The b-book set to linger on for years to come despite consumer demand for agency model

Despite a widespread shift to the agency model by many FX firms, banks and institutions, the process of internalizing trades or executing via a dealing desk is likely to continue for at least another five years according to many traders.

With regard to the future of the entire FX trading ecosystem, FXWeek reported recently that many senior FX traders consider that the chance of 50% of the FX market moving to agency (a-book) execution within five years is highly unlikely.

Greater understanding of the electronic trading markets as well as expansion of retail FX platforms into direct market access systems has generated a global demand for the ability to execute trades which are directly passed to the liquidity provider either via a liquidity bridge in the case of MetaTrader 4, or an API in the case of some of the more recent entrants into the retail FX trading platform arena such as cTrader and Tradable.

Indeed, the forefather of agency execution in the retail sector was the institutional platform, many of which still internalize a considerable proportion of order flow.

In this respect, the report continued to observe that a number of major banks are considering moving some FX business away from the risk-taking, principal-based method of trading and towards a more brokerage-like agency service, as margins tighten and costs continue to rise. With such tight margins in place, and the new trade reporting regulations which all market participants in the OTC derivatives sector are now subject to in North America, whereby all non-exchange order flow must be processed by central counterparties and trade repositories, and the increasing cost of maintaining the relevent infrastructure, some banks are beginning to charge their peers for processing benchmark orders.

Within Britain’s financial sector, a vast amount of the global order FX flow is accountable to a handful of London-based banks, therefore the onset of the new trade reporting measures which are intended to echo those of the US is likely to generate further cost and lack of opportunity for ensuring that all risk management procedure is conducted in favor of the banks.

Some market participants see the agency desk model potentially growing to 50% of the overall market, but others remain unconvinced. “I could potentially marry Cindy Crawford, but it’s rather unlikely,” a senior e-FX trader in London quipped to FXWeek. “When you hear a figure like 50% being mentioned, it sounds like someone is talking up their own book. Agency desk coverage could probably get to between 10% and 20%, but 50% is incredibly optimistic.”

Whilst somewhat less flippant, the perspective of the head of electronic distribution at a UK bank echoed that of the aforementioned trader, as he stated “Fifty per cent of all flow being agency driven within five years seems a little excessive. A lot depends on what the final version of regulations like the Markets in Financial Instruments Directive looks like. The fine detail of these will have a big impact on the cost of capital and the amount of risk that banks can comfortably warehouse.”

With regard to warehousing, there may be nothing intrinsically wrong with conducting the practice, as long as transparency is maintained and the correct reports are submitted. The case surrounding IBFX in October last year in which the National Futures Association issued a $600,000 penalty to the firm for warehousing certain trades and failing to report them correctly, instead selling that proportion of the order flow off to a smaller brokerage. Subsequent to the National Futures Association having become aware of this and beginning an investigation into IBFX’s execution practices, the firm attempted to withdraw from National Futures Association membership, a request which was not granted.

The opinions of these bank executives echo that of a report by LeapRate in September, which highlighted that the policy within many trading desks and institutional companies with regard to trade internalization remains unchanged from how it was in times before the agency model gained popularity, however two months ago the sentiment within the indutry was that increasing volatility and regulatory attention may result in restructuring of execution policy industry wide.

In the case of IBFX,  the regulator was concerned that IBFX had been 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.

As the retail FX sector, both from a corporate and consumer perspective, has evolved significantly, largely emulating the institutional trading desks, retail FX firms find themselves hampered by the same difficulties in satsifying client requirements as well as remaining profitable.

For retail FX firms, the prime brokerage solution is largely responsible for risk management rather than an internal department. LeapRate today spoke to Paul Orford, Vice President of Business Development at TopFX for his view on this matter. Mr Orford explained “From speaking to many of the traders at some of the large banks, they seem to believe there is a 50% chance of the market going to an exclusively agency execution model within 5 years.”

These smaller institutions by there very nature will have to adopt the new model,as they cannot sustain the same risk appetite as their larger competitors in the industry.”

Mr. Orford continued to explain that “Moreover, a significant proportion of them believe that the agency model is the future of the industry. We could see a significant chunk of overall FX trading flow following this pattern. We are already seeing several of the banks moving their FX business model away from a risk taking, principal based method of trading, to the more risk averse business model.”

“I believe that the more forward thinking institutions will move to the agency model as the industry is evolving to this solution. I can appreciate that there are some who are willing to stay in the old model, but this perhaps could end up having a significant negative effect on their business” concluded Mr. Orford.

Jake Amar, CEO and co-founder of Mercer Capital is a firm advocate of the agency model, believing that in the future, no company will be able to survive in such an increasingly sophisticated market place without adopting an a-book model. He explained to LeapRate “I think the whole means of ensuring that broker partners provide good quality client referrals by giving a good spread and execution, yet still providing good commission comes down to the profitability of the client, his trading experience, and the level of support he receives.”

“Today the broker-partner relationship is changing due to unrealistic commission structures and rates, which are moslty based on a B-book business model within most companies. This makes a real STP broker’s business model more of a long term profit model, versus a short term, quick profit model. Really, though, running a solely A-book brokerage is the only way to sustain a long term business” is Mr. Amar’s view.

He continued to explain that “It’s very unfortunate how things have turned for the retail brokerage business model. I can tell you, for a fact, that anyone offering 0.2 pips on EUR/USD on a constant basis is B-booking their traders.”

“The biggest liquidity providers in the market don’t offer 0.2 for 95% of the brokers they work with, so how can the broker offer a price less then they receive? The only way to bring in and retain clients is by being honest, having good support, giving traders multiple platform options, and most importantly, providing first-rate trade execution. Real traders know right away when they are getting slipped” concluded Mr. Amar.

Whilst the retail FX industry is continually evolving in attempts to emulate the banking sector, it may be that the banks themselves could be forced into a situation whereby they are not able to internalize as many trades as they currently do, largely due to the enormity of the high-profile investigation into FX rate manipulation across six banks and two continents which ended last week with $3.3 billion of administrative fines being issued to said banks.

The new European trade reporting rulings will require a trade repository and central counterparty to be present within the execution cycle, however this does not eliminate the benchmark rate fixing. The only means of doing so is to ensure the use of complex, multi-source liquidity which is not able to be interfered with by traders themselves. The two obstacles in the way of this would really be whether the cost of paying the fines to regulators is less than the earnings gained from rate manipulation bearing in mind that at present no criminal convictions have taken place, and whether the ability to manipulate benchmarks lies in the hands of the traders, thus effectively allowing them to alter a-book order flow, rendering it as invalid as if the bank was b-booking it.

FXCM, whose business is global and encompasses both institutional and retail markets, is quick to realize this, having eradicated all spread markups across the entire product range, instead providing an external commission which is payable by clients for using the platform, and no built in margin for IBs or partners, with the entire model being focused solely on direct market access and raw spread.

Whether this is a sign of the times is yet unknown, however the move toward pure agency model may be slower than had initially been anticipated across many companies.

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