Is the broker agent model a myth? Part 1

In this article we will make an attempt to eliminate the uncertainty, which, in our opinion, can be purposefully supported by individual brokers to attract additional audience. The author expresses his personal vision, formed while working in a brokerage company that adheres to different business principles. We will describe several practical methods that you can use to critically analyze the activity of your broker. In this article, we intentionally do not consider introducing brokers (IBs) that operate under an open agency contract model. We are talking about companies that position themselves as clearing agents who execute trades on behalf of the company.

Broker's agency clearing model: trades are transmitted to the interbank market

This unconfirmed model is based on an attempt to disguise the conflict of interest between the broker and the client. Its creators emphasize that the "broker-agent" is not a beneficiary of a trader's unsuccessful transaction, since the interbank network, not the intermediary company, acts on the opposite side. The only earnings in this case are the company's commission in the form of spreads/.swaps etc.

• In the most popular model (Fig. 1), it is assumed that the "agent company" receives a stream of quotes via FIX/FAST protocol from several liquidity providers. Some institutions are further designated: Barclays, JP Morgan, UBS, Deutsche Bank, etc.;
• The company's aggregator, i.e. a separate server, performs clearing - forms the minimum purchase price and the maximum sale price among streams of providers, forming optimal conditions for the client;
• The client sends an order at the current price, which is transmitted by the "broker-agent" to the prime broker (partner);
• The prime broker executes the order at the specified price or as close to it as possible.

The model has variations: some companies claim to execute the order from the company's account, preserving the trader's anonymity. Some companies explicitly state that each trader's order from his account (ECN accounts) is transmitted to the interbank market. What unites these models is the complexity of the architecture and multi-step: up to six data transfer procedures.

Typical trader misconceptions

• A novice trader has many motivations other than making money, unlike a professional trader. These motivations make it difficult to trade successfully and impede impartiality, but it is not easy to get rid of them. One of the motivations is the feeling of self-importance from belonging to the financial sector. A trader gets genuine satisfaction when he realizes that his every order is processed by Barclays and JP Morgan.
• A novice trader turns a blind eye to statistics and exaggerates the practical significance of conflict of interest. The American investment company Philadelphia Financial has conducted an independent study based on disclosure data among retail brokers in the USA. The results of the study are in the form of a chart of the probability of total deposit loss (see Figure 2). Looking at this diagram, the question arises: does it make sense for a broker to create artificial difficulties for a trader if the mathematical expectation of deposit loss is determined by the psychology of the process? The excitement and lack of risk management leads to the fact that the broker's profitability is comparable to that of a casino. Do you honestly believe that a casino is setting up roulette and using speckled cards, putting its reputation at needless risk? If so, take a look at the statistical significance of the Roulette field.
• The trader doesn't understand the principles margin trading. Transactions in the interbank foreign exchange market are carried out with 1:1 leverage. Banks do not need to find liquidity. This is the reason why leveraged trading means that the broker has to provide additional own funds for position translation: opening a position for $1000 requires direct delivery of $0.5 mln at a leverage of 1:500. Taking into account the volume of client orders, the broker in this case is obliged to have liquidity comparable to that of the largest investment banks.

• Finally, a trader who suffers losses tends to look for the source of the problem outside his system of work - victim psychology. It is unbearably difficult to admit your own mistakes. This does not mean that you should not critically evaluate the broker's work, but it also does not mean that you should exaggerate the shortcomings of his work.

Analyzing the agent-based interbank brokerage model

There are two available methods for analyzing the agency model: technological and legal. All methods lead to the same conclusion: the presented agency interbank model is possible, but unlikely in the competitive environment of brokers. So, let us start the review in order:

• Technological conflict

Have you ever wondered why hedge funds place their trading servers directly in the Exchange's branch? Using Direct Market Access (DMA) technology is the only way to reduce order processing to 0.5-3 ms and avoid additional network delay of order execution. In this case, the company uses the equipment of the venue (bank, exchange) and has the ability to implement its own software environment that determines the trade flow. If the hedge fund uses algorithmic trading, the software is periodically updated and new program modules are loaded. That is, if the company's trading server is located in the server department of MICEX or another trading floor, 1 ms is the typical available quote resolution.

The use of remote access introduces an additional signal delay of 100 ms for an Ethernet connection (twisted pair) and 500-600 ms for a satellite link. The additional delay is also due to the use of intermediate proxy servers and signal repeaters with additional amplification. Each proxy server receives millions of requests, queuing them up for execution, and thus creates latency that is a priori absent in DMA. Have you ever wondered what the delay is between receiving a quote and executing the request?

In order to check the signal transmission delay from your PC to the broker's proxy server, you can use a number of simple utilities, or services, such as: ping.eu. The IP address, or host address of the trading proxy server is entered into the only field. The simplest experiment with pinging the proxy server of one of the "companies - agents" from my home PC (Internet traffic speed - 100 Mbit/s) led to the following result:

In the field avg You will find the average time it takes to send a signal to the server (order) and its confirmation, i.e. the time it takes a trader to perform one operation. The result exceeds the speed of order execution on trading platforms by 300 times. It should also be taken into account that after the order is received by the proxy server, it is transmitted to the company's main trading server, then to the liquidity aggregator and finally to the servers of the liquidity provider. We have considered only the first link of this chain. You can perform this experiment involving the trading proxy server of any broker positioning itself as an "interbank agent" and you will come to a value of delay that will lie in the range of 100-1000 ms. You can find the address of the trading proxy server in two three ways: on the official website of the company, on thematic forums or by yourself. In the latter case you can open a file with the extension .srv in the folder [terminal folder]/config/ (MT4). You can find more information on how to find out the IP of a company's trading proxy server yourself, for example, here.

The main conclusion that can be made on the basis of testing: to execute an order at the current interbank price, its value must remain constant for 500-1000 ms. Otherwise, execution of the order on the side of liquidity provider or even prime broker at the declared price becomes impossible.

Continued