Speaking at the iFX Expo in Cyprus last week, James O’Neill – a director at ASIC-regulated liquidity provider FairMarkets – discussed the pricing errors that many brokers make when trading against their clients.
To a room full of the leading executives in the retail brokerage space, O’Neill noted that most companies expect to make money from their customers through a spread, by trading against them or via a mixture of the two. Using empirical data, O’Neill showed that a broker’s revenue is, in the long run, the spread which it charges – not client losses.
Using FairMarkets’ own experience operating as a liquidity provider, O’Neill examined the market making industry and showed the errors which firms often make. More specifically, the liquidity provider executive highlighted the problems brokers are likely to face if they use a pricing aggregator.
“We started out using a pricing aggregator,” said O’Neill. “And we suffered significantly from it. We used a trader’s tool as our pricing tool and were regularly hit off market. Whether it be Million Dollar Pips or any other ‘expert advisor’ tool, we were getting [arbitraged].”
Building an engine
To prevent traders from making money off of a broker via arbitrage, FairMarkets, which is also the liquidity provider to trading platform BrokerMate, created its own pricing engine.
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“A broker without a pricing engine cannot forecast revenue,” said O’Neill. “And without a revenue forecast the broker cannot budget.”
Despite its central importance to brokers’ operations, pricing may be the most misunderstood – and hence underestimated – component of market making.
Without the banks’ pricing technology to lean on, a market maker must have in-depth knowledge about the methodologies and technology required to create a derivative price on every financial product in a market that can change in microseconds.
In order to ensure that its pricing engine works properly, FairMarkets forged connections with 18 tier-1 liquidity providers. The prices those firms quote are then fed into FairMarkets’ pricing engine and, using proprietary algorithms, churned into meaningful prices for the liquidity provider’s clients.
“A pricing engine provides brokers with the ability to act as a market maker without the risk of being harmed by off market pricing,” said O’Neill. “The opposite is true of aggregators. These are designed to enable traders to beat the spread and, even with an a-book / b-book model, means that your business is not sustainable in the long run.”