When traders are trading with a brokerage who executes client orders using a No-Dealing Desk model (STP/ECN brokers), retail traders are exposed to what is known as liquidity risk. Genuine, No-Dealing Desk brokerages simply act as an agent for their clients passing trades onto the firms liquidity providers. No-Dealing execution can lead to a decrease in counterparty risk and also removes any conflict of interest between the brokerage and it’s client base. However, the trader may be exposed to liquidity risk during periods of high volatility, which can make it difficult for traders to exit their positions and may lead to them incurring huge losses.
The Spot Forex market is one of the most liquid financial markets in the world, which means the majority of the time traders can enter and exit positions at a price relatively close to the last traded price. Most of the time volatility in the major FX pairings is pretty low, which allows Tier 1 liquidity providers to still operate profitably while offering tight spreads and prices close to the last traded price. However, during periods of massive uncertainty these liquidity providers look to protect themselves from this volatility. What this leads to is liquidity providers either withdrawing their liquidity completely or offering prices a significant distance away from the previous trading range. This can lead traders to be unable to exit their positions or alternatively may lead them to have their positions closed out at very unfavourable prices.
Offering services to the retail market involves understanding a different mentality. Retail clients are primarily looking at the ‘top of the book’ while institutional clients care less about the price on EUR/USD at $250,000 and are far more interested in the average price they will get for a $1,000,000 or $5,000,000 order.
So when it comes to liquidity, it’s not just the amount that matters but also its depth. Retail traders would not be content with Institutional liquidity pools because they service a different motive. An individual trading at an institutional venue such as FXAll or HotSpot would find high minimum trade requirements, lower leverage and an abundance of trading tools that are not applicable.
Vice versa, institutional traders trading at a retail venue are likely to see re-quotes, comparatively slower execution and ‘shallower’ liquidity. This would effectively rule out any price certainty and would prevent effective risk management.
When it comes to liquidity there are 3 main factors….
- Depth and availability of liquidity
- Spreads that are offered
- Market volatility
All go hand-in-hand, and each factor applies to all market participants on both the buy and sell sides.
Low market volatility and low margins affect liquidity in the market. If volatility is too high, the amount of traders active in a market often falls — but in the retail space, volatility brings more traders into the game.
There isn’t a lack of liquidity but providers have to be much smarter when offering very competitive pricing because the room for getting it wrong is now minuscule and still falling. More competition is forcing all brokers to be more shrewd in how they price their services, which can sometimes mean marketing ECN/STP accounts as a means for retail traders to move into professional trading. In fact, this is rarely the case and is only a marketing gimmick.
It’s clear that while spreads and market volatility have broadly fallen, especially in the major currency pairs over the past 5 years, the availability and depth of liquidity have risen. In very few other industries would you expect to see narrowing margins and lower activity enticing greater amounts of market entrants. This counter-intuitive trend can be partially attributed to technological progress, and the rapid growth of financial technology, aptly titled ‘Fintech’.
Risk vs Reward
The underlying unchangeable fact in trading is that risk and reward are inextricably linked and are always proportional to one another.
If you seek more reward, you must take on more risk; and vice versa. In modern markets, brokers have felt the pinch of tigther spreads — but must still execute trades with the same potential loss. This effectively means that the risk brokers see is relatively higher today, than it was when spreads were much wider.
Spreads on EUR/USD in 2000’s were around 2 pips, compared to 0.2-0.5 today. That has mean brokers are now playing for a much smaller pie, but must still risk manage the same nominal amounts. It’s much harder to maintain revenues without taking on more risk.
Every provider has different priorities when they offer liquidity. For some, the primary objective is to revenue optimise which often means offering a standard feed with a mark-up. For others, it’s to hold the position for short periods until the spread is realised and then offset with another liquidity provider or broker. Others sit on a position and target long-term profits because they believe the market will eventually go in their direction and against the client. Providers such as large banks, often want to accept as much flow as possible and potentially suffer losses on some trades as long as they can offset the exposure with other asset classes.
The average amount of revenue generated from every $1,000,000 traded has fallen rapidly over the past 5 years. When trading activity declines due to falling market volatility and in tandem trading spreads decline due to competition, it puts additional pressure and challenges on all sell side market participants such as brokers, liquidity providers and market makers.
A prime example of this would be the extreme volatility in the Swiss Franc which occurred during early 2015. Without providing prior warning the Swiss central bank announced they would no longer be defending the Swiss Franc peg against the Euro. Many of the liquidity providers to retail FX brokerages completely withdraw the liquidity they were offering on CHF pairings, while others continued to offer prices but a significant distance away the previous trading range of the CHF. This lead to a large number of traders having their entire account balance wiped out, with some traders running up massive negative balances. Another recent example would be the significant volatility in the Russian Rouble which lead to brokerages to close out positions and stop trading in Rouble currency pairings as they were worried that their would not be the liquidity to close out positions. Though in this particular case traders themselves were not to badly effected.
Mitigating Liquidity Risk
In theory retail FX traders who are trading with a brokerage with a variety of liquidity providers should face lower levels of liquidity risk, than those trading with a brokerage who relies on a sole liquidity provider. However, in the case of ‘Black Swan’ events the majority of liquidity providers will react in the same way and withdraw their liquidity from the market place. This can lead to stop and limit orders being fulfilled at very unfavourable prices for traders. There is little that traders can do about such risk. One way to limit liquidity risk, is simply to limit the leverage used with many of the worst effected during the CHF volatility of 2015, being those who were using large amounts of leverage. However, many traders are reluctant to cut back on the use of leverage as it allows them to maximise profits when markets move in their favour. A certain degree of liquidity risk is part and parcel of trading with a brokerage who operates an agency model (ECN/STP execution).