A widespread misconception has taken hold in FX, that retail flow is easy to price or, as it is commonly referred to, “soft”. At a very basic level, the logic behind such an assumption generally runs as follows: retail traders represent uninformed flow and the vast majority of them lose money, therefore it must be easy to price.
The reality is quite different. As highlighted in the November Profit & Loss article on the 2019 BIS report, the flow that comes from the retail space can be fairly sophisticated, with several e-trading sources referring to retail aggregated flow as “sharp” or “institutional” in its nature.
The truth is that it can be pretty easy to accrue profits if you are showing a 0.5 EURUSD spread and capturing either side of the trade by offsetting it with positions in your book. By contrast, if you are expected to show spreads of 0.1 or even choice to end customers, as can be the case in the retail segment, it is a very different and more difficult proposition.
P&L spoke to Jonathan Brewer, managing partner at FCA regulated prime of prime brokerage, IS Prime, part of the ISAM Capital Markets Group, to find out how the firm is able to price this flow so effectively and competitively.
“Retail flow can be very directional and the number of trades that come through simultaneously can be huge,” Brewer explains. “There is also a whole array of trading styles with a significant proportion of volume made up of EAs (expert advisors), copy traders and advanced algorithmic strategies. This means that without the right technology, the right relationships and the right liquidity in place, it can be extremely challenging to handle.
“The Group deploys some very sophisticated tools that make our liquidity management incredibly robust which enables us to be more effective at profiling, and subsequently routing, flow,” he adds. “This has the effect of ensuring that, on balance, we limit damage to our liquidity providers from having significant volumes of what can be very difficult flow to price. Although this sounds simple, the reality is that it is extremely complex, and many firms fail to get it right.”
This is evidenced, Brewer argues, by the fact that many platforms and brokers have tended to solely focus on volumes – sacrificing quality for quantity and failing to understand that the longevity of their businesses is reliant on their relationships with key partners – in particular their LPs. To a degree this mistake is understandable: brokers believe they will make more money if they broker more transactions and their businesses will continue to grow. It therefore theoretically makes sense to be indiscriminate in their drive for volume.
Understanding the Flow Profile
“The fact of the matter is that chasing high volume players without understanding the profile of their flow can, and often does, lead to the onboarding of extremely toxic flow, much of which can come from high frequency trading firms and EAs who would bite your hand off to get access to a pool of retail liquidity,” says Brewer. “While trading with these types of firms may bolster volumes in the short-term, it will also end up hurting the liquidity providers receiving it. The liquidity providers will naturally then try to protect themselves by either widening their spreads, requesting to remove clients from their liquidity stacks or even deciding that they don’t want to provide your prime of prime with liquidity anymore.
“For this reason, IS Prime strongly believes that if you do not very carefully control who you allow to trade on your liquidity then that liquidity may go away,” he continues. “This will then lead to a broker’s core business suffering as its “good” clients are made to trade on less favourable terms and may move elsewhere. Should this happen the balance of soft vs sharp flow will continue to shift in the wrong direction, further exacerbating the issue, meaning an ever-greater percentage of their flow is sharp and further driving away LPs, widening spreads and so on.
“As much as sales teams might wish this not to be the case, the truth is that not all business is good business,” Brewer adds. “Toxic flow, whether from a high frequency trading firm that wants to trade on retail spreads, or a sharp news trading strategy, will always be difficult to handle. Ultimately onboarding this type of flow without the correct technology in place can be extremely damaging to the long-term success of a broker.”
Addressing the Challenge
The challenge lies in identifying which market participants are likely to harm a given liquidity pool. IS Prime’s solution includes utilising its proprietary analytical tools to analyse client flow down to an individual end client tag. This can be segmented by trader, pair, time of day, LP or any number of factors. The firm typically analyses time horizons of around 10 seconds before a trade is placed and 60 to 120 seconds after in order to determine whether this client’s flow would be seen as toxic to liquidity providers.
“To be clear, toxic does not mean ‘profitable,’” states Jonathan Brewer, “A trader would not be defined as toxic because they regularly buy and sell at a profit. Tier 1 market makers are unlikely to see both sides of a trade, so profitable trading on the client side is less of a concern. The concern here is around the profile of the individual entry and exit trades themselves, and ensuring that LPs are not in negative P&L in the first few seconds after trade inception.”
The chart to the right shows the average mid-market theoretical P&L of a trader’s flow from the perspective of the liquidity provider with the X axis showing time and the Y axis showing the LP’s $/m P&L. As we can see, the market is moving against the Liquidity Provider at trade inception (0 seconds) and after 60 seconds they are sitting on a position that is losing around $30/m. Most market makers look to exit risk within a time horizon of between 1-5 minutes, and trading of this profile leaves no opportunity to do so without taking a loss.
This begs the question of what can be done with this flow?
Just because a strategy is toxic it does not mean that it cannot be effectively executed. In order to do this IS Prime has worked extremely closely with liquidity providers to create pools that are designed for varying profiles of trading strategies as well as custom pools for individual clients.
As the saying goes, “one man’s trash is another man’s treasure”, and segmenting flow in this way ensures that IS Prime is protecting its core spreads whilst continuing to offer high quality of execution across the board.
Liquidity Provider Relationships Are Key
IS Prime does not just analyse what its clients are doing as a whole but also drills down into what the individuals at the end tag level users are doing in order to really understand the profile of the flow that’s coming through. This is done to ensure that this flow isn’t going to hurt liquidity providers and this is when the relationships and trust that the group has built with the market comes into play. Providers understand that at times there will be some flow in its liquidity pool that may prove unusually sharp, or there may be a client whose flow is usually benign that sends through an enormous burst of orders which proves challenging to deal with, but they can be confident that such instances are few and far between and that the Group will do everything it can to mitigate that risk.
Brewer concludes, “At the end of the day, brokerages like IS Prime are fundamentally flow businesses, and it is in our interest to maintain an environment in which retail players, broker clients, liquidity providers and, obviously, IS Prime itself are profitable. If this is skewed one way or other for any of the market participants, then things quickly fall over.”
This article is sponsored by IS Prime.