When starting a new brokerage an important consideration is the risk model the firm will adopt. For those new to this industry, a risk model is simply the way a brokerage will manage the trading volume it receives from its traders. Currently, a broker has two options when making this decision: STP (straight through processing) or managing the risk internally, known as market making. The decision is not an easy one, especially for a new brokerage. Since establishing brokerages is one of the services we offer at BT, many of our partners often ask us for guidance on this subject. Although the choice is ultimately in the hands of the brokerage, we've noticed a trend in the past couple of years toward an STP model. This begs the question, "why are more FX brokers adopting an STP model?" I've come up with 5 reasons behind this trend which are outlined below.
Risk management is a skill. A new brokerage will either need to hire an experienced risk manager or develop a plan on its own. To add to the challenge, the 24 hour nature of the FX market requires a dealer--another name for a risk manager--to be present at all times, otherwise the brokerage runs the risk of losing money overnight. An STP model on the other hand is completely hands off. Orders simply get passed from the trader to the liquidity provider which translates to less work for the broker.
An STP model works as follows: the broker gains access to quotes and the means to execute client positions through a relationship with a liquidity provider. This means that when the brokers' clients trade, the order flow goes to the liquidity provider, not the broker itself. How does a brokerage make money with this model? By marking up the rates provided by the liquidity provider, the broker earns a certain amount of revenue for each trade opened by its clients. As long as the brokers clients are trading, revenue is generated which means that in order to grow the business, the broker simply needs to add more clients. This is not the case with market makers. Although additional traders should bring in more revenue, it's not guaranteed. The reason why can be found in the next point.
The biggest downside to managing risk internally is that just like a trader, the broker is at the whim of the market. As a rule, market makers stand to
do better in times of volatiity than in quieter times. This is because dealers have an easier time managing volatile conditions than quieter, range bound trading. Since future market conditions are impossible to predict, revenue projections for a market maker are equally as challenging to forecast. With this thought in mind, an advantage to an STP model is that revenue will remain relatively consistent regardless of market conditions. Although it is true that volatility attracts volume, there are plenty of traders who not only prefer range bound conditions but have also designed systems to trade them.
News events, ultra short term traders, and the unexpected are just a few of the situations a dealer must contend with on a daily basis. It only takes a few mismanaged trades to sabotage revenue books for the week, and if risk management is extremely poor the brokerage runs a fair chance of going under. An STP broker only has to concern itself with the stability of its infrastructure. As long as its traders can execute orders, it's smooth sailing for the broker.
In many ways dealing is not just a skill but an art as well. Dealers who are too aggressive will make money for the brokerage but run the risk of scaring away the traders. A balance is needed which only comes with time and experience. Furthermore, the trading patterns alluded to in the previous section, such as scalping or news trading, pose significant challenges for dealers, often resulting in a poor trading experience. Ironically, the traders who cause the most headaches for dealers are most sought after by STP brokers because they tend to generate the most volume. This is one of the main reasons why these type of traders intentionally seek out STP brokers.
There are currently well-established brokerages that have successfully run both STP and market maker models, proving that either can be successful. As mentioned earlier, the choice is ultimately in the hands the broker; neither Boston Technologies nor this author advocate one over another. The trend, however, is in the direction of STP so we felt it would be worthwhile to examine the reasons behind it in more detail.