What no one is Telling You about FX Margin Aggregation

Margin aggregation has become a popular topic amongst retail FX brokers recently with many having lost their Prime Broker relationships and with the squeeze on credit conditions.

What is FX Margin aggregation?

FX Margin aggregation is a way of pulling together FX price feeds (typically using best bid/best offer logic) from Prime of Primes, the “institutional” divisions of retail FX brokers, and from retail FX market makers. Unlike in the purely institutional trading environment, where a Prime Broker would handle the settlement of transactions with the banks and ECNs, with FX Margin Aggregation there is no such a clearer, and the retail FX broker is solely responsible for all trade reconciliation.

What kind of technology do you need to perform FX Margin aggregation?

Typically, most FX brokers contract with a commercial MetaTrader bridge provider who is already connected to multiple prime of primes and other, competing retail FX brokers. The cost for such service ranges from $1-3 per million and normally comes with monthly minimum commitments. No intense infrastructure/aggregator/ integration with clearing parties is required.

Benefits of FX Liquidity Aggregation on Margin
Proponents of FX Margin aggregation promise instant benefits such as improved spreads and risk diversification. The thinking behind this is that by aggregating multiple providers, a firm can benefit from reduced spread as each price provider has their own particular way of deriving their feeds (some are market making and some are passing some, or all, of their trades through to either a Prime of Prime, or perhaps a bank).

How much of a spread reduction should one expect? I think it’s fair to say 0.1-0.2 pips on average on some of the majors.

Another benefit of aggregation that is commonly put forward is the distribution of risk. In the post-SNB environment, the safety of funds and mitigation of counterparty risk is on everyone’s mind. As the crisis proved, there are no “too big to fail” FX brokers. As such harsh reality is now part of everyday life, brokers are looking for ways to secure their funds, or find way to reduce their counterparty risk. Distributing margin between different counterparties is one of the ways that is supported, and encouraged by this FX Liquidity Aggregation method.

What are the potential pitfalls?
While retail FX aggregators continually market the benefits of their product there are a significant number of cons associated with the model. While improved spreads are great, paying double spreads with your counterparties is not so great. By opening a trade with one margin Liquidity Provider (LP) then closing it with another you will, at some point, need to close the offsetting positions at both LPs in order to reconcile and in doing so you will pay the spread twice.

Many brokers are solving this by configuring their systems to close a trade at the same LP that it was opened with, but this causes slippage and totally defeats the purpose of margin aggregation. Moreover, the reconciliation process between the various counter parties is mostly manual and labor intensive and carries with it significant financial risk in the event of trade mismatches or technology failure.
Margin management is another area where a possible breakdown can occur at any time. “Prime of Primes” and the like provide significantly higher leverage than any Tier 1 aggregator (an aggregator with a bank, prime broker relationship) but this comes at a price to the retail broker. Multiple margin accounts have to be monitored and maintained to ensure adequate funding in order to avoid margin calls resulting in significant losses and market exposure (where positions on one side of a matched trade are closed at one counterpart while the other side remains open at another).

Another downside associated with this particular model is that you will not capture the full benefit of reduced swaps/rolls on your corporate account due to the fact that you will  be paying swaps at all of your counterparties (and we all know that swaps are definitely uniform across all brokerages). There is also the issue of double-hits for STP Liquidity providers (who provide liquidity to multiple venues and can therefore be hit multiple times on the same price) and market makers who are concerned about not seeing both sides of the trade. In addition to these, the extra technology costs associated with this model may also impact broker’s bottom line.

In conclusion, the decision on whether or not to aggregate your liquidity is nearly always a function of available resources versus the money that can be generated. There are some who can implement this model successfully but many spend unnecessary time and resources only to eventually realize that this doesn’t help their business. A retail broker can potentially achieve the best of both worlds by utilizing the services of a regulated Tier 1 STP aggregator, one who has a solid bank, prime broker relationship and who is agnostic to flow direction. By doing so they will have the benefit of tight spreads, reduced costs, no conflict of interest (not receiving liquidity from a market maker or competitor) built-in trade reconciliation and safety of funds.

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