In the OTC FX and CFD trading industry, there are many thousands of brokers catering to a variety of different customer profiles. Since the start of the twenty-first century, the online trading industry has exploded. It’s no longer just top-tier financial services companies buying, selling and trading FX at inter-bank rates. The universal distribution of internet connectivity, relatively high-performance computers in everyone’s homes, easy-to-use trading applications and low-cost derivatives have made the industry appealing to many.
The extent of liquidity takers is incredibly broad. The scope includes retail traders speculating on currencies, consumers with multi-currency e-Wallets, asset managers trading on behalf of clients, businesses hedging risk or another broker taking liquidity. All these consumers need a place to trade. Each of these personas needs their forex administered in a slightly different format. Therefore, brokers catering to those niches employ distinct businesses practices to serve the target client and solve the associated challenges.
Despite there being so many forex brokers in the world, it’s ironic that the phrase broker has begun to lose its meaning. According to Wikipedia, A broker is a person or firm who arranges transactions between a buyer and a seller for a commission when the deal is executed. Somewhere along the way, forex brokers have evolved from solely being middlemen, and become principals, dealers and agents.
At Scandinavian Capital Markets, we act exclusively as a broker, who negotiates terms and connects clients with various liquidity sources, depending on their needs. There is not much ambiguity around that practice, but if you want to understand what we do behind the scenes, read our recent article on how we build the best forex liquidity feeds. In this article, we look at other models (that Scandinavian Capital Markets does not necessarily use) forex brokers use to execute trades and to provide liquidity.
A-Book vs B-Book
Forex broker execution models are very broadly defined as either A-Book or B-Book. An A-Book model executes orders externally, and a B-Book model does not.
When the Swiss National Bank unpegged the franc from the euro, most brokers operated an A-Book model. Most brokers essentially delegated all risk-taking and risk-management to their liquidity providers. An A-Book execution model is where a broker uses a concept called straight-through-processing (STP). The trader submits an order to a broker, then the broker submits it to their liquidity provider.
In 2015 and the preceding years, forex regulation was much looser than it is today. The barrier to launching a broker was not particularly high and unregulated brokers looking to swindle as many traders as quickly as possible were still able to access the same payments and banking infrastructure and lead generation tools as regulated brokers. It was easy to avoid the expected standards involved in operating a sound brokerage, like safeguarding client money, execution policies and record keeping. These bucket shops were able to onboard inexperienced traders and pocket their inevitable losses by running a B-Book model.
It was all boiled down to, a B-Book broker wants you to lose, whereas an A-Book broker is on your side.
Based on this pretence, A-Book brokers have been glorified while B-Book brokers have been vilified. Ironically, the legacy A-Book model did not fare well during the Swiss franc black swan event. The situation unearthed a systemic failure in the A-Book business model.
Since then, brokers have overhauled their risk management processes. As of today, there are many different flavours of A-Book and B-Book execution, and so much ambiguity surrounds forex execution, not just in the retail environment, but also at the professional and institutional level.
Internal Order Matching (B-Book)
Some large retail brokers have tens of thousands of small trading accounts. With technology, they have found a way to capitalise on this. Instead of using STP to hedge those orders, they can allow those trades to net off internally, while still using external reference prices, usually from a liquidity provider. These brokers have essentially developed their own internal order matching engines, or rather offsetting engines. When exposure grows on one side, they simply hedge the risk and scale back the position as the internal book becomes more balanced. This method allows brokers to reduce execution costs in the pursuit of achieving a more appealing bottom line.
Dealing and Market-Making (B-Book)
As opposed to using an external price feed to conduct internal order execution, some brokers use an automated dealing desk and generate their own quotes. An algorithm will review each new order and decide how to proceed. The algorithm will either accept the order, requote the order at another price or simply reject it. A market-making algorithm can skew the price in a particular direction according to the size of the firm’s net open position.
A broker operating an STP execution model hedges all client trades with a liquidity provider which the broker keeps a pre-funded margin account with. Some brokers use different liquidity providers for covering other instruments to access the most competitive conditions.
The problem with A-Book execution is that nothing implies who the counterparty on the other side of the trade should be or what sort of execution method should be applied by the receiving counterparty. Theoretically, an A-Book broker can STP clients orders to a B-Book broker.
Brokers often aggregate liquidity from multiple sources to access the best possible pricing and get more weight behind those prices. There are numerous high-calibre forex price aggregation and distribution platforms relied on by brokers worldwide. However, due to the fragmentation of the wholesale liquidity sector, aggregation is tricky. Many brokers believe when adding LPs into their network, the more the merrier.
Consider a broker has two LPs and has deployed capital with each provider. Behind the scenes, they each have the same LP. That means the broker has twice as much liquidity, but half of it is phantom prices.
As mentioned in the introduction, Scandinavian Capital Markets operates exclusively as a gateway to top tier venues and liquidity providers. The various execution models discussed in this article are intended to present a contrast between what we do and what others do.
Not all STP feeds are equal, which is why Scandinavian Capital Markets offers customised liquidity feeds where we consult with clients on what they need. Buy-side firms stand a lot to gain from custom forex liquidity.
There is nothing inherently wrong with any of the models outlined above, they can all have a rightful place depending on the context, and this article did not go into high levels of detail. But one thing is for sure, most brokers do not have systems designed for high turnover trading strategies or firms trading entire clips in one go.
If you want to know how our business model is different from other brokers, one of our relationship managers would be more than happy to elaborate on the characteristics of each execution model and try to give a balanced opinion on the pros and cons of each.