STP – “Stop Transferring Profits”
In the ever changing landscape of the over the counter brokerage industry, the need for experienced risk management remains constant.
In the ever changing landscape of the over the counter brokerage industry, the need for experienced risk management remains constant. There are many different techniques on running a book of business and risk management has evolved drastically over the years. This largest impact an experienced risk management team can have for a broker is converting from an agency (STP) model to a hybrid principal model. This can be a drastic shift for a broker, but the impact of increasing revenue by over 70% is definitely worth the transition.
An effective hybrid principal model is not easy to implement. The shift requires an extremely experienced risk management team with shrewd attention to detail. Every broker is different, but the magic number tends to hover around 70% B-book, 20% A book, and 10% C book. This is not a “set and forget” formula since changes in market conditions affect traders differently. Also, client trading behaviors evolve and change over time, requiring a constant evaluation of all books. A principal hybrid set up has to be a fluid model.
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Another critical component to the shift in risk management is technology. Traders should not feel a difference in execution based on their corresponding book. Brokers should have the ability to shift traders amongst different books without server restarts or forcing the traders onto a new symbol set. The model needs to be dynamic and changes need to be made on the fly. It doesn’t matter how good a risk management team is if they are using outdated tools.
Almost all of the large players in the industry run a hybrid model, and it is scalable across any broker of any size. STP brokers don’t always realize what is being left on the table. Sometimes a quick analysis of the customer base can go a long way. No matter the size of the broker, it is a worthwhile exercise to look at client profitability as a ratio to volume. There are resources available to help with this review.
Jeff While I completely accept that if managed properly, running a B Book can be more profitable than running an STP model, can you really avoid the reputational issues associated with this approach even if you offer both A and B models? There are ways to run a B book in a less disingenuous way for your clients, but while brokers make money from client losses how can they ever claim impartiality? At the moment a mixed A and B approach is common as you say, but will this be true in the future as clients become better educated or… Read more »
Great question. I think it is fair to take a step back and look at the fact that this is a zero sum game. A broker may be 100% STP, but those trades have to go somewhere. Customers may get better service if their broker is able to warehouse trades instead of adding another layer 100% of the time. The reputational issues just come down to education. I would love to see brokers actually give customers an understanding of the risk model. There is a misconception that principal brokers operate like a casino. That is not always the case. The… Read more »
Excuse my ignorance, but what is a C-book? I understand A-book trades will be hedged immediately, while B-book trades would be internalized.
At ThinkLiquidity, we classify C book as anything that does not fit what you described for A and B book. Examples would be net/partial/over/reverse hedging.
It all comes down to analyzing the flow. I have never seen a case where 100% B book yields the best results. In many cases, we just ask for a data dump and can provide recommendations. The most common form of C Book is partial hedging. A good example is a very large client with B book characteristics, but P/L swings that are simply too much for a broker to handle. With the right technology, a broker can run a portion of the risk and not give up all of the upside on the account.
– What is wrong with legitimate STP with A-book only?
– Although I do agree from a client perspective that as long as it is STP on the client side, who really cares where the trade goes?
But I guess ripping off clients is too tempting with some B-bookers. What I would like to see in regulations is making the broker show in plain english the order flow of any challanged trades upon request. So a broker cannot just delay orders haphazardly. They must apply the rules to every trader equally.
Michael D: You make a good point about the order flow being available. Even with some supposedly “STP” solutions, the broker is just STPing the flow to another entity who is market making 100% of the flow and so there is little difference from normal market making. Any decent STP broker will be able to provide evidence of the cover trade done with the bank and it should not be the same bank every time if it is a proper STP solution! With multiple bank Liquidity Providers, no one LP knows the overall client position (Skewing prices accordingly) and with… Read more »
In regards to “B bookers being tempted to rip off clients” the same goes for an STP broker. They have the ability to slip beyond the LP fill. At the end of the day, if you are with an honest broker, it shouldn’t matter to to a trader on how they handle the risk. The fact remains that a hybrid model will yield ~70% more revenue for the broker in comparison to an STP model.
Just becuase a solution is more profitable doesnt make it the right one for long term strategic success in capturing and maintaing market share.
Making a few extra tenths of a pip on a trade is not the same as taking 100% of a clients deposit and a client would stop trading pretty quickly if they were frequently slipped.
There are elements of market making that are more favourable to some trading styles, such as instant execution, but these come at a high price and require a huge level of trust for traders.
A broker should always fill clients at the prevailing market rates regardless of STP or hybrid. I am not suggesting brokers run 100% B at all. There needs to be a healthy hybrid model in place. At the end of the day, it is a zero sum game and somebody will always be on the other side of the trade.
Do market makers always fill clients at the market rate? The spreads they offer would normally be wider than the spreads offered to them to cover at. Brokers can cover in a variety of ECN’s and SDPs and all canhave slightly different rates. It is common for a market making or STP broker to mark up the spread instead of charging commission, so Im not sure how you can say that a broker should always fill clients at the prevailing market rate. There is nothing untoward with this practice. In fact many clients prefer the cost of transaction to be… Read more »
When I say prevailing market rates, I mean the marked up rate the broker is showing their clients. Whether the broker is getting rid of the trade or warehousing the trade, the client shouldn’t feel a difference. A trader should care that his funds are safe and he gets fair execution. The broker should care about maximizing revenue in a fair, safe and calculated way. As for the MF Global situation, I would say that is unrelated to STP vs Hybrid and more about misappropriation of client funds coupled with poor oversight.
Most desks have a custom name for C book that typically is a descriptor of the strategy (A50, Net, Reverse). These are all lumped into the C Book category. I am not sure how Leverate defines C book.
I totally agree with you on the execution, but again I just ask whether you can fully trust a market maker when he can benefit from a client losing all their deposit. As for MF global, what happened there is completely related to risk taking. The misappropriation of client assets came about because of bad bets… ie risk taking. The low interest rate environment busted many of the Futures brokers business models, where commissions had been slashed to near zero and brokers earned the bulk of their profits from the difference in interest paid and received on cash deposits. John… Read more »
My opinion: given the utter inability to trade in a profitable manner on the average retail clients part, there is simply no need to play dirty, marketmaker or not. This would just cause reputational damage for no reason. The odd highroller or profitable ones can be hedged in one way or another, the other ones will do all the heavy lifting by themselfs, sooner or later.
Evidence would suggest that brokers play dirty all the time. Mind you, clients do as well, which is another reason to be careful market making. I have heard of banks losing a few million on a gold trade in a few seconds… can small to medium sized brokers really wear this?
Jeff or whomever:
How do brokerages or risk management depts of banks/liquidity providers classify trading strategies? Can you provide some of the major classifications categories?
I was considering asking the experts as a separate question, as it is worth casting some light on.
Banks use two catagories only. Those that make them money and those that lose them money. Surprisingly the tools that banks have to tell whether a clients trades are good or bad are not that sophisticated. The problem is that the banks are often not seeing the opening and closing trade if their price feed is being aggregated. I would therefore say that this is another reason for a consistently profitable trader to trade with a broker that is aggregating banks. Ultimatley if you consistently make money then you are taking money from a market making broker and they wont… Read more »
The most common is A and B book, but beyond that there are unlimited classifications. A good example is classifying traders that have similar strategies and coming up with efficient net levels to hedge. This works really well with groups of clients that consistently fade market movement. It is important to constantly be back testing the efficient levels to hedge as it will change over time, but in many cases, you can step in with a bulk hedge and beat the clients rate by quite a large amount. It honestly comes down to analyzing the book and optimizing strategies from… Read more »
It really depends on the makeup of the feed. I’d be happy to discuss in depth if you ever want to have a chat. my email is jwilkins@thinkliquidity.com