Why Client Flow Needs to Be Matched Against Appropriate Liquidity Pools

Posted by Barry Flanigan on Jun 26, 2020 9:06:00 AM
Barry Flanigan

In a follow-up to my recent post on Aggregation & Spreads: The Race to Zero, I’d like to drill down on the best practices that we use to help brokers distinguish between true retail flow and institutional or proprietary trading flow.

How can they tell which is which, and what can they do to ensure they are receiving the appropriate liquidity for each?

liquidity pools client flow

‘Good’ and ‘bad’ flow?

First of all, it’s worth pointing out that, so long as you are able to identify and deal with malicious activity (as discussed in my previous blog post on toxic flow) there really are no such things as “good flow” and “bad flow”. Whether retail, institutional or high-frequency trading (HFT), the flow in and of itself is neither good nor bad, it just needs to be correctly identified and managed accordingly, so that it is routed to the appropriate liquidity pool.

Where problems start to occur for brokers is where they are unable to do this. Which, unfortunately, is a common situation in our industry.

Because many brokers don't have the ability to identify, manage and route different types of client flow, they end up lumping everything together and sending it all down the same pipe to their Prime of Prime (PoP).

And, if that PoP doesn’t distinguish between flow from institutional traders, HFTs and retail clients - and routes it all to the same liquidity pool rather than to bespoke liquidity pools created for each subset - the net result is that, before long, the quality of the downstream liquidity will deteriorate.  

Larger institutional traders for example, so as not experience slippage, need to be able to trade on larger top of book quotes, or full amount pools, versus the smaller type of book that PoPs would typically be quoting.

But perhaps more pernicious for the unwary broker, is where HFTs masquerade as retail clients or Expert Advisors (EAs) in order to gain access to retail spreads, which can cause those spreads to balloon before too long as Liquidity Providers (LPs) correspondingly adjust their prices.

For a more in-depth discussion on why LPs widen their pricing when faced with HFTs – and what this means for brokers - see our recent blog post - Re-Evaluating Prime of Prime

prime of prime checklist

‘Just the way things are’?

Brokers may believe that this is “just the way things are”. But this is absolutely not the case.

By using the correct systematic and quantitative methods to analyse client flow, it is perfectly possible to categorise it and route it accordingly, so that the appropriate liquidity is matched to each type of client business.

The good news is that brokers don’t need to figure out how to do all of this themselves. At IS Prime, our proprietary technology uses pattern recognition to look not only at the size and the frequency of trades, but also the aftermath and market impact of those trades, to determine what kind of flow the client is sending. From this pre-trade and post-trade analysis, we are able to categorise client flow and use intelligent algorithms to split and route the flow to bespoke streams that are specifically tuned for each subset of that flow.

Classifying flow in this way serves two purposes. First, it ensures that the LPs are not disadvantaged in any way, so they continue to provide us with the best possible spreads. Second, it gives brokers who trade with IS Prime the security of knowing that their clients will consistently receive competitive and executable pricing, regardless of which category they fall into.

In summary, although brokers might not have the tools and technology to be able to effectively control different types of client flow themselves, they are not disadvantaged if they trade with IS Prime who is able to take care of this for them. The net result is that they will continue to receive the best quality prices and executions for their clients.

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Topics: Insights