It’s obvious that the relationship between B-book brokers and liquidity providers differs from the relationship between A-book brokers and their providers and here we dive into the nuances of a complex two-way relationship.

First things first, what’s the difference between market making, A-booking (STP) and B-booking?

Market Making

In general, unless the broker is STPing, the flow of any model where the broker is quoting some variation of “bid” and “ask” prices and accepts trades on the quoted price can be called “market making”. In this model the risk is off-set with a delay or partially based on the risk appetite of the financial firm.

However, there’s a couple of things missing from this equation:

1. Where do the bid/ask prices come from?

2. What happens to the trade after the broker has accepted it?

Where Do Quotes Come From?

Let’s start with where the quotes come from.

Of course, this will depend on the instruments we are looking at, but for simplicity’s sake, let’s just look at FX. For any model, including market making, the broker needs to either have a reliable (and most importantly, tradable,) feed of quotes, or it must be able to derive its own price feed.

The derived pricing is usually based on either own views and trades (e.g. principal trading) or based on the foreseeable demand, e.g. historic data or existing trades. In the case of banks, different maturity and different types of obligations such as forward contracts or possibly current exposures on existing trades can be used, either their own trades or trades the bank/broker has accepted earlier.

This allows the market maker to understand what spread should be quoted between the “bid” and “ask” and which quantities should be offered at each level of the market depth , as, of course in FX the more someone is willing to buy, the more expensive the price (volume bands) - but that’s a different subject.

Unfortunately, due to a lack of knowledge, or sometimes volumes of tradable flow and the need to offer thousands of instruments, brokers are forced to seek reliable price feeds from other market makers , as they simply don’t have enough knowledge or inventory to provide their own feed or to derive their own pricing.

The most important factor here is that the feed is tradable, as any market maker with even the simplest risk management procedures in place needs to have the option to offset exposures in the market; so, if the prices are not tradable, this leaves the broker with risks that can’t be offset and the potential for arbitrage.

This answers the first part of the question regarding the pricing and quotes and this is one of the reasons why even B-book brokers (market makers) need to have a relationship with a real liquidity provider and not just a “price feed” that is not tradable.

The Fate of the Trade

So, what happens with the trade after the broker has accepted it?

There are many answers to this question, depending on how sophisticated the broker is and what type of trade we are looking at.

In the traditional A-book hedging model, when the client buys at the “ask” price, the broker hedges with its liquidity provider at the “ask” price – the standard STP model, with only the mark-up as profit (if any, in the current market conditions where the “real” market prices are much higher, then the trading conditions offered to the retail traders), as it’s simply not possible to get 1 point spread on DAX (and of course 0 spread on EUR/USD and swap free XAU) if offset immediately in the market. The trading conditions offered to the retail traders are very often “artificial” and they do not reflect the true situation and trading conditions available directly with the liquidity providers. This of course would leave the broker in a position where the risk can’t be offset without also taking a loss on offsetting the trade.

In general, this is the reason why the USD per million on A-book trades is significantly lower than on B-book trades. Unless, the broker is using a more sophisticated hedging model and understands the risk and the exposures of the unhedged positions.

But how could a broker earn more USD per million without holding the unhedged exposure? One of the models would be to place resting limit orders at, or around, “bid” price for buy trades and try to capture the whole spread and the mark-up – i.e. traditional market making. The broker can then decide how long the trade should be held in order to be executed and what happens if it exceeds the time limit. For example, it could go into unhedged exposure and “rest” until a certain market movement to be offset later. I believe Drew Niv wrote a very interesting article regarding true market making a while back on the Financial Magnates.

For this type of market making the broker will most certainly need a liquidity provider and a technology provider that supports resting limit orders.

Depending on the unhedged exposure, a market maker may algorithmically change the pricing models to offset their risk when needed by changing the pricing and perhaps making one side of the trade more attractive than the other. All in all, the models can become very complex and sophisticated. It goes without saying that for those models, brokers should choose a technology provider and a liquidity provider who can support their needs.

However, all models always include, firstly, understanding the broker's counterparties – for example, a liquidity provider that is a high frequency trader (HFT) will be pricing very differently from a Tier 1 bank, and understanding the broker's own flow and clients, be they B2B clients, such as other brokers, asset managers or retail traders, is key.

Smaller Brokers and a Simplified Model

Now let’s assume the broker is a start-up with around 100 mid-size retail clients. In this case, there is not much the broker can do other than to sign up with a reliable liquidity provider, and, in my opinion, the provider’s reliability should be judged by how tradable the prices are, which will ensure that the risk can be offset (fill rates- and execution statistic-wise, which any broker should always monitor).

The broker can add bid/ask mark-ups on top of the quoted pricing to ensure that if the risk needs to be offset, it can be done at a profit and start “market making” by simply taking the opposite side of the trade hoping that the negative mathematical probability and the nature of speculative trading will do its job over time. This model is known as “B-book” in the retail FX/CFDs market.

With this simplified model, if the broker does not know what to do with more profitable clients, the easiest solution is to just back-to-back STP the trades to a bigger, more sophisticated market maker who can then run other models. That’s where knowing your clients and their trading patterns becomes even more important, as categorizing the clients correctly will make the biggest difference.

Some liquidity providers also offer a revenue share model, so smaller brokers can continue investing into marketing and simply hand over dealing and market making to the liquidity provider.

Therefore, for smaller brokers monitoring the trade statistics of their clients and categorizing the clients by both client-related parameters and trade-related parameters and monitoring the liquidity including execution statistics and the pricing profiles becomes the key to success.

Unfortunately for the industry, very often the brokers fail to recognize the need to switch to a more sophisticated model and look for new talent or knowledge. This is where using a partner who has a wide range of clients, be it a technology provider or a liquidity provider becomes extremely useful, as the new tools can be introduced and used and the knowledge across the industry can be shared from the small brokers to the bigger more sophisticated financial institutions.