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In his autobiography, Stuart Wheeler – the founder of IG Group – writes about an incident that took place in the first couple of years of the business.
A client took a position in silver equivalent to one third of a lot. You could only hedge one lot at the time and as IG had very little cash in the bank, the risk associated with hedging was arguably greater than it was by taking the other side of the trade. Note that at this point in time the risk would have been compounded by regulation. Because spread bets were regulated as a gambling product, any loss beyond margin put down would have been a legally unenforceable debt.
IG decided to take on the risk that the client was wrong, which ended up happening. My reading of the book is that the company finished the week with £30,000 in the bank and was up an additional £16,000 by the start of the next one. So keep in mind readers – many of you may only have jobs because two guys chose to b-book a client in the mid-1970s.
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The 1970s is also oddly similar to today. Inflation, Middle East kicking off, protests in Iran, gold and silver going crazy.
Much like another creation of the 1970s – Han Solo – for some reason I got a bad feeling about this year. There is too much mania and craziness and something feels like it’s got to go boom. I would add the caveat that I feel like this a lot of the time.
If you look back at the history of the industry, markets suddenly tanking tends to either be great (February 2020) or terrible.
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When it is terrible, it’s usually not because brokers are booking flow, but because they are hedging a lot and have a funding gap. For example, if you are offering 200:1 but can only get margin of 20:1 with your liquidity provider, the problem is obvious.
Almost every major industry shakeout has happened as a result of this funding gap. Back in 1987, IG and City Index both almost went bankrupt because of the ‘Black Monday’ crash. City Index almost went bankrupt again after the financial crisis.
Probably the most famous wipe out came in 2015, when the Swiss franc was unpegged from the Euro. Again, it was not b-book firms that got hit by this – it was companies that were hedging a lot of one way flow and could not offset the losses they had with their LPs against the gains they accrued from client trading.
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If you want to see the opposite of this then you can look at Plus500’s results from 2018. If you think back, the first quarter of that year saw one of the first big sell offs in bitcoin, when the market dropped about 60%. Revenues at the company went from $437.2m to $720.4m in a single year. Even now, if you were to remove acquisition-based revenues, 2017 would probably be their third-best year of business.
This is why it is better to just b-book up to a risk limit. Markets are random and traders are picking up pennies in front of a steamroller. When the market goes boom, then you make lots of money.
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What I wonder at the moment is if we are in a position where brokers are b-booking a lot but for two different reasons. If you are IG or Plus500 you have such a big balance sheet that you can keep booking flow and wait until a correction (like we saw in October).
Alternatively you should be hedging but your business model is so predicated on b-book revenue that you cannot afford to. More of these people are at risk and are on their knees, prostrating themselves and praying that gold (and silver) start crashing.
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However, if there are people in the same position that IG was back in the 1970s with silver – and the periods are weirdly similar in lots of different ways – then I wonder if we could see some impact this year from that same funding gap dynamic.
Nothing to do but wait and find out.
