Running a brokerage business requires vigilant awareness of market risks. Several critical factors deserve careful consideration; in this article, we will look at these factors to be able to limit their negative impact on the development of businesses. First, Black Swan Events, rare and unpredictable occurrences with profound economic consequences, challenge conventional wisdom and demand preparedness. Additionally, Low Liquidity Instruments pose challenges for B-Book model brokers due to volatile price movements caused by scarcity in liquidity. Moreover, dealing with White Whales- large traders whose extraordinary trades influence the market significantly, necessitates risk management to protect balance sheets and ensure market stability. Lastly, the peril of Concentrated Flow among traders highlights the need for hedging and risk management strategies to mitigate potential losses when clients overwhelmingly trade in one direction. Understanding and addressing these risk factors should empower brokers and traders to navigate the forex market.
Black swan events
Black swan events are rare and unpredictable events that have a major impact on the economy. They are often considered highly improbable or impossible based on past experiences or data. Black swan events can have severe consequences, including economic downturns, political upheavals, or technological disruptions. Due to their unexpectedness and the lack of preparation for their occurrence, this kind of event can have a disproportionate impact to the whole market and, from a broader perspective, an entire civilisation. They can result in significant changes to the status quo, including changes to societal norms, business practices, and political structures.
The most famous black swan event, the effects of which we still do not fully realise, is the Covid-19 pandemic. The pandemic was a rare and unpredictable event that had a major impact on the global economy. It caused widespread economic disruption, leading to job losses, business closures, and a decline in economic activity. The pandemic also had a significant impact, from which we are just emerging as a society. Many people will have to deal with the consequences throughout their lives. Other examples of the black swan event would be 9/11 attack, the unexpected outbreak of WWI, or the October Revolution.
Black swan events are a reminder that the future is uncertain and that there are always risks that we cannot predict. However, by understanding the potential impact of black swan events, we can better prepare for them and mitigate their negative influence, for example, by hedging some of our market exposure.
Low liquidity instruments
Brokers that use only a B-Book model are at risk from instruments with small liquidity. These instruments are rarely traded by a broker’s clients, but their low liquidity can cause massive volatility in extreme situations. To avoid the risks associated with these exotic symbols, it is worth hedging them.
Liquidity and volatility are inversely related. When liquidity is low, volatility is high. This is because there are fewer buyers and sellers in the market, which makes it more difficult to trade without moving the price significantly. As a result, the price of an instrument with low liquidity can move very quickly in either direction, making it difficult to predict.
In addition, instruments with low liquidity often exhibit a phenomenon known as “thin trading.” This means that the price of the instrument may move in a narrow range for a long period of time before suddenly making a large move. This can be very deceptive for traders who rely on historical price data to make their decisions.
For these reasons, it is important for brokers that use a B-Book model to carefully consider the liquidity of the instruments they offer to their clients. If an instrument has low liquidity, it is worth hedging to reduce the risk of large losses.
Here are some additional tips for brokers that trade instruments with small liquidity:
- Use a risk management system that takes liquidity into account. This will help you to avoid taking on too much risk when trading these instruments.
- Be aware of the potential for thin trading. This means that you should be prepared for the price of the instrument to move suddenly and unexpectedly.
- Use hedging strategies to reduce your risk. This could include using stop-losses, limit orders, or spreads.
White whales
A white whale is a large trader who makes extraordinary trades that can have a significant impact on the market. These traders are often institutions, such as central banks or hedge funds, but they can also be individuals with large sums of money to invest. Brokers that trade with whales face significant risks. Whale trades can have a disproportionate impact on a broker’s balance sheet and can destabilise the market. To mitigate these risks, brokers should carefully manage the size of individual trades and require whales to provide additional collateral.
In addition to these measures, brokers should also get to know their whales and monitor their activity closely. By understanding the whales’ trading strategies and risk tolerance, brokers can better assess the risks associated with each trade. By following these tips, brokers can help to manage the risk of whale trades and protect their businesses from potential losses.
Here are some of the specific risks associated with whale trades:
- Large losses. If a whale makes a large loss, the broker could be forced to close out other client positions in order to meet its margin requirements. This could lead to cascading losses for the broker and its clients.
- Market instability. Whale trades can also destabilise the market. If the whale is making large bets in one direction, it can create a self-fulfilling prophecy. Other traders may see the whale’s position and start to trade in the same direction, which can further amplify the market move.
- Fraud. Whale trades can also be used to commit fraud. For example, a whale could make a large trade in order to manipulate the market and then profit from the resulting volatility.
The Risk of Herd Mentality- Concentrated Flow
In forex trading, it is important to be aware of the risk of herd mentality. This is the tendency for traders to follow the crowd, often without thinking critically about their own trading decisions. When all of a broker’s clients are trading in the same direction, it can pose a risk similar to big trades of a “whale”. Because the broker’s exposure to the market is concentrated in one direction, in the scenario that the market moves against the broker, it could suffer large losses. To mitigate this risk, brokers should monitor their risk on a daily basis and hedge their exposure when it is not balanced.
Hedging is a risk management strategy that involves taking a position that offsets the risk of another position. For example, if a broker’s clients are all trading long EUR/USD, the broker could hedge its exposure by shorting EUR/USD. This would reduce the broker’s risk of losses if the market moves against EUR/USD.
If you want to mitigate the risks connected with the concentrated flow, you can consider:
- Educate your clients about the risks of herd mentality. Help them to understand that it is important to make their own trading decisions and not just follow the crowd.
- Offer a variety of trading products and services. This will give your clients more options and make it less likely that they will all be trading in the same direction.
- Use risk management tools. These tools can help you to monitor your risk and hedge your exposure.
