Cannibalization of Profit Margins

A broker has to contribute millions in capital, take all of the regulatory risk and advertise in order to obtain

As I write this, I am staring at one of our clients aggregated feeds and am seeing 0.3 wide for EUR/USD. Behind that feed is $22 million in collateral sitting at one of the largest prime brokerages in the world. The components of that feed are a ladder of over a dozen investment banks as well as some very sharp non-banks. This pool of liquidity took 8 months to develop and will always be an ongoing project. On one of my other monitors, I have a demo account up for an FX brokerage that will apparently give me a feed of 0.4 even if I deposit $100 into an account. There is something clearly wrong with this picture and it is an epidemic that is sweeping through the industry.

A broker has to contribute millions in capital, take all of the regulatory risk and advertise in order to obtain a client base, yet every day I am seeing brokers “buying flow” with these razor tight spreads. Ignore A book and B book considerations for a moment and think about the economics of the situation. In order to secure a prime line there is a net capital requirement of at least $5 million, yet I can deposit $100 into an account and be up and trading on a similar spread in a few hours.

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Now look at what has happened in the Futures industry over the years. Everything is on exchange so the only revenue stems from commissions, which are now a micro fraction of what they once were 15 years ago. Regulatory requirements are stricter than ever, leverage has changed and profit margins are as low as they have ever been. Sound familiar?

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The industry we all know and love is under attack by price wars and it doesn’t help anyone in the long run. I’m sure everybody reading this wakes up, checks the markets, checks their emails, deals with flow or customers and doesn’t stop until they go to sleep. There is no other industry where people are more passionate about their jobs than the FX industry. That is a fact. We need to preserve the balance between brokers and retail clients.

Let’s look at one more example of an IB that approaches that 0.4 broker and works out an agreement of a 1.4 markup. They are now out there selling a 1.8 spread and keeping 1.4. Yes, IB’s are almost always more nimble and have a grass roots local selling strategy, but how are they selling at 1.8 and the brokers are offering 0.4 directly. The fact is customers are not as price sensitive as we think. They want security of funds, great service and a fair trading environment.

So what does this all mean? At the end of the day, everyone is fighting tooth and nail to get as much volume on boarded as possible. Many times, this is being done at the expense of profit margins for the industry as a whole. As pricing wars continue and spreads for retail clients are tightening at a seemingly exponential rate, every broker is losing.

It is not because clients are unwilling to trade on higher spreads, as is evident by some of the IB offerings prevalent in the industry, rather an imbalance in the relationship between brokers and retail clients. Know your place in the food chain; be honest about who you are and what you can afford to offer clients. Structure deals that are mutually beneficial to you and you client base. Stop the paradigm of brokers fighting with each other over spread, and differentiate in ways that allow clients to feel confident about your trading environment. Volume does not equal revenue. Structure deals right and manage your risk.

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