Why Do You Need to Know Who Your Forex Broker’s Broker Is?

The recent Black Swan event of January 15 has forced the trading community to raise more questions, as the unfoldings

swiss-army-knife-296740_640Financial derivatives trading will never be the same after the events of the 15th of January, driven by the impact on the retail and institutional broking space after the SNB triggered a gap in the EUR/CHF market.

The landscape has made an already vulnerable operating environment go further on the edge, with the trading community standing their ground for greater transparency and information about the providers they deal with. The demise of brokers such as Alpari UK and LQD Markets has raised an important question among traders, who is behind your front-end platform providing the liquidity?

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Investigations, post-SNB debacle, show that the most exposed brokerage firms were those that had client positions trading STP with their liquidity provider or sitting with their prime broker/ Prime of Prime. The famous A-book notion, whereby firms claim their agnostic nature to a trader’s trade, actually was the venom in this instance.

Anuj Ojha, a trader from Pune explained to Forex Magnates: “When we would source a new broker our due diligence would finish at the broker’s-end enquiring about their systems, regulations experience etc, however it’s a whole new ball game, my first question now is, who is your PB?”

The Revised Due Diligence of a Forex Broker

The new environment is certainly one where risk and the implications of Black Swan events are to be factored in, for retail and professional traders the uncertainty whether their provider can sustain the damage. However, by thoroughly assessing the ‘ins and outs’ of a broker’s conduct, there could be room for relief.

On the one hand, retail providers who have relationships with banks serving prime brokers, especially the tier-1 providers such as BNP Paribas, Citi, Deutsche Bank, RBS, UBS and JP Morgan, would require the firm to hold a vast amount of capital as collateral. Banks have been weary of the FX industry and if they don’t make enough from fees and commissions then its not an attractive business, as seen by Morgan Stanley’s departure from the sector.

On the next layer are the tier-2 providers; in this instance the bank acts more like a Prime of Prime with lower capital thresholds and aggregates liquidity, again the bank’s rating will speak for itself, however last year the likes of Rabobank and SEB Bank exited the PB space. Therefore, if your forex broker used them then a viable replacement was needed, on this scale only a handful of banks are suitable, primarily, ABN Amro.

Lars Holst, CEO, CFH Clearing
Lars Holst, CEO, CFH Clearing

With the critical change in the Forex Prime Brokerage space post-2008, a new breed of providers came into existence, to fill the needs of retail brokers and small hedge funds that require certain functions of prime brokers, the Prime of Primes (PoP).

This segment has been the main service provider to the vast number of forex and CFD brokers due to the way they have structured the product. In its core sense, the PoPs enable brokers to A-book their trades direct to the PoP who further passes on the trade to the designated LP that provides best execution and best price. When assessing who your broker’s PoP is can be tricky, mainly because apart from FXCM Pro, GAIN GTX, Intl FCStone which are publicly listed firms, a trader will only know as much information as they know about their broker.

Going Technical

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Mitigating risk is the new buzzword, post-15 January, and by having an understanding of exactly how a PB or PoP manges this will aid and assist the trading community when sourcing a broker. The concept of circuit breakers, commonly used in exchanges, where trading is restricted if an instrument moves a certain %, could be a viable mechanism firms have in place internally.

Another function is to assess leverage, although the name of the game is margin trading, if PBs and PoPs offer high leverage then during volatile events both the broker and the PB can come under the radar as their exposure will be significant.

Lars Holst, CEO of CFH Clearing, a technology and risk management provider to brokers and institutional firms, commented about how the PoP provider weathered the storm: “The main reason why we weren’t adversely affected is because we have fully automated systems and market leading risk management solutions – we envisage that our risk management solutions will be particularly in high demand moving forward.”

Capitalisation Is King

Although a number of providers became insolvent as a result of the crisis, most of the industry held on and continues to ‘operate as usual’. Capitalisation and holding adequate capital has supported brokers, and for traders this should be the number one question they ask their providers, how much funds their broker has and similarly, how well is the PoP capitalised.

Andrew Henderson, Director at UK-based broker, One Financial, explained to Forex Magnates in a comment that CFD brokers need to be well-funded and those that suffered were simply not, he said: “It seems most of the companies that faced difficulties held their client funds in segregated accounts, so most clients should get their money back.

Once clients realise that these companies that did go under, or were in trouble, were poorly capitalised compared to the client funds held on accounts, they will recognise that well-funded companies are a safe place to trade and I believe that business will come back to the financially sound brokers.”

Charalambos Psimolophitis, FxPro'sCEO
Charalambos Psimolophitis, FxPro’s CEO

The Future of FX Trading

Understanding risk is crucial for the continued growth of the industry both from a retail traders and a broker’s perspective. Leverage and capitalisation are the two key factors that are on the agenda for regulators as they signified the difference between brokers who are in the money and those that our out.

Nonetheless, the forex derivatives industry continues to grow as more and more participants appreciate the opportunities in the $5 trillion a day traded asset class. The events of 15/1 are definite dilemmas, however with continued volatility across major instruments, particularly in the euro, investors and traders can seize new opportunities.

FxPro’s CEO, Charalambos Psimolophitis, explained: “ Volumes have seen a significant increase in the days after the SNB announcement. Something that we believe will continue in the near future as there is a huge interest from new relationships.”

The importance of a broker checklist with an additional page for prime broker scrutiny will help traders make better, confident and informed decisions when choosing their broker.

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