The dynamic development of the global economy and the subsequent civilization progress are periodically interrupted by crises that lead to a significant slowdown in economic growth. Regardless of whether the crisis is caused by financial institutions (Subprime mortgage crisis), epidemics (Coronavirus) or new war threat (Iran and US tensions) – it causes an immediate reaction in global financial markets. And how such market uncertainty affects the forex industry? Should Forex Brokers fear financial crisis? How can they take advantage of increased volatility and protect their brokerage business against the risk it brings?
The opportunities for Forex Brokers
By definition, the retail Forex industry is based mostly on highly leveraged instruments. In case a broker offers his clients high leverage accounts, volatility plays a major role in affecting both broker’s and traders’ profits. Most traders believe high volatility is an ideal occasion to become very rich in a short time. That’s why brokers usually note an increased number of traders on their platforms in “uncertain times”. Regardless of the forex business model adopted by the broker, whether it be an A-Book or B-Book, increased activity of investors generates enormous turnovers for forex brokers, which is reflected in profits generated by paid spreads, commissions and swaps.
Additionally, market makers would take advantage of a higher than the usual number of “stop-outs” on trading accounts as markets like to swing up and down before going in one direction. Every time higher volatility appears on the market, brokers like XM, Plus500, Exness or IG report records both profits and turnovers. It is very common for forex brokerage businesses to reach profits’ yearly targets in just 2 months of increased volatility.
The risks of brokerage business
On the other hand, brokers need to remember the risks that can be brought by unexpected events called “Black Swans”. Every broker remembers “Black Thursday” caused by SNB intervention, which caused many brokers to fail, including FXCM – one the biggest brokers in the world. “Black Swans” can be very dangerous for both market makers and STP/ECN.
Also, B-Book brokers must remember that monitoring the distribution of exposures is crucial to the profitability of their business. That is why most of them try to avoid the so-called “Longtails”, which means a situation where one or two traders generate significant exposure. To be more precise, if an investor was right bo open a huge position in a good direction, we would have experienced an enormous market open gap, and many small and mid-size B-Book brokers would probably go bankrupt.
In this situation, also A-Book brokers are not secure. There are many examples in the forex industry of STP brokers’ failures. Counterparty risk associated with liquidity provider can be crucial if we mitigate their significant and concentrated exposures. In case chosen liquidity provider is not able to cover profits generated on the hedge accounts, our business model will collapse like a house of cards.
Even if you decide to minimize the counterparty risk by connecting to the biggest liquidity providers or even prime of prime, in most cases such LPs are not flexible enough and cannot offer you negative balance protection. This can lead to a situation where your clients would generate huge negative balances on their accounts. A liquidity provider would ask to cover the negative balance on a hedge account, but the broker wouldn’t be able to reclaim money from traders. Such loss can be disastrous for your brokerage, especially as STP is a commission-based model.
Operational risk is the last type of risk associated with higher volatility. During highly increased interest in trading, the broker’s IT infrastructure needs to be able to handle thousands of users and trades coming in online. We’ve observed in the last two weeks two examples of Robinhood servers outage during high volatility, which caused a lot of frustration among traders. Many investors would probably blame Robinhood for the loss they made during the market price down, so the number of officials complaining, as well as the risk of a bad reputation, can be very problematic for the future of every brokerage business.
How to prepare your business?
There are certain solutions to deal with the high market volatility periods. For forex brokers, it is extremely important to have trusted partners who can help them limit the risk of their client market exposure. The nature of every market turmoil is that it happens suddenly, so the broker should be prepared to react quickly and effectively. Even if it runs a pure B-Book model, having an active and ready-to-use liquidity connection can be very valuable in such situations. Most of the liquidity providers charge high monthly fees even for unused connections, so it is important to find a partner, who provides this option at a reasonable price.
Liquidity partner should also have easy and quick deposit options. In case of a crisis, there is no time to send wire transfers which can take from 3 to 5 days to be delivered. Therefore LPs who can collect deposits in Bitcoins or via various online payment gateways should be favoured by the brokers. Some of the LPs can also offer leverage adjusted to the broker’s needs and credit line options, which is a very convenient option for the brokers, who usually have most of the funds locked on their bank accounts or e-wallets.
These factors are extremely important also for fully A-Book brokers, who need to cover all of their clients’ trades with LPs. In the case of high volatility periods, clients’ activity is increasing rapidly and margin requirements on LP accounts can surpass the actual balance. Therefore, the flexible approach of liquidity provider (an increase of leverage, providing a credit line) can save the broker’s business. Each broker needs to know that no client will understand that the reason he couldn’t open or close his transaction, was the margin shortage on the liquidity account. It is the sole responsibility of the broker, therefore it is important to choose the partner wisely.
If issues described in this article caught your eye and you’d like to dive deeper, we encourage you to contact@match-trade.com as our Liquidity offer was created to help brokers protect their business in volatile times. Here at Match-Trade Technologies, we have years of experience in the forex industry and we understand the brokerage business very well so we know what problems brokers face both in day-to-day and extraordinary situations.