What liquidity is good liquidity?

Bailey White, Director of Electronic Trading and Execution at 26 Degrees Global Markets provides his insights in this article by David Kimberly. To view the full article, click here.

When you talk to anyone from a dealing desk about what they do, particularly higher up the food chain, the likelihood is that person will start to sound like Tom Green pretending to be a stock market analyst.

The reality is much simpler. Basically, the dealing desk has a computer with a line on it showing the broker’s risk limit. When the broker hits its risk limit, a warning light shows up and an alarm sounds. Sometimes a voice will go over the tannoy saying ‘warning, warning, b-book limit breached’.

This wakes up the head of the dealing desk from his nap and he then, usually half asleep, walks over to a big red button that has ‘hedge’ on it. He hits that button and then all the risk is sent to the liquidity provider. Then he goes back to bed or, if he’s feeling like working, watches some cricket, waiting until the alarm goes off again. Something like that anyway.

But this ties into an interesting question as to what flow is good flow for the liquidity provider that works with this broker?

Taking that into account, in theory, a smaller broker should send better flow to their liquidity provider than a larger one, simply by dint of the fact that they aren’t able to take on as much risk. The result is that their risk limits get breached faster and then they end up hedging out flow which a larger provider would warehouse.

But then one of the things I have always assumed is that random, faceless brands based in places like St Vincent are either crooks that just nick any deposits they get or they internalise everything. This would go against the idea that a small broker can provide good flow.

So what is the answer? Well, it seems that it’s probably those two widely despised words – it depends.

Many offshore brokers do internalise a large proportion of their flow. However, after writing this newsletter for a couple of years, I’ve come to the conclusion that this is not because they are crooks but far more due to the fact they are typically run by people who used to be IBs and have absolutely no idea what they are doing when it comes to dealing.

Another component of this is that these companies make extensive use of IBs to get started, as it’s the lowest cost route to market. The result is that, in order to provide competitive rates to their IBs, they have to drive higher revenue from their flow. This means internalising more.

However, a lot of the time they can actually end up getting whacked by their IBs. They get large clients, which they may not have even been expecting, via their IB partners. When this happens, they then freak out and just hedge out their exposure because they don’t have a strong enough balance sheet to deal with it.

“Lots of people assume that the big players in the liquidity space are also the ones making the largest amount of money from it,” said an executive who spent several years at a liquidity provider. “But a lot of the time they won’t touch small and start-up brokers and so they leave a lot of money on the table. Those companies can actually be very profitable because they send you flow that is easier to monetise.”

Of course, you could then infer from this that larger players would be worse, simply because they can internalise most of their clients trades and then only send flow to their liquidity providers which is difficult to monetise.

However, again, the sentiment here seems to be that it depends. Providers that follow something like the model described at the beginning of this article by hedging out after breaching risk limits, even if they are large, can still end up sending good flow to their liquidity providers.

This makes sense if you think that a risk limit is not an arbitrary number when it pertains to the broker’s resources, but is an arbitrary number in relation to what is happening in markets. In other words, when a risk limit is breached, it doesn’t actually say anything about that flow or how difficult it is to monetize from the liquidity provider’s point of view.

On the other hand, bigger players do tend to be more sophisticated and have the ability to filter out all the ‘annoying’ clients and bad flow. Some of them may then take this and send it all to their liquidity provider.

This is obviously bad for the liquidity provider. However, it will also be bad for the broker in the end as well, because they’ll either start to get worse pricing from their liquidity provider or just get shut off.

“The best flows are actively segregated by brokers,” says White from 26 Degrees Global Markets. “High impact clients are moved to streams with a wider spread to compensate for the market impact they cause post trade. This allows an LP to show the majority of non-impactful clients pricing that is consistently tight and therefore lowers their average cost to trade.”

And that is ultimately why it’s kind of hard to say who provides good flow and who doesn’t. Small providers may be more likely to give you good flow, but their volumes are likely to be lower and they may also just bucket loads of it anyway.

On the other hand, large players that just manually hedge out flow when breaching risk limits can also provide good flow. But then they can also end up, as one executive at a liquidity provider put it, treating you like an exhaust pipe by only sending you the worst flow possible.

So it goes back to those two annoying words – it depends.

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