Is waiting for a ‘client drop’ really the best way to manage P&L and risk?

Retail brokers generally state that around 75% of retail investors lose money - the majority of these losses are in the spread value of their trades (because they are trading on wide spreads) rather than because they call the market wrong. 

However, studies have shown that over the long-term (if you take out transaction costs and spreads), clients’ trading P&L is generally no better or worse than that of their brokers.

B-book Risk Management

Regardless, this is still a widely held view and one which has led to a common risk management strategy among B-book brokers, where their goal is to capture 100% of ‘client drop’ when it occurs.

Sometimes this approach can work. The market volatility during March and early April this year – the highest we’ve seen since 2008 - was generally good news for such brokers, who were no doubt congratulating themselves on being able to profit from their client’s losses.

But waiting every 12 years or so to make a killing from unprecedented market events is not the most optimum way to run a business, particularly when it comes to managing P&L and risk.

Brokers need to take a more systematic and calculated approach to risk

So rather than just hoping for the best and getting lucky from time to time, brokers need to take a more systematic and calculated approach to risk and thus put themselves in a much stronger position.

The key is in being able to break down and accurately measure all revenue components, rather than viewing it as a sort of ‘P&L soup’. By analysing what constitutes risk revenue (from B-booking their clients’ trades), versus risk-free revenue components (from things like spreads, swap mark-ups and commissions), brokers can better predict what their month-on-month revenues are likely to be, gain a better understanding of how to set up a cost basis against that, lock in consistent revenue streams over time and budget for the future. 

At IS Risk Analytics (ISRA), we’ve been helping our clients in the retail broking community do exactly that. And what we’ve been able to show them has been quite enlightening.

Trends we are seeing

Another factor to consider is the Liquidity Provider’s policy on changes to margin requirements. In market conditions such as the ones we currently face, Liquidity Providers are at times required to increase requirements for certain instruments to mitigate their own risk. The important consideration for brokers is the amount of notice that the Liquidity Provider gives before making such a change. An instant increase in the requirement on a large position can immediately trigger a liquidation event.

First of all, it’s clear that in many cases, the money they make from their B-book is actually just a small proportion of their overall revenue but it comes with a very high proportion of risk, which means that their P&L is extremely volatile. Brokers often don’t realise how small the risk revenue component causing the massive variability in their monthly P&L is at any given time. 

Their risk-free revenues on the other hand are much more linear with their clients’ trading volumes. And by deconstructing each transaction, we are able to show brokers how much revenue they could be locking in risk-free. 

The issues of revenue volatility

With the B-book model, in any typical year in there is likely to be six fairly average months, three very poor months and three very good months. So is it worth the stress, the aggravation and most of all the risk, that these high-percentage swings in revenue cause? Is it worth sacrificing the ability to grow a consistent, sustainable business for the hope that clients have a “large drop”?

Only the brokers themselves can answer those questions. But a brokerage is a business. And any investor looking to inject money into that business will want to see consistent revenue streams rather than highly variable month-on-month P&L that devalues the business.

How ISRA can help

Brokers could make things so much easier on themselves by fully understanding the components of their revenues and adapting their business models accordingly. And that’s where ISRA can help, by providing and implementing models that give them full visibility into their revenue, P&L and risk on a transactional, day-to-day, week-to-week and month-to-month basis. The net result is that they can take a more informed approach to risk, and monetise their flow on a more consistent basis.

The key message here is that this is not as difficult as it may seem. There are clearly identifiable revenue components and ISRA can help brokers recognise them, to help facilitate more sustainable business models. 

Don’t treat your financial services institution like a casino. There are better – and easier – ways to run a brokerage business, and we can help you find them.