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One of the big hurdles for prop firms so far has been managing risk.
The basic model is quite simple. People pay for challenges. If someone passes a challenge and gets a payout, the prop firm pays them from the revenue generated by challenge fees.
The problem here is obvious. If someone is trading on a ‘funded account’, they have the potential to make a huge profit, which is in turn a huge liability for the prop.
Indeed, if that profit is of a significant size then the prop can end up having to pay more than they are earning (or have earned) from challenge fees.
This is presumably becoming tougher due to increased competition in the sector, which means more spend on marketing and a drive to offer lower fees for larger account sizes.
Combined, these reduce overall revenues and mean there is more pressure on your balance sheet and thus your ability as a firm to pay out to traders. Not a good scenario to be in.
We have looked previously at how this model operates by examining FTMO’s finances. The situation at the company seems to be that they payout just shy of 50% of revenues to traders.
As costs at the firm are much, much lower than they would be at a broker, this is not such a problem. However, there are a couple of obvious risks. One is that you get someone that gets a huge payout that massively increases the payout ratio. The other is, as noted above, you see increased marketing costs and/or other administrative expenses that cut into margins.
FTMO is also the biggest ‘brand’ in the sector too, meaning they probably have a better payout ratio than many of their peers because they are likely to benefit from more organic traffic and revenue.
The result of all of this whole impasse is that you really have two options. One is to reduce payouts in some way. The other is to somehow derisk anyone that passes your challenges.
With regard to the former, the most obvious way to do this is to just make the challenges harder. This has its own limitations because there is competitive pressure to make challenges easier to attract more clients.
Another big factor is to reduce fraud and scam payouts.
TradeInformer understands that one prop has been touting a model that can reduce payouts to 15% of overall revenues by removing scammers. How accurate these claims are remains to be seen.
Indeed, one rival prop exec that TradeInformer spoke to recently looked longingly into the distance as we discussed this very point.
“15% brother,” he said (or at least I think he did). “It seems impossible.”
Anyway, the basic problem is that, although there are things you can do to limit payouts, they have limitations themselves. There is probably some nice ‘delay’ strategy that you can use to do it but some of you have ‘morals’ and ‘values’ and stuff like that.
That basically leaves you with the other option, which is to try and derisk the people who are trading with you. And this model does seem to be becoming more popular.
In the last month, we’ve seen Alpha Capital launch live accounts for trading. FunderPro has done it for a while, so too has Fuze Traders.
This week we also saw BullRush launch A-book accounts where you actually see who your trade was executed against, assuming you make it to the funded account stage.
The potential problems here are two-fold. One is that giving people a funded account eats up a lot of capital, which you have to put down as margin with your brokers / LPs.
The other is that you could end up in a situation a bit like handing a bazooka to a 10 year old. You are giving someone the ability to trade in huge notional volumes, when they could easily blow up. And if they do, then you are on the hook for it.
With regard to the latter, you can remove the problem by basically setting a maximum loss of whatever drawdown limit you ascribe to the funded account.
In theory this would mean that your potential loss is known and capped at whatever that drawdown limit is. It might be annoying that you lose that money, but you don’t have to worry about a huge potential payout. Plus if you are working with an LP, it’s plausible you could have some kind of rebate agreement where you recoup money that gets lost.
The eating up of capital is a problem that is harder to remove. However, it might be that, as a prop, you just look at that and think it’s a price worth paying for not having to deal with sleepless nights. Yes you are having to put down a lot of margin, but that is probably a better situation to be in than having to worry if you’ll have enough fees coming in to cover your liabilities.
Ultimately we’ll see what happens but it seems as though something like this mechanism will work. It also has obvious branding benefits. If you are able to say you are a-booking everything, it’s kind of like the whole ‘STP’, ‘ECN’, ‘no dealing desk’ marketing language you’ve seen for over a decade in the broker space. Let’s see what happens.