Back to the Future: The Rise of Carry Trades

Retail FX Brokers can optimize their market making revenue in a far better way than just A book/B book.

The FX trading business is about to undergo some major shifts in customer behavior that will require many adjustments by brokers.

For those too young to have been in the FX business before the 2008 Financial crisis, interest rate differentials between USD and JPY were 6%+, and GBP, AUD and NZD differentials were even higher. There were lots of customers who traded purely to earn the daily rolls. Those customers typically used 5 to 10X leverage and held onto positions for weeks not hours.

Lower leverage meant that they held those positions through most smaller moves and were only stopped out during major swings. In many pairs, interest rate differentials meant there were always one-way open positions and a lot more herd-like behavior.

Customers compared brokers on overnight rollover payouts as much as they did on spreads. Carry trade customers typically carried higher balances, were older, and tended to be more profitable than those who day traded with higher leverage.

Post-financial crisis as interest rate differentials disappeared, most carry trading disappeared apart from emerging market currencies, but those volumes were a tiny fraction of what carry trades entailed when G7 currencies were involved.

With individual trader participation far higher in 2022 than in 2007 and interest rates marching ever higher, it's expected that carry trades will once again become the norm in the retail fx market as they already are amongst buy-side macro funds. Brokers will need to adapt as traditional B-book trading will not work in monetizing this flow. It would be suicidal not to hedge a position that will stick around for weeks and months paying out daily interest.

To be competitive brokers will have to offer fairer rolls to customers, and it means they will have to get more competitive rolls from PBs and PoPs. There will be less two-way flow and MUCH larger open positions.

One benefit to FX brokers will be the attractiveness of FX as an asset class will increase tremendously amongst more mainstream investors and FX trading will be far easier to sell when it looks more like fixed-income investing with higher success rates than day trading. The other big benefit will be that revenues from overnight rolls will be far higher than today as a percentage of the total and that will increase profitability overall.

The following challenges will arise:

• Customer profitability of carry traders, one-way positions, and interest payouts will render the B Book useless for many pairs. This is especially true in jurisdictions that restrict leverage.
• A book flow will be profitable yet skimpy per trade. LPs will love when customers are entering positions but will choke on large position margin calls when the herd in mass is forced out of positions, leading to many disputes.
• News trading will make a major comeback as the FX market will be held hostage to the whims of central bank policy, therefore, every econ data point will move the market.
• Overall volatility will increase and together with larger open positions challenge most brokers' overly lenient leverage extension policies as a potential for negative balance increases for highly leveraged traders.
• Competitive rolls will have to be market standard in any FX offering on the retail and wholesale side.
• Brokers will need to secure large NOP (net open position) limits to take this business.
• As customers are attracted to more carry trading strategies emerging market currencies with double-digit yields will become increasingly attractive.

The winners in this new age of FX trading will be those that adapt to the new world of trading and do not cling to what worked in the past ten years. TTs' new PriceOn market-making product is perfectly suited to this return to proper market-making that this new era will usher in FX.

Retail FX Brokers can optimize their market making revenue in a far better way than just A book/B book. Five to ten times the P/L of an A book can be captured without taking the risk of a B Book. Holding inventory risk for minutes as opposed to hours or days significantly lowers P/L variability.

Drew Niv is the CEO of TraderTools, read more of his articles here.