The broker agent model - a myth? Part 2
Consider the EUR/USD tick chart of the largest supplier liquidity, of the Swiss bank Ducascopy. BID and ASK charts are presented. Current time: 15:00 (MSK), 14.02.2015. The market is relatively calm: no news and no macroeconomic indicators are released during the hour.
A window with a width of 1000 ms is chosen arbitrarily. Inside this window there are 44 different values. If you move the window one step forward, the number of ticks will increase to 50. Let's assume that the trade server allows you to conduct operations with a delay of 500 ms (which is an excellent result). Attempting to sell at the initially declared price of 1.12770 could result in more than 35 requotes by the bank, before the bank confirms it. This time we were unlucky and after 3 seconds the price never returned to the declared level. What is the broker's reaction? The broker forwards the requotes to the client (5-6 requotes in our case) or opens a position at his/her own risk and waits for the price to return to the range, independently hedging the risks. In the first case, the quality of service falls below the acceptable level. In the second case, the broker goes beyond the "agent model" and becomes a market maker, i.e. does not actually translate the position. For a reasonable execution of orders, the maximum delay a broker can allow is 30 ms, i.e. 1000 ms/N at the current market condition.
- Legal conflicts
In addition to the obvious technological contradiction, there are legal aspects that cannot be avoided. The trader has the opportunity to read two fundamental documents: the client agreement and the license, if any. A conflict of interest is not possible only in one case: if the company has a license solely for the transmission of client orders (Reception and transmission) and works according to the 100% DMA/STP Agency Model (Direct Market Access). In this case company's functions are clearing and customer support without executing orders: online support, web-interfaces etc. We emphasize that customers' orders are broadcasted to the site market makerand not opened from the company's account. The third party, i.e. the market maker/liquidity provider, is fully responsible for the execution.
The second type of license - the expanded license of the market maker, includes function of execution of orders Dealing on own Account. In this case the company has the opportunity to execute transactions on its own account, without taking them to the interbank level. Companies of this type are subject to higher capitalization requirements. Let's take the Cypriot regulator's requirements as an example CySEC (Cyprus Securities and Exchange Commission). In case the company claims to be a liquidity provider, i.e. plans to perform transactions on its own account (Multilateral Trading Facilities), the requirements are raised from €200,000 to €1 million of share capital. If the company exceeds the limit, the license is revoked. Thus, if the broker you turned to has a license with Dealing on own account, you can immediately draw two key conclusions:
- The company maintains the capitalization necessary to function as a market maker. That is, the company specifically limits its costs and risks in order to maintain a license that allows it to overlap trades in the company's account;
- Other than verbal promises, you have no reason to believe that the broker broadcasts all trades to the interbank level, since legally the company has this capability and regularly pays for it with lost profits.
Let's consider a simple method of checking the type of broker's license using CySEC as an example. Open the official website of the regulator and go to regulated entity section. If the company is registered in Cyprus, then we need the section INVESTMENT FIRMS (CYPRIOT), if in another EU country, then the tab INVESTMENT FIRMS (MEMBER STATES). Suppose the broker is registered in Cyprus, i.e. is a resident. In the search line enter the name of the company and get a brief summary of the license. We have chosen arbitrarily one of the companies, which are not represented on the Russian market (see pic.6). The Investment Services section lists the company's capabilities under the license: reception and transmission of orders and Dealing on own account.
The second point says that the company can be a market maker and is not required to withdraw all trades. If you find this type of license, you have no guarantee that your trade made it to the interbank level.
The second document for the analysis, available to the trader - the client agreement. The company is obliged to provide this document when opening a trading account. It is desirable that the client agreement is available online on the official website - in this case, the regulator may issue a claim for non-compliance with the clauses of the agreement to the terms of the license up to criminal liability. If you receive a refusal to provide an agreement, there is reason to think about the advisability of further work. The main section we are interested in is Legal obligations, or Legal Responsibility. I opened the client agreement of a popular Russian company, which I chose at random. The Russian version of the agreement was not available on the Russian-language site (!). I had to go to the English version of the site and download the document. I opened the section Capacity (Legal Obligations). The first paragraph of the section is key:
8.1 The Company shall act, at all times, as principal
"Attention! A broker acts as a principal, i.e., he is fully legally responsible for the execution and performance of transactions. In the case of a broker only transmitting transactions to a third party, that is, being an agent, the responsibility for execution does not lie with the broker, but is transferred to the appropriate entity." We are dealing with a market maker. The next interesting section is Services (Services). Suffice it to read the first three paragraphs, one of which reads:
6.3 The client understands that no physical delivery of a CFD's underlying instrument (or reference instrument) that he/she traded through his/her trading account shall occur
"Client acknowledges that there is no direct delivery of the instrument that underlies the CFD." Recall that CFD - a contract for difference concluded between the client and the broker. CFD - the own instrument delivered by the broker, using the quotations, which underlies it. Thus, this clause of the contract indicates that the company introduces its own derivative instrument, which is indirectly related to the interbank trading flows and is not directly related to them. All of the above was written in the contract of the company, which positions itself as a banking agent. In the author's opinion, it is risky to work with such a company, because its business model allows for the role of a market maker, but the company itself does not emphasize this in official press releases.
Trader's choice
So what is a trader to do if at the end of the chain there is always a market maker - a big bank or a Prime Broker? Even if there is no conflict of interest on the first step, on the last step it will be present, because the market is ultimately determined by the market makers (as it follows from the definition of this type of players). If you have created a trading system, tested it on a sufficient amount of data and strictly adhere to the trading plan, then the basic requirements you have for a broker might look as follows:
- Market Quotes. Open two accounts with the same broker and compare quotes. It's great if the quotes are available online on the website. If they are a complete match, you exclude their falsification in favor of the broker.
- The fastest possible execution of the application. Delays can deprive you of some profits and are not taken into account in testing.
- Fixed spreads are ideal. You won't be able to test your system objectively if the commission has an arbitrary floating value.
- No slippage or requotes. Otherwise, you are again deprived of part of your profit.
- Transparent scheme of the company and the presence of regulation.
- Disclosure and independent audit. This item is a nice option and occurs very rarely, but it should not be forgotten either.
If you are interested in trading as a kind of earning, meeting these requirements is enough to work with a company, especially if it has been in the market for several years or decades. The way the company deals with your position - whether it takes it to the interbank level, takes it partially (hedges), or overlaps it in a single account, in the author's opinion, is a secondary factor, on one condition - all the above requirements (or almost all) are met. You don't make claims to the bank when you make a currency exchange transaction, do you? And you do not demand that it immediately place your funds on the MICEX?
Work on your own trading style and be skeptical of the terms a broker gives you. Distribute your deposit among several brokers, diversify your strategies, and your risks will be acceptable for sustainable trading. And most importantly - as soon as you find discrepancies and falsifications - warn other traders. Only this way you can achieve honest and professional work of brokers on the domestic market.