Are You Gobbledybooking Me?

Are you gobbledybooking me, Mister?

These last few months, a hitherto unknown word has been making waves, so much so that US authorities themselves have thought it wise or savvy to express their opinion about it.

The word is b-book. You saw it here first.

For about 10 years, a not so well kept secret was that if a retail FX operation really wanted to make money, it should not or almost never hedge its clients positions. As many retail clients may not have the required professionalism or discipline, so the story says, not hedging them is just the way to go. The stop-losses of the customers become the take-profits of the retail operator. You can even guarantee stop-losses, which makes you look good. Hence the a-book was the book of deals to hedge, because these are perceived to get it right, and the b-book is for everybody else., and where the real gravy comes from.

The official line is that positions are not hedged so that buyers hedge sellers and the operator earns the spread whilst still hedging customers. This is partly true. However, most of the time,positions are simply warehoused and everyone hopes for the best.

As the Soviet used to say of capitalism : this business is rotten, but what a great smell.

At first, this was done without much of systems to control what the operators position was. Alas, retail clients, once in a while, will get it collectively very right, as, e.g., during the financial crisis. This was partly the cause of some of the consolidation we have seen in the sector. Today, b-booking is done in a much more sophisticated way, with algos kicking in to hedge positions or maximise returns.

But before going there, let us look at what b-book really means: it just means a client deal is left unhedged for a while at least. First, any trading desk is b-booking its customers at least for a short while. Many of the prices made to customers are narrower than what can be hedged straight away. These deals can only be hedged if customers buy and sell at the same time, which only happens in very active operations and not all the time, or if the trader is savvy enough to bid below the sale price and get given, or already has a position he hedges against.

So, narrow spreads are often achieved with at least a little of b-booking.

But even the most nefarious rationale behind b-booking, i.e. clients do get it wrong most the time, is useful in this respect. We can say that narrow spreads, which could create losses for the operators, are in a way financed by the less lucky clients. Fortune favours the astute. This is so much true that in the institutional world, clients look for bank having reverse views so they get a better price.

So when authorities set up rules that all client deals will need to be hedged in the future, they should perhaps spend some time thinking about the effect on spreads.

The saga goes further: eager to say that b-book is not a good word anymore, some operators now hedge all of their clients deals, only pocketing small commissions. Operators can swear that they do not b-book anymore, no no Sir.

But... they hedge it with banks providing them with extremely very narrow spreads, which are only for them. We are even hearing of rebates from banks for this business.

So look dad, no hands : now you see it, now you dont.

The truth of all market is that they are a bridge where willing sellers meet willing buyers. As long as all clients is treated fairly, which is the case in most electronic platforms, the fact that not hedging some positions improves the spread should be seen as a benefit, not a fault, of OTC markets.