an evolving business model

By Paul Towne, President of Back Bay FX (BBFX.com) an NFA registered IB/CTA since 2007.

Like many aspects of the foreign exchange business, the role of introducing brokers (IB) is rising in prominence, but it is an industry that has been experiencing a shake-up. While the basic idea has been around for some time, there remains confusion as to the value of using an IB and its role in forex trading – ultimately to be beneficial along the supply chain.

The most straightforward explanation of an IB is a company or salesperson that refers retail customers to brokers or futures commission merchants (FCMs) for a commission. Typically there is no cost to the retail client when using an IB as they are compensated by brokers. The brokers benefit from this outsourced sales force by gaining clients and IBs are able to generate income from their leads.

But this is a simplified version of the model and such a basic model has largely become obsolete over the past decade due to industry changes and the evolution of the retail FX client. Competition for clients has led the IB to expand the services they offer to include rebates, trading signals and an enhanced customer service.

Clients have in turn come to expect more from their IBs than just a referral to a broker. As the FX industry handles the sweeping regulatory changes which are a result of the global financial meltdowns, introducing brokers have been forced to adjust their business models. Those IBs who could not successfully react to the new market conditions have closed down, while others have moved to countries with more FX-friendly regulation.

A changing environment

This changing industry environment has resulted in more specialized firms who concentrate on particular products and solutions for their client base. In a market where brokers/FCM’s are seeing consolidation, IBs (along with the technology support firms) serve as the main innovators and developers of new products and trends.

In order to better understand the options available to clients, the IB market can be broken into general categories that describe the focus of an IB:

- Rebate brokers

- Customer Service Firms

- Trading Signals

- Social Media sites

- White Label Services

Rebate introducing brokers

Rebate IB’s are the largest and most saturated category in the IB space today. Rebates are the return of a portion of the IB's commission earned from the broker to the retail clients on a ‘per-trade’ basis. Paying clients rebates essentially reduces the spread, or their cost of trading. This model was started by IBs to attract clients with lower-cost offerings, but as the market evolves rebates are now also directly offered to clients by brokers and FCMs.

An example of how a rebate from an IB might work is as follows:

- A client places a 1.0 standard lot of EUR/USD trade and pays a spread of 1.8 pips

- The IB is compensated for the trade by the broker who gives the IB a portion of the spread paid by the client

- The IB then pays the client a portion of their IB compensation

The rebate would be calculated like this:

- The client receives $4.00 back per standard lot traded (standard lot = 100K of base currency)

- If the client trades 85 standard lots in a month, they would receive $340 in rebates

Thus, clients who receive rebates from IBs and brokers are saving money on each trade and reducing their transaction costs. Rebate programs can be beneficial especially for electronic and automated (EA) traders because of the larger volumes generally traded with automated systems.

However, IBs that are rebate-focused are generally competing on price and do not have attentive customer service or other value-added offers.

Akin to low cost airline carriers, customers get what they pay for. Rebates are an interesting marketing tactic. Brokers could just reduce the spreads paid by clients initially instead of having the clients pay a larger spread and then returning a portion. Clients would save the same amount of money in fewer steps and there would be less work for brokers.

This rebate model persists likely because clients are accustomed to it, and also because it may be more attractive to clients to feel like they are getting paid, rather than just ‘saving.’

Client service firms

A service-based IB can be thought of as a "forex concierge" for its clients, focusing on finding solutions that fit a client’s individual trading requirements. These types of IBs will typically offer other add-ons such as rebates and FX signal data, but attention to customer service is what differentiates them from their competitors.

Developing a comprehensive understanding of what customers need allows the service-based IB to identify the right broker for a client as well as additional services they might need to achieve their trading objectives. Generally a service-based IB’s relationship with brokers also benefits retail clients since the IB can help clients secure bonuses and other offers they would otherwise be unable to access.

"A service-based IB can be thought of as a "forex concierge" for its clients, focusing on finding solutions that fit a client’s individual trading requirements."

Service-based IBs also serve as advocates for their clients when there are trading issues, often allowing traders to solve a problem with just one phone call to their IB.

Clients who prefer to work with service-based IBs are typically people who would want to speak with a live customer service representative rather than cope with an answering service or set-up accounts exclusively through a website. These clients derive value from having a dedicated point of contact and the ability to reach them for problems and questions. Clients using these firms typically receive the benefit of a more "hand-holding" approach and a greater attention to detail than with other types of IBs. Service-based IBs can be a great asset for clients in terms of broker access and general market knowledge.

On the other hand, a disadvantage to the service-based IB may include a decreased level of rebate due to the added support clients receive. An FX client should contact both price-based and customer-service brokers to determine the value package when shopping for a broker.

Trading signals and social media IB’s

Social media and signal service providers/IBs are as new as the technologies they exploit and took the lessons from the successes of Facebook, Twitter and other social media sites, and applied the model to the forex market. IBs who were early adopters of social media trends in this field encouraged the sharing of trading ideas, sentiment and the performance of individual traders in real-time. These IBs gradually evolved into facilitating the sharing of signals from one user to another, allowing clients to "follow" fellow traders and directly mimic the trades in their own accounts. These services simulate traditional money-manager programs, without the larger minimum investment and commitment to a long-term strategy associated with commodity trading adviser (CTA) programs.

Clients have the ability to easily receive trade signals direct to their forex accounts from fellow traders by use of a Signal provider/IB. The signals can come from any number of traders, both new and experienced, and can allow for clients to diversify into multiple automated and discretionary programs.

Some drawbacks can include additional costs associated with technology fees and the risk of following traders' strategies without knowing experience or background. Clients should be careful to always test signal services by tracking them over a period of time to evaluate performance and risk before actually investing funds.

White Label Services

Most clients are not aware that their broker may be a "White Label" of a larger broker/FCM. White label firms are brokers who outsource their liquidity from an FCM and act as their own entity. They service all aspects of the client accounts just as a true broker would, including an operations department, trading account parameters, technology solutions, firm strategy and marketing. The difference from an genuine broker is that a white label firm does not actually clear trades or, in most cases, hold client funds.

In a market where regulatory agencies impose high requirements for broker net capital adequacy and complex reporting, a white label solution can offer an alternative and cost-effective soltion for smaller firms to follow an FCM/clearing house model.

Clients who use white labels get access to a new class of smaller more nimble brokerages potentially able to provide tighter spreads, client services, technology and the trading parameters that clients want. A good white label should have a considerable amount of control over their trading conditions and offer completely different services than their larger, more established FCM/Clearing counterparty.

One thing to consider when using a white label is the risk exposure to their counterparties. If the FCM that is behind the white label goes out of business or is closed down there could be issues with delays in the transfer of funds and new trading conditions associated with the FCM or brokerage to which they transfer existing client accounts. Clients should be aware of the brokerage actually clearing the trades so that they can evaluate these conditions.

How Do I Choose an IB?

For those traders who decide that working with an IB is good solution, there are factors to help make the correct choice.

Firstly, consider what services or offers are most important for trading: initially perhaps the client is most concerned about getting the lowest trading costs possible. It may be the client would prefer to use a professional's advice about what for investing or perhaps prefer to follow money manager trades.

By prioritizing items of a clients' trading ‘wish list’ first, it makes the process of researching appropriate brokers/FCMs easier, helping explain your needs to an IB. Another factor to consider is regulation and measures that may be taken to protect retail clients. Is your potential introducing broker registered and in good standing with a government regulatory agency? By choosing to use an IB, clients can save money, get assistance in navigating the FX market, access signals and benefit from promotions and value-added services.