By George Selinsky
A new proprietary trading business model popularised in the United States might provide a solid source of revenue for the struggling Cypriot Forex industry without radically altering a firm’s risk profile.
In the wake of the subprime mortgage crisis, proprietary trading has become somewhat of a dirty word in the financial industry. As a result, most banks and brokerages have turned exclusively to liquidity provision and brokerage services, shutting down or spinning off their proprietary trading desks. Many Forex brokers, including those in Cyprus, have adopted the no-dealing-desk model, offering customers a sense of safety that their broker won’t profit at their expense.
In a traditional proprietary trading business, the firm hires traders who learn how to provide liquidity and hedge the firm’s exposure (if they are a bank or brokerage) and to take advantage of market opportunities. Each new trader is a risk. Some may hedge well, but lose those profits on speculation. Inevitably the underperformers get fired, costing the firm not only losses but a salary.
American proprietary trading firms that were focused on the equities and futures markets had to pivot away from this business model in the age of high frequency trading, where relatively easy to learn short term trading strategies were washed out of the market. Instead, they shifted their focus toward the trading education and brokerage business. A number of firms began doing this online, attracting customers who wanted to learn how to trade but lived far away from a financial centre or those who wished to trade from home.
Some of these firms also began offering the option for their customers to become traders of firm capital. This benefit has particular resonance with customers who do not have the necessary risk capital to participate in the capital markets, as well as experienced traders who are looking to branch out into institutional money management.
Such a business model might work this way: a customer pays for an online, live trading education webinar where several rule-based technical trading strategies are taught. Customers trade in simulation mode and are given individual feedback on their performance by a trading instructor, with the ability to interact with other traders. Having gone through the programme, the firm then allows the trader to trade a small book of capital with a strictly defined loss limit (a percentage of the price paid for the trading education package). If this loss limit is not breached and the trader sticks to agreed upon risk management guidelines, the trader can be bumped to a larger book and be paid a split of the profits. As the trader builds a base of profits, their payout percentage and/or book size is increased in order to incentivise them to stay with the firm.
HIT LOSS LIMIT DURING TRIAL
Statistically speaking, most traders are likely to hit their loss limit during the trial. However, the fee for the trading education package includes a sufficient profit margin for the trading firm taking the loss into account.
Numerous variations exist. A firm may allow a customer to put down a risk deposit and trade in simulation mode, with an option to move up to trading a live book with a profit split if profitability and risk management guidelines are met during the trial period. Otherwise, the firm is entitled to the risk deposit to compensate them for the use of software, data feeds, and trading room access. At the same time, the customers are cross-sold education packages on trading strategy and psychology, which is offered as an option as opposed to a requirement.
This particular variation has the appeal of attracting experienced, home based traders who may otherwise balk at paying for a trading education service.
These alternate proprietary trading models achieve three things. First, a new revenue stream that is fairly diversified from brokerage income. Second, the potential benefits of proprietary trading with lowered risk: firms can find and nurture trading talent and even put to work experienced traders without incurring salary costs while buffering their losses. Third, if the customer is receiving regular payouts from trading, there is less concern about the custodial arrangements of the firm. In the event of financial insolvency, the customer is not at risk of losing own trading capital, only the most recently accumulated profits. Thus the customer is experiencing the benefit of risk reduction as well.
One of the biggest challenges in setting up such a model is establishing a reputation as a reliable provider of educational services and proprietary trading opportunities with the target customer base.
THE CYPRUS EDGE
Cyprus has potential edges in this area that it can effectively exploit. It has an educated international workforce with contacts and experience that can be effective in growing a sizable global customer base, including in the U.S. There are also a respectable number of Cypriot and Eastern European proprietary traders with successful track records who would make good trading instructors, especially in Forex.
Cypriot brokerages also have an edge in attracting a less capitalised clientele than their American counterparts due to their ability to offer Contract For Difference trading in addition to Forex. CFDs permit less capitalised clients exposure to the futures and equities market which would otherwise be outside of their reach had they used traditional exchange traded products. A firm that wishes to attract new proprietary futures and equities traders could offer considerably lower risk deposits with CFDs than firms that are forced to stick to exchange traded contracts for regulatory reasons.
Assuming no serious regulatory hurdles exist to establishing such a business model, Cypriot Forex brokerages would be wise to leverage their unique position within an international EU based financial hub to attract this new, diversified stream of revenue.
George Selinsky is an independent financial market analyst and proprietary trader based in New York City. He holds an MBA in Finance from Baruch College with Beta Gamma Sigma honors. He can be reached at GSelinsky@gmail.com
Get all the latest news and videos in your inbox. Register FREE