Why #Francogeddon Will Kill the FX Broker Model

  • Bernard Lunn
  • January 18, 2015
  • 1

The Broker model is the heart of Wall Street. Brokers take a risk-free fee for executing a transaction. It has been a wonderful cash cow. As this book asks, “where are the customer’s yachts?”

So why have many foreign exchange brokers gone bankrupt (and others lost most of their equity) after the Swiss National Bank (SNB) dropped their peg to the Euro, thus sending the Swiss Franc soaring by 30% in a matter of seconds?

The answer (as usual when discussing Wall Street crashes) is…leverage. Historically Fiat currencies move against each other by only a small % each day. A 1% swing in a day is headline stuff. So speculators make money on small changes by leveraging (borrowing to amplify the trade). Brokers vary by how much leverage they will offer (this site has the basics). A swing of 30% means that speculators who assumed the Franc would stay pegged to the Euro (which most did) lost 30%. Leverage that up 10x (considered conservative), means they lost 300%. Which means the trader lost 100% and their broker lost 200%. In the best scenario, this means the broker loses a ton of money and may go bankrupt. In the worse assumption, the broker raids client funds (illegal but it has happened). In the worst case, taxpayers bail out the brokers. So far, only speculators and brokers have suffered, which is just a free market operating as normal.

Of course, #Francogeddon is a Black Swan and Black Swans do not come often. However, you can count on Black Swans coming; you just don’t know when and from where. So the model has to change.

The Broker model is fundamentally flawed in a world of Black Swans.

The alternative is Blockchain based. One company that is working on this is Ultracoin. They point out that any lending to support leverage happens outside the Blockchain. This means no systemic risk. In a Black Swan, the money the trader puts into their Blockchain account goes and they have to repay their loan but that loan has nothing to do with the Blockchain.

 Blockchain trading separates the matching function from lending.

You do not need a Blockchain to do this. A broker could simply say, “no leverage allowed”.  That is theoretically possible, but practically highly unlikely because broking without the lending becomes unprofitable. The broker model has been slammed by two waves of change:

  • End of fixed commissions. This happened decades ago and simply opened the market up to competition.
  • Internet. This is what enabled the human broker to be replaced by servers and led to e-broking from firms such as eTrade, Charles Schwab and many others. This is a Moore’s Law race to the bottom that can only end in free (for example, Robin Hood).

Any broker who banned leverage would see their profits tank as volumes tanked. Yet if they keep leverage, they are in mortal danger from Black Swan events.

So, the real value of a Blockchain model is automation and lower cost, meaning that the “Blockchain Broker” (or Decentralized Autonomous Corporation or whatever we want to call it) can make money on tiny spreads at low volume.

To adapt what Bill Gates said about banking:

“There will always be broking. There might not be any Brokers”.

Broking will move to a zero cost model. The matching function will be totally automated using Decentralized Autonomous Corporation on a Blockchain. That will be a Free in Freemium. The Premium part will be services “up the stack” such as Personal Financial Management.

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