In the intricate world of financial trading, contract for difference (CFD) proprietary trading firms, popularly known as prop firms, face unique challenges, particularly in managing order flow and hedging risks. CFDs, by nature, allow traders to speculate on price movements without owning the underlying asset, making them highly attractive due to their leverage but also fraught with complexities for those managing these trades.
B-Booking and Order Flow Management
One of the lesser-known but crucial aspects of how CFD prop firms operate is the practice known as B-booking. Almost all, if not all, prop firms utilise a B-book model, where instead of passing client orders to the external market or liquidity providers (A-booking), they internalise these trades. This means that the firm becomes more of a data collector to the trader’s position, effectively “warehousing” the orders within their own systems.
“Based on my observations, the majority of prop firms are relying on internal order processing,” Brokeree’s Marketing Manager, Anton Sokolov, told Finance Magnates. “Although we are seeing a completely different model for brokerage-backed firms, B-book is still the favoured model by far.”
Sometimes, prop firms have to B-book the orders out of necessity as well.
“The amount of data you can collect from a trader before they’re funded is insufficient to make any decision,” highlighted James Glyde, CEO at PipFirm. “The rules required to enable a prop firm to operate an A-book model would be highly unpopular with the average trader.”
The advantages of B-booking for the firms include reduced execution costs, as no real market transactions occur, and the potential to profit from customers who lose the fee paid with little risk to the firm.
Challenges of B-Book
However, this model of B-booking the traders introduces several challenges.
One of the key challenges is risk concentration. By not hedging or passing client trades to external liquidity, CFD prop firms assume all the risk associated with these positions. The firm could face considerable financial exposure if a significant portion of its client base trades in the same direction, especially with leveraged trades.
As the participants mature in the marketplace, nefarious behaviour has become more frequent. An influx of so-called “finfluencers” have figured out ways and methods to pass prop firm accounts with zero risk in an attempt to gain a following by posting passing and payout certificates all over social media. This type of trading behaviour is random, and it is not really possible to effectively A-book as it holds no alpha. The only solution a prop firm really has is to remove this user from their database and prevent them from further purchases.
“Upon entering the space, we thoroughly researched who the participants are in the niche and their behaviours. We spoke to some industry veterans to get an understanding of what to expect from the traders and looked at solutions prior to entering,” said Siju Daniel, CCO of ATFX and their proprietary trading arm ATFunded.
“It is important that anyone entering the space doesn’t do so blind; the types of order flow that a company can experience are vastly different to a brokerage, so having an idea of what to expect is key. The industry really cannot tolerate more bankruptcies.”
Conflict of Interest and Hedging Risks
The B-booking model, while legally permissible in many jurisdictions where CFDs are regulated, often draws criticism for potentially conflicting interests. Here, the firm’s profitability might inversely correlate with client success, leading to ethical concerns about transparency and fairness.
It is important that firms enter with the right intentions. Future regulation may look towards what plans for a firm’s order flow and ability to execute it rather than simple capital requirements.
Hedging is a critical strategy for managing risk, but this becomes a complex endeavour for CFD prop firms.
When using a B-book model, traditional hedging becomes more about internal risk management rather than external market offsetting. The firm might use other internal positions to hedge or rely on predictive analytics to manage exposure, but this internal approach doesn’t always align perfectly with real market movements.
Further, there are volatility and exposure risks as well. CFDs are leveraged products, amplifying both potential gains and losses. If the market moves against the firm’s net position significantly, especially in times of high volatility, the risk can escalate quickly due to the absence of natural hedges from external market interactions. The brokerage industry is extremely familiar with this scenario when the EURCHF cap was removed, and the currency moved 30%.
Notably, the risks of the prop firms are much higher than those of CFD brokers.
In a typical scenario, suppose a funded trader has paid $500 for a 100k challenge and passed the first time. Their maximum loss is 10%, and their profit share is 80%. If that trader makes a 5% profit, they’ll receive $4,000 (700% ROI), and the firm has $1,000. Suppose the trader breaches their account by losing the 10% max loss. The firm is down $9,000, while the trader is up $4,000.
“Once a trader is funded, even with a large number of funded traders, the risk is skewed towards the firm, while the profit is skewed towards the trader,” Glyde added. “The most likely risk (trader failing) has a fixed limit, while the unlikely risk (trader making over 10% profit) is unlimited. While the risk is unlimited in a typical B-book CFD, props cannot transfer risk as CFD brokers can.”
Data Utilization for Revenue: The Two-Fold Challenge
Prop firms need sophisticated tools to predict market movements and manage internal risk. The data they collect from client trades should ideally inform these predictions, but the correlation between client behaviour and market movement isn’t always straightforward. This predictive capability is crucial for revenue but is often limited by the quality and quantity of data and the algorithms used for analysis.
Prop firms will need to adopt almost ‘data fitting’ rules to use the data over the long term accurately and allow systems to grow with the user base, knowing that data fits into pre-set parameters that the system is familiar with.
While firms collect vast amounts of trading data, converting this into revenue without directly competing with clients (which could conflict with their business model) is tricky. The most likely scenario for monetisation is successful dealing methods to offset the money-in-to-payout ratio. Most of the fallen prop firms would not have fallen if only they had a portion of their outflows covered from other sources.
“The main risk is that the company cuts out additional revenue sources and has to rely on fees collected from trading challenge sales and other services,” Sokolov added. “Whereas firms that hedge b-booked trades in one way or another are able to benefit from the traders activity directly. That’s why we’ve seen so many brands close down due to insolvency after being unable to pay out traders profit splits – they only had a single source of revenue.”
“However, running a B-book first firm does not mean a company is destined to fail as long as they are aware of the money ins and outs of their business or are hedging their risks for the symbols high exposure.”
CFD prop firms operate in a niche where they must balance the allure of high leverage with the inherent risks of managing order flow and hedging. The B-booking strategy, while profitable, complicates traditional risk management practices, requiring firms to innovate in how they use data, manage internal risk, and maintain ethical standards. The sector continues to evolve, with firms seeking new ways to leverage technology and data analytics to navigate these challenges while ensuring sustainable business practices. As larger, more sophisticated players enter the marketplace, the industry moight be on the verge of seeing a disruption to an otherwise tired marketplace, bringing new participants into the hands of old professionals.
In the intricate world of financial trading, contract for difference (CFD) proprietary trading firms, popularly known as prop firms, face unique challenges, particularly in managing order flow and hedging risks. CFDs, by nature, allow traders to speculate on price movements without owning the underlying asset, making them highly attractive due to their leverage but also fraught with complexities for those managing these trades.
B-Booking and Order Flow Management
One of the lesser-known but crucial aspects of how CFD prop firms operate is the practice known as B-booking. Almost all, if not all, prop firms utilise a B-book model, where instead of passing client orders to the external market or liquidity providers (A-booking), they internalise these trades. This means that the firm becomes more of a data collector to the trader’s position, effectively “warehousing” the orders within their own systems.
“Based on my observations, the majority of prop firms are relying on internal order processing,” Brokeree’s Marketing Manager, Anton Sokolov, told Finance Magnates. “Although we are seeing a completely different model for brokerage-backed firms, B-book is still the favoured model by far.”
Sometimes, prop firms have to B-book the orders out of necessity as well.
“The amount of data you can collect from a trader before they’re funded is insufficient to make any decision,” highlighted James Glyde, CEO at PipFirm. “The rules required to enable a prop firm to operate an A-book model would be highly unpopular with the average trader.”
The advantages of B-booking for the firms include reduced execution costs, as no real market transactions occur, and the potential to profit from customers who lose the fee paid with little risk to the firm.
Challenges of B-Book
However, this model of B-booking the traders introduces several challenges.
One of the key challenges is risk concentration. By not hedging or passing client trades to external liquidity, CFD prop firms assume all the risk associated with these positions. The firm could face considerable financial exposure if a significant portion of its client base trades in the same direction, especially with leveraged trades.
As the participants mature in the marketplace, nefarious behaviour has become more frequent. An influx of so-called “finfluencers” have figured out ways and methods to pass prop firm accounts with zero risk in an attempt to gain a following by posting passing and payout certificates all over social media. This type of trading behaviour is random, and it is not really possible to effectively A-book as it holds no alpha. The only solution a prop firm really has is to remove this user from their database and prevent them from further purchases.
“Upon entering the space, we thoroughly researched who the participants are in the niche and their behaviours. We spoke to some industry veterans to get an understanding of what to expect from the traders and looked at solutions prior to entering,” said Siju Daniel, CCO of ATFX and their proprietary trading arm ATFunded.
“It is important that anyone entering the space doesn’t do so blind; the types of order flow that a company can experience are vastly different to a brokerage, so having an idea of what to expect is key. The industry really cannot tolerate more bankruptcies.”
Conflict of Interest and Hedging Risks
The B-booking model, while legally permissible in many jurisdictions where CFDs are regulated, often draws criticism for potentially conflicting interests. Here, the firm’s profitability might inversely correlate with client success, leading to ethical concerns about transparency and fairness.
It is important that firms enter with the right intentions. Future regulation may look towards what plans for a firm’s order flow and ability to execute it rather than simple capital requirements.
Hedging is a critical strategy for managing risk, but this becomes a complex endeavour for CFD prop firms.
When using a B-book model, traditional hedging becomes more about internal risk management rather than external market offsetting. The firm might use other internal positions to hedge or rely on predictive analytics to manage exposure, but this internal approach doesn’t always align perfectly with real market movements.
Further, there are volatility and exposure risks as well. CFDs are leveraged products, amplifying both potential gains and losses. If the market moves against the firm’s net position significantly, especially in times of high volatility, the risk can escalate quickly due to the absence of natural hedges from external market interactions. The brokerage industry is extremely familiar with this scenario when the EURCHF cap was removed, and the currency moved 30%.
Notably, the risks of the prop firms are much higher than those of CFD brokers.
In a typical scenario, suppose a funded trader has paid $500 for a 100k challenge and passed the first time. Their maximum loss is 10%, and their profit share is 80%. If that trader makes a 5% profit, they’ll receive $4,000 (700% ROI), and the firm has $1,000. Suppose the trader breaches their account by losing the 10% max loss. The firm is down $9,000, while the trader is up $4,000.
“Once a trader is funded, even with a large number of funded traders, the risk is skewed towards the firm, while the profit is skewed towards the trader,” Glyde added. “The most likely risk (trader failing) has a fixed limit, while the unlikely risk (trader making over 10% profit) is unlimited. While the risk is unlimited in a typical B-book CFD, props cannot transfer risk as CFD brokers can.”
Data Utilization for Revenue: The Two-Fold Challenge
Prop firms need sophisticated tools to predict market movements and manage internal risk. The data they collect from client trades should ideally inform these predictions, but the correlation between client behaviour and market movement isn’t always straightforward. This predictive capability is crucial for revenue but is often limited by the quality and quantity of data and the algorithms used for analysis.
Prop firms will need to adopt almost ‘data fitting’ rules to use the data over the long term accurately and allow systems to grow with the user base, knowing that data fits into pre-set parameters that the system is familiar with.
While firms collect vast amounts of trading data, converting this into revenue without directly competing with clients (which could conflict with their business model) is tricky. The most likely scenario for monetisation is successful dealing methods to offset the money-in-to-payout ratio. Most of the fallen prop firms would not have fallen if only they had a portion of their outflows covered from other sources.
“The main risk is that the company cuts out additional revenue sources and has to rely on fees collected from trading challenge sales and other services,” Sokolov added. “Whereas firms that hedge b-booked trades in one way or another are able to benefit from the traders activity directly. That’s why we’ve seen so many brands close down due to insolvency after being unable to pay out traders profit splits – they only had a single source of revenue.”
“However, running a B-book first firm does not mean a company is destined to fail as long as they are aware of the money ins and outs of their business or are hedging their risks for the symbols high exposure.”
CFD prop firms operate in a niche where they must balance the allure of high leverage with the inherent risks of managing order flow and hedging. The B-booking strategy, while profitable, complicates traditional risk management practices, requiring firms to innovate in how they use data, manage internal risk, and maintain ethical standards. The sector continues to evolve, with firms seeking new ways to leverage technology and data analytics to navigate these challenges while ensuring sustainable business practices. As larger, more sophisticated players enter the marketplace, the industry moight be on the verge of seeing a disruption to an otherwise tired marketplace, bringing new participants into the hands of old professionals.
This post is originally published on FINANCEMAGNATES.
