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FX Liquidity for ECN Brokers, where does it come from and what about charges involved?

On this Quora Question Thursday, a really interesting question remains unanswered because the more nefarious and ignorant in the industry have yet to respond with canned responses and awkward plugs for their services.  FX Liquidity is the topic of conversation and more specifically the questioner wants to know how liquidity providers charge brokers for data and liquidity.  It's a question that very few can actually answer because not many individuals actually created an FX Brokerage or have enough insight into the business side of the retail FX industry.  Freevestor was a brokerage and this meant having a technology and liquidity partner/provider.

It's a real question on Quora.

An Important Preface to Explain FX Liquidity and Technology Partnerships

Every contract for technology and liquidity is different.  Every client has different specifications and relationships forged with their technology and liquidity providers.  Just to break it down as far as these distinctions in FX Liquidity and Technology Platform providers, the way it is handled can fall into a few different categories as far as how the relationships work.

  1. The FX Liquidity Provider and FX Technology Provider are the same company.
  2. The FX Liquidity Provider and FX Technology Provider have the same contact individuals, but different companies for each type of operation.
  3. The FX Liquidity Provider and FX Technology Provider are two different, unrelated companies that do not go hand-in-hand in any sort of a package.

The experience that Freevestor had as a brokerage was Scenario #2.  Freevestor worked with the same people to handle technology and liquidity, but they just split up their business into two different corporations in two different domiciles.  The technology provider was under one company name in one domicile and the liquidity provider was under another company name in a different domicile (under a different company name that was somewhat similar to the technology provider name).

How are FX Liquidity Firms Compensated?

Each contract is different and the contractual terms that Freevestor engaged with its former technology and liquidity partner (wonderful company and people to work with) are confidential, but the general expense structure is as follows.

Setup Fee:  Waived

Pre-paid Monthly Fee Commitment:  (confidential amount)

Monthly Fee:  First few months have a graduated flat fee as a guaranteed expense.  An allotment of a confidential fee amount per X Lots Traded.  If the total of the X Lots Traded fee exceeds the flat fee, the X Lots Traded fee is the amount paid.  If the X Lots Traded fee is less than the flat fee, the flat fee is the amount paid.

VAT (Value-Added Tax):  Some impose the VAT and for others the VAT is already included into the fees.

The Trading Platform was complimentary with the FX Liquidity in the arrangement that Freevestor had.

What do FX Liquidity Firms Do?

FX Liquidity Firms connect trades to the Tier 1 Liquidity Market (Institutional Market) either through prime brokerages or directly into the Interbank Market depending upon the relationships that exist.  Each position requires a counterparty to take the other side of the transaction.  This means that despite the speeds and the networked pool, the execution is not instantaneous.  This is what it means to be working with an A-Book, Straight-Through Processing.

A B-Book has instantaneous execution and even fixed spreads because they define the market and serve as the liquidity provider hedging against the trades of their own clientele.  This creates massive conflicts of interest as the broker actually profits from the losses of the traders.  However, profitable traders and arbitrageurs can abuse B-Book brokers with lagging rates and instant execution quite frequently.  It's why these brokers impose a unique set of rules concerning trades, but arbitrageurs have unique ways to get around these policies and it forces these brokers to send these trades into the liquidity pool (A-Book activity) or else incur losses.

The cost of FX Liquidity has to be factored into the overall spreads that a retail broker provides.  The mark-up process is actually quite involved as it factors in these costs and competitiveness in the general market.