Gain Capital’s revenue-per-volume drops 37%(!) in Q4

Was this a one-time drop, or more indicative of a downward trend in Forex industry profitability?

LeapRate Analysis: In its recently-announced results for the fourth quarter of 2010, Gain Capital (Forex.com) announced a healthy 29% increase in average monthly trading volume, at $157 billion per month in Q4 versus $122 billion in the first three quarters of the year.

With such growth one would expect a nice rise in revenues. However, Gain Capital’s Q4 trading revenues of $39.7 million were surprisingly 19% below the company’s $49.2 million average through the first three quarters. Doing some more math, this means that Gain’s revenue-per-trading-volume dropped precipitously by 37% in Q4, with the company earning just 1.7 pips per (round-trip) trade, versus 2.7 pips in the first nine months of the year.

On Gain’s investor conference call, the company blamed this drop on having less ability to “match” trades internally during Q4, requiring the firm to move/hedge trades outside the firm, thereby cutting into revenues. This inability to match – supposedly caused by most client trades being on the “same side” of the market – may or may not be true, but as an explanation for such a large drop in expected revenues we simply do not buy it. We believe that there likely are other, more powerful forces at play within Gain and the industry at large which may have led to the drop. In particular, we offer the following possibilities:
 
1) The double-edged sword of institutional clients – Gain did a great job of building an institutional business in 2010 (see our March 3 report), where others failed. With the launch of Gain GTX, institutional volume grew to 22% of Gain’s overall trading volume by Q4, up from practically nil at the beginning of the year. Quite impressive. However, the flipside of institutional volumes is that they are significantly less profitable than retail volumes. Institutional traders demand (and get) lower spreads than retail clients. And institutions tend to trade in a more disciplined way, and on average lose less to the market maker than retail clients.

2) US leverage limitations – More than its main competitor FXCM, Gain relies on US-based clients, with only about half of its volume coming from international traders (FXCM does about 75% of its volume abroad). As such, we expected the new 50:1 US leverage limits (on Forex major pairs, and 20:1 on all others), introduced at the beginning of Q4, to have more of an effect on Gain than FXCM. And, we believe that this is what happened. Although overall volumes were indeed healthy at Gain, we believe that volumes transacted at lower leverage levels are not as profitable for Forex market makers. At higher leverage levels, traders stand a much higher chance of being closed out of their positions, losing all of their equity to the broker. For example, at 100:1 leverage a trader will be closed out of his/her position if the market moves just 1% in the wrong way. At 50:1, that margin for error is doubled to 2%. In volatile markets with prices rapidly varying up and down – e.g. witness movements in the Japanese Yen over just the past week! (thank-you to Adam Kritzer and Forex Blog) – even a trader who is “correct” about the eventual movement in markets stands a good chance of losing his/her entire equity and being closed out of his/her position before the market does eventually move in the way expected.

3) Increased competition – As we remarked in our report last week on Saxo’s lower volume and revenue levels, we believe that the online Forex industry is, after years of near unabated growth, finally reaching the maturity and saturation phase in many key markets. And as in other industries, this phase of the business cycle usually means more price competition, lower prices for consumers, and lower margins for the companies. We feel that this trend will continue for several of the major Forex firms in 2011.