms are b-booking trades at times such as the hours surrounding the London or New York market opening each day.

Whilst this method is relatively common, it is becoming increasingly apparent that significant changes in price may require some dealers to rethink their internalization ratios.

Within the interbank sector, matters remain unchanged in terms of the number of trades which are warehoused, despite a change in volatility in the upward direction. According to a report by FXWeek, electronic risk management systems can still handle the level of price movements currently seen in markets, but extreme price swings could force some dealers to cut back on matching flows internally.

Dealers within many sectors of the FX industry have been increasing their internalization ratios, some of whom have experienced regulatory reprimands with regard to the means of carrying this out, as experienced by IBFX in North America in October last year, when the National Futures Association issued the firm with a $600,000 penalty for reporting inadequacies in the circumstances in which trade warehousing occured with IBFX acting as the counterparty for trades whose value was less than the notional volume threshold level lnterbank had established for STP trades. Interbank would aggregate the “warehoused” trades for risk management purposes and earn revenue from the bid/ask spread and from beneficial market moves that the aggregated “warehoused” trades experienced.

It has become such a prevalent practice that in recent times up to 90% of trades are being internalized among the most liquid currencies as firms consider the cost of execution, risk management issues and managing the protracted period of low trading revenues from FX business.

While a low volatility environment enables banks to match orders without sending them to open-market platforms such as EBS and Thomson Reuters, times of extreme price swings could offer better trading opportunities for dealers and lessen the risk of costly glitches with electronic risk management systems.

“One reason you would internalise less and execute on external platforms more is if the trades become harder to handle; if the markets move to such an extent that the spread you were paid for a trade is cancelled out within a short space of time,” Chris Purves, global head of FX, rates and credit electronic trading at UBS in London explained to FXWeek.

Whilst b-book business is still prevalent, this potential industry-wide rethink may become advantageous all round, as automated trading systems would require re-engineering to take into account widening spreads across the live market at certain times, whereas brokers would be free from the fear of losing clients should spread increase, as traders would become more satisfied that this is the behavior of a live market, and not the brokerage or bank accelerating spread at important market times.

This, in turn, could serve to provide better stability for traders, more revenue for FX firms and bank trading desks as well as contributing toward meeting the requirements of regulators in a much simpler fashion, as best execution practices are certainly on the agenda for many authorities.

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