New regulations are pushing many retail foreign exchange platforms to move away from market making, towards an agency brokerage model, but this may not be good news for clients.

Every seller needs a buyer, and vice versa, and with the phenomenal rise of retail foreign exchange (FX) trading came the increase of online brokers and market makers to deal with demand. At first the model was simple: the large FX banks fed prices to retail aggregators, which added a margin and trading tools. But as the market grew, so did the number of retail FX firms coming to the market with improved technology and algorithms that enabled them to make their own prices.

The agency and market making models used in retail FX trading have continued to exist side by side. The trend seems to be veering towards the less traditional model and towards the high-tech online platforms, where all trades are executed instantaneously with no human intervention.

But some firms straddle both techniques. FXCM (Forex Capital Markets) has built up a considerable franchise using the agency model, where flow is passed seamlessly out to the market, but is launching a dealing desk for smaller accounts. And it seems that for every firm that leaves one model, it is quickly replaced by another.

The principal model

Launched in February this year by the co-creators of Barclays Capital’s BARX, MahiFX is a new online retail FX platform based in New Zealand which operates as a market maker. As opposed to an agency model, where price formation and risk management are outsourced to liquidity providers and the retail aggregator takes a brokerage fee, MahiFX has adopted a principal model.

This challenges the traditional retail FX broker model by providing institutional-level technology and continuous, dealable FX rates to retail customers that wish to trade on a margin/leveraged basis. The firm is headed up by David Cooney, former global co-head of currency options and e-FX trading at Barclays Capital, and Susan Cooney, former head of electronic FX institutional sales in Europe for Barclays Capital. The platform’s sophisticated proprietary software systems have been designed to execute retail customers’ orders with no human intervention and to aggregate and manage the resulting FX risk.

“The term ‘no dealing desk’ describes a brokerage model where trades are passed directly through to the market. So firms that tout no dealing desk are declaring they are pure brokers, taking no risk into their books. Of course they are passing that risk on to people who do, and in the process add a commission or brokerage fee. So it has always seemed to us that the lowest cost model is for the client to have direct access to the market maker,” says Mr Cooney.

He adds that market making means different things in different contexts. Some would say that market making is simply being prepared to take the other side of some trades – to internalise some of the flow. Others say that it is about engineering and constructing rates from the primary pricing environments.

“Market makers provide a continuous market, facilitate price discovery, and allow clients to trade at a time of their choosing. They don’t need to charge commission or brokerage. So all other things being equal they can provide a tighter price to clients by being prepared to take the risk onto their own books. To be comfortable doing that they most likely will want to engineer their own rates. They will also need the ability to manage the resultant risk,” adds Mr Cooney.

New rules in the US

However, just after MahiFX came into the market with the market-maker model, one large retail broker, FxPro, announced a major milestone for its business in July with the move from market making to an agency model on all its platforms, across all jurisdictions. Charalambos Psimolophitis, chief executive of FxPro, says the biggest difference between the two models is that the interests of the broker under the market-making model are less aligned to the interests of the client.

“The market maker can make more money if the market moves against the client – whereas the agency model does away with that conflict of interest. All trades are sent directly to the banks for the best liquidity possible and the agency model broker makes its fees from the mark-up on the spreads it receives from the banks,” says Mr Psimolophitis

According to Kurt vom Scheidt, chief operating officer at Saxo Bank, the new model for retail FX trading started to emerge as a result of the US regulation and the new capital requirements that weeded out a number of participants. The new execution rules governed the way the remaining US brokers behaved, which resulted in a movement towards a ‘no-dealing-desk’ model. In short, the model has grown out of more stringent execution rules rather than client demand.

Price slippage

By contrast, Saxo has retained a market-making model. Mr vom Scheidt believes the primary difference between how a broker with a dealing desk works versus a no-dealing-desk model is best illustrated with what happens with a stop/loss order.

“The way that the vast majority of retail brokers work, and how listed markets work, is that once the stop is triggered, it is filled as a market order, on the next price. This is what happens in an exchange world but it does not really happen in the OTC [over-the-counter] world, where there is a relationship with a single bank that is a liquidity provider, and is taking the other side of the position,” says Mr vom Scheidt.

Although there have been attempts to promote the no-dealing-desk model, it is handicapped by the fact that an investor risks not getting an exact stop/loss order, but instead the next market price. Mr vom Scheidt believes this calls the no-dealing model into question.

“We have not been very vocal to date about this core difference in execution," he says. "Clients recognise it, understand it, and gravitate towards us because of this. We are about to launch an advertising campaign that stresses the benefit of the dealing desk to provide clients with confidence of the stop order getting filled.”

The Saxo Bank dealing desk works to fill client orders at their specified level, and Mr vom Scheidt says statistics show that about 99% of stop orders are filled with no slippage. He classifies this as one of the firm’s major competitive niches.

But Mr Cooney points out that the difference between a stop order and the price delivered is not necessarily due to trading slippage, because a stop order has two components – a trigger and a market order.

“The trigger is the market-going bid at the trader’s stop buy rate. This then triggers a market order to buy at the market offer, which by construction is going to be one spread above the stop rate. The trigger and the ultimate result are actually predicated on the different sides of the spread,” says Mr Cooney.

Boosting liquidity

Saxo Bank offers an aggregated price feed that it derives from the market, in the style of an electronic communication network (ECN). But the prices offered are not agency, they are Saxo Bank’s prices. However, the bank is looking at building an ECN to give clients the choice of an agency model, where execution against an ECN directly to the market is available if preferred.

“While we do not have execution against ECN-style liquidity right now, I would not say that we simply have the old model of just retaining our clients positions and bet against them. This has never been part of what Saxo has done. Our risk management techniques are far more sophisticated than that and while we would be the counterparty to a client’s trades, that is very different from taking every trade and holding it,” says Mr vom Scheidt.

While he acknowledges the industry shift away from the dealing desk model towards an agency model, where trades are passed to an ECN, Mr vom Scheidt believes it is being influenced simply by market conditions rather than customer demand or technological developments.

“These brokers are not offering their clients the option of a dealing desk in any case. They are simply making a business decision based on their risk tolerance and appetite for earnings volatility. The only decision they have to make is whether to STP [straight-through process] to a single bank or an ECN, and ECNs make more sense as they are simply looking for best price, rather than a relationship bank working to fill stop orders,” he says.

But while the retail market is changing, it is not yet maturing. There has been some consolidation among the retail brokers and the lessening risk appetite among smaller brokers is prompting the shift towards the no-dealing-desk and ECN-type model. But the jury is still out on whether the more sophisticated new generation dealing desk model that is emerging alongside it may actually be better suited to what is essentially an OTC market, and will win out in the end.

“The two models already co-exist, and ultimately the customer will vote with his business,” says Mr Cooney.

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