The recent SNB events raised a very troubling and important issue of negative balances. Extreme market volatility and lack of liquidity led the clients of the brokers to lose more than they had in their accounts, which triggered the chain reaction of clients owing money to brokers, brokers owing money to LPs, LPs owing money to banks and subsequent bankruptcies.
And most important, it left the clients reluctant to start or resume trading fearing the possibility of not even losing their deposit, but being left with a debt to the broker.
There have been many opinions on the critical question as to whether a negative balance has to be covered by the broker from legal, financial and ethical perspectives. I will look into this in this article and evaluate the options that the brokers have when facing such a decision.
The three main points to consider are the type of client and the relationship they have with a broker, the business model the brokerage runs, as well as the reason for the negative balance.
1. The standard clause outlining that the client is fully liable for the negative balance incurred and owes it to the broker is a part of any broker’s agreement. Market, execution and software risks are usually clearly described in the contract, which in most cases is applicable to all types of relationships the broker has with its clients.
Now we have to distinguish between the client types and the relationship they have with the broker. This could be:
- Retail individual client
- Legal entity
- White Label relationship
- Liquidity partnership relationship
- Eligible contract participants and clients with professional status
Although they are subject to the same agreement, it is obvious that the same rules cannot be applied to all of them.
While clients who are considered to be eligible contract participants and/or having professional status as well as liquidity partners should be fully liable for the losses incurred on their accounts, it is arguable who should pick up the loss in the case of white label relations.
Despite the fact that all retail clients are fully liable for the losses according to the agreement they have, it is very difficult for the broker to go after negative balances and recover the amounts owed, especially if the client doesn’t have any funds in his/her other trading/omnibus accounts held with the broker. In this case, the firm doesn’t have a choice but to write off the negative balances of retail clients as losses.
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2. Another crucial factor is the business model adopted by the broker.
- A-book model
These brokers route all of their flow to their LPs, acting as an intermediary between the LP and the end user, charging volume commission for their services. In this case, the losses of the clients equal the losses the broker has on his clearing accounts with LPs. Should LPs fail to cover the negative balances of the broker on their side (which is very likely), and should the broker choose to forgive the negative balances of the clients, they will have to cover them from their own funds. This expense might be hard to swallow and it might not be financially feasible if the negative balances greatly exceed the revenue that the broker earned from this client in commissions.
- B-book model
B-book brokers usually internalize all of their flow, thus acting as counterparty for their client trades. Therefore, the losses of the clients represent the profits of the broker. In this case, if the broker opts for covering the losses of its clients, he will do this by partly digging into the profits he has already made. This decision is pretty reasonable and viable from the financial standpoint, as the broker profits remain in green and the negative balances of the clients are covered.
- C-book model
C-book brokers who partially hedge some of the client trades and partially internalize the flow face a difficult decision if they choose to cover all or none of the client negative balances.
3. The reason that led to the negative balance should also be considered. It is most likely to occur in the event of:
- Extreme unexpected market movements: the SNB event on the 15th of January is a great example of this.
- Expected strong market volatility: the market movements triggered by important economic news, e.g. non-farm payrolls.
- Abuse of trading risks: this would be the case of the client neglecting the trading risks and abusing marginal trading without taking into account the repercussions it might lead to (e.g. negative balance). In this case, the client should be fully liable for the loss incurred.
So, from the financial perspective it is very challenging for a full A-book firm to guarantee full negative balance protection as there are no risk management strategies and algorithms sophisticated enough to ensure that a full A-book broker can have a total loss on his accounts with LPs being lower than the total loss of his clients.
Therefore, before entering into a client-broker or broker-liquidity provider relationship, everyone should assess their trading needs in terms of the business model of the broker/LP of their choice. Based on this and the legal status the clients are subject to they are able to estimate the outcome in case their account suffers a negative balance.
The straightforward and honest answer on how the negative balance situation will be handled should be a part of the decision-making process when choosing a broker.
Taking into consideration all of the above, no way should the negative balance controversy be a sticking point for the brokerage business moving forward as long as the market stays transparent, brokers are open about their business models and the awareness and the understanding of the trading risks by the traders continue to grow.