How do broker-dealers price CFDs? What is a price validator? How do they profile traders? Finance Magnates (and an industry expert) have taken an educational initiative to dissect and reveal the basics of the broker-dealer industry. Anyone working in this industry or willing to join must know the structure of how a broker-dealer operates.
The first part of the series explored the basic definitions of the broker-dealer industry. Now, this second part delves into pricing for broker-dealers’ operations and how they monitor traders.
Pricing
Correct pricing instruments are an essential part of any broker-dealer’s operation. So, how do broker-dealers price an instrument and receive price feeds, and what is a price validator?
Pricing Instruments
The revenue of a broker-dealer from the pricing of the instruments is generated primarily from three sources: markups, commissions, and rollover fees. A broker-dealer must properly manage all these three revenue-generating components.
Markups: A markup is the additional amount a broker-dealer adds to the spread or price of a financial instrument when offering it to traders. Broker-dealers must apply markups to both sides, bid and ask, and never use negative markups, as this will expose them to arbitrage. However, markups must be fair and transparent to maintain compliance with regulatory standards and uphold client trust.
In some rare cases, brokers intentionally use narrow spreads or slightly negative markups to attract liquidity or outcompete rivals. However, this is a calculated decision and not standard practice. In such cases, brokers generate revenue through other means, such as commissions or alternative fee structures.
Commissions: Commissions are fees charged by broker-dealers for executing trades on behalf of their clients. For CFDs broker-dealers, commissions can generally only be zero if markups are in place. However, it is to be noted that some broker-dealers offer commission-free trading models without applying markups, generating revenue through other means such as payment for order flow or interest on uninvested cash balances.
Rollover Fees: Rollover fees, also known as swap fees, are charges applied when a trader holds a position overnight. Long-short or short-long rollover fees are influenced by the interest rate differentials between the currencies in a forex pair. It is generally positive for most of the currency pairs but can also be negative depending on the direction of the trade and the specific currency pair involved. Any abnormal rollover fees might allow traders to open arbitrage positions (e.g. holding one long and one short position, not necessarily in the same accounts).
The Price Feed
The price feed generated from the ECN is critically essential for a broker-dealer, as traders can exploit pricing vulnerabilities or experience unfavorable conditions in certain situations, leading to toxic behavior or abuse.
Delayed Price: Due to slow updates, traders may engage in arbitrage.
Bad Price: Due to filtration errors, traders may arbitrage or get stopped out, requiring broker-dealers to reopen trades.
Spike Price: Due to mispricing in feeds, traders may face liquidation.
Non-Updating Price: Due to technical issues, traders may be unable to execute trades, their orders may not be filled, or they may trade at stale prices and potentially benefit from this, depending on the platform.
As with anything, having two price feeds is preferable in case one feed goes down, providing redundancy and ensuring consistency through latency equalization.
The Price Validator
The price validator, or checker, double-checks the entry and exit prices of trades. Traders might enter on bad prices (arbitrage) and exit on good prices or vice-versa. In such cases, it can be difficult to detect when traders are arbitraging or violating the terms and conditions related to stale or misquoted prices.
When a broker-dealer is asked how to determine if a price is good or not, it needs to compare the price with at least one or more price feeds to check if the price you’re providing is inaccurate or mispriced. Sometimes this can cause the broker-dealer’s filtration system to offer an incorrect price because the matching engine might assume the price from a liquidity provider (LP) is better when, in fact, the LP is providing a wrong price. Adjusting the filtration settings can help correct this issue.
Monitor Traders
Risk profiling traders is crucial for broker-dealers. As such, these platforms must monitor trades. However, brokers must profile traders ethically and in compliance with the data protection laws.
Trader Behaviour: The Three Trades Rule
To quickly profile a trader, it typically takes just three trades to form an equity curve and assess their behavior. Common trader profiles generally include arbitrageurs, novice traders, and technical analysts. In some cases, a broker-dealer may also encounter insider traders (news traders) who have access to non-public information related to the financial products you offer.
However, this profiling may not be accurate if the trader is masking their trading behavior.
Statistically Correct: The 30 Trades Rule
If a broker-dealer prefers a more mathematical approach, it will need at least 30 observations (a general rule of thumb) to validate a trader’s behavior, similar to performing a T-test for statistical significance.
Trading Performance
If a broker-dealer is looking to evaluate which traders perform better than others, it can monitor their performance using the following metrics:
Success Ratio (SR): The Success Ratio, or “win ratio,” is the percentage of winning trades relative to all executed trades. It is used to measure a trader’s ability to consistently predict future price movements.
Return on Investment (ROI): This metric indicates the per-period profitability of a trader and how effectively their capital was invested during the observed timeframe.
Big Hit Ability (BHA): Using a small regression analysis, the forecasting ability and investment performance of a trader can be assessed. This method assumes multiple small losses offset by a few large wins, which helps keep profitability high. It involves a simple correlation between trade volume and realized profits or losses.
As we’ve explored, broker-dealers operate in a complex environment where accurate pricing, trader profiling, and compliance go hand in hand. For those in the industry, these practices are fundamental to maintaining a competitive edge while upholding trust and transparency.
In the final part of this series, we’ll dive into the critical role of hedging in broker-dealer operations. Stay tuned to continue enhancing your understanding of this fascinating industry.
Disclaimer: This guide is for informational purposes only and is not intended as financial, legal, or operational advice. The strategies and recommendations provided may not be suitable for all broker-dealers or applicable in all jurisdictions. Readers are advised to consult with qualified professionals and regulatory authorities before implementing any of the practices discussed. The publisher assumes no responsibility for any financial losses or regulatory issues arising from the use of this content.
This article was written by Finance Magnates Staff at www.financemagnates.com.
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