Setting up FX Brokerage (Part II) - 5 common mistakes when choosing liquidity providers

In Part I of this blog, we have explored the role of liquidity and liquidity providers (LP) in the FX ecosystem. Part II of this blog dives deeper into the practical aspects and processes that can serve as guidance for you as a broker when choosing your ideal liquidity providers.

As pointed out in the previous blog, the daily average volume of the FX market remains strong at US$6.6 trillion, according to the 2019 BIS survey. Although the liquidity in major currency pairs remains healthy, the structure of market-makers and liquidity providers of FX has changed.

According to Soren Klausen, Sales Director at AlpFin, increased regulations have caused fragmentation of liquidity sources in the FX market.

“The stringent capital requirements under Basel III and restrictions of proprietary trading (Volcker Rule) have reduced the risk appetite of Tier-1 banks to make markets. As a result, quite a few LP banks now source liquidity from buy-side clients and repositioned themself to an “agency model” by leveraging technology, distribution and execution capabilities instead. This has a downstream effect on retail brokers to identify what is “recycled” vs “true” liquidity. Given the critical role LPs play in the FX trading process, selecting the right LPs can have a significant impact on the profitability of a retail broker.”

How do you measure the quality of liquidity?

Leading FX market-maker, XTX Markets, summarized the following criteria when measuring the quality of liquidity:

Given that measuring the quality of an LP is more of a science than art, it is imperative that brokers and LPs look beyond spreads. The other metrics listed in the table above are equally important when brokers evaluate the quality of their LPs.

“At AlpFin, we spend a considerable amount of time analyzing the quality of execution with our LPs for every trade our client put through us. We have a daily conversation with the broker and the LPs in order to ensure that the flows are directed to the LP that is best-suited for that particular currency pair or size of the order,” adds Klausen.

5 common mistakes when selecting LP

Cheaper is not better - pricing and fees are important factors when making business decisions but these factors should not compromise the quality of the service and breadth of products you will receive from LPs. Besides FX, it is best to select a multi-asset LP that covers equities, indices, cryptocurrencies and commodities. The diversity of assets will prepare you to grow your product offerings in the future.

Tightest spread does not equal Best Execution - as pointed above, tight spreads is an important consideration but it is irrelevant if “what you see is not what you get”. Optically, an LP can show you the tightest spread but if your user experiences a high number of rejected trades or poor fill rates (slippage), the quality of execution will deteriorate. This significantly impacts your firm’s reputation and adds a burden to your client support team to keep your customers happy. Your chosen LP must be able to work based on your needs and provide you with a transparent execution report analysing their performance upon request.

True relationship matters, “less is more” - Logic seems to suggest that having more LP relationships will create more liquidity and tighter spreads. However, this argument is only true up to a certain extent. Too many LP relationships will result in a “shark tank” scenario where LPs are pressured to tighten their spreads in order to match the orders. Over time, this leads to adverse selection and LPs will begin to widen their spreads to protect themself as a result of the toxic flows. A better approach is to segment your liquidity pool and direct the flow based on each LP’s strength instead of co-mingling every LP into a single pool.

Trustworthiness - firstly, a regulated LP will give you the comfort that it is legally obliged to act in accordance with the law. If you decide to choose an unregulated LP, make sure you perform due diligence on the LP in terms of reputation in the market, peer reviews and level of professionalism. In addition, there needs to be a constant dialogue and analysis of the flow with your LPs to ensure it is a sustainable relationship between both parties.

Technology and Support - your chosen LP must demonstrate that they have robust technology to support your business. The LP has to be reliable across pricing feed, execution, connectivity, hosting, software and integration with your systems. Besides infrastructure, your LP needs to be experienced enough to understand the pain points and anticipate any potential issues ahead of time.

All in all, your chosen LP has to be your trusted partner at all times, especially when issues arise and how well they handle those difficult situations determines their pedigree.

Choosing the right LP – risk or opportunity?

The introduction of stricter regulations governing traditional financial institutions and the rise of retail participation accelerated by the internet has contributed to the gradual convergence of institutional and retail flows. The blurring distinction of “true” vs ‘recycled” liquidity has made choosing your LPs a more challenging task.

The biggest merit of choosing a single LP is the cost of integration but it also represents a concentration risk that may bring down your business if the LP fails to perform as expected. Adding more LPs can help reduce systemic risk of over-relying on a single LP but it requires careful selection based on the quality of execution as discussed above. There is no “one-size-fits-all” but a diligent and thoughtful approach to the selection process can make you rise above the rest of your competition.

1) Would you like to find out how improved liquidity can drive more trading volume from your customers?

2) Would you like to know how you can improve your profitability by selecting the right LPs?

Leave your contact details for a complimentary LP analysis and learn more about how liquidity can drive more trading activities.