What do brokers consider toxic flow?

Toxic flow is a term to describe undesirable trading activity from traders, which affects brokers and market makers. The term toxic flow is subjective, as one person’s toxic flow may not be toxic to another, so the term is used to describe flow that is damaging or unprofitable to a particular business.

In this article, we will be breaking down what toxic flow is, the different types of toxic flow, and what brokers can do to avoid it.

If you are concerned about toxic flow, make sure to check out our list of broker risk management tools which you can use to identify toxic flow. 

Toxic flow definition

In simple terms, toxic flow is trading activity that results in losses for brokers or market makers. Brokers will have clients that use their processes, and these clients will be looking to make a profit via the broker’s services. However, some activity will result in manipulation and therefore negative results for the broker, as well as disrupt processes and activity for other traders. Brokers are looking to avoid this.

Traders considered toxic are essentially looking for ways to game the system and turn a profit at the expense of the broker or market maker. 

The below is a very good overall review by Sean Overton of what is considered toxic flow. Bottom line, it is when a broker or a bank finds it difficult to make money of the flow they are receiving. The video is from 2012 but the key points are still relevant:

Types of toxic flow

There are many different forms of toxic flow, and as stated earlier, what is considered ‘toxic’ is at the discretion of the broker and what is harmful to their business. Some brokers and market makers may be able to cope with more toxicity than others.

Toxic flow is often rooted in two factors: latency and coverage. By abusing dips in latency, traders can trade against market makers before other brokerages have caught up. If a trader has efficient internet speed and server connection, they can observe the market and identify brokers that are lagging behind and manipulate this to their benefit.

With vast coverage of the market, traders might have access to a lot more information than the broker. This means that the trader will be able to have an insight over the brokerage and potentially manipulate trades.

Here are some other types of trading that could be considered toxic flow:

1. High-Frequency Trading (HFT)

With high-frequency trading (HFT), traders can make a huge amount of trades within a split second by using advanced trading technology. Combined with excessive risk-taking, this can be destructive, as brokers and market makers will not be able to compete with the volume. There is also a further ethical issue of most brokerages and market makers not having access to such tools, therefore giving HFT users influence over the market.

Scalping could be considered a form of toxic flow, particularly if this is combined with high-frequency trading (HFT). A trader could use a broker that is marginally slower than competitors and execute trades instantly with unfair insight.

2. Latency arbitrage

As we covered in our article on latency arbitrage, traders take advantage of the latency between brokers and traders, often due to server distance or simply internet speed. This allows them to take advantage of the unofficial price differences that occur in fractions of a second.

3. Spoofing & pinging

Spoofing is a type of trading behaviour that involves placing a bid with no intention of fulfilment and then cancelling the order. The purpose of spoofing is to move the price of the security by giving the impression that it is being heavily bought or sold. 

For example, if a trader has multiple positions, they could theoretically place a huge separate ‘trade’ to spike interest, benefiting their other positions.

Pinging is where traders will place many small trades on an exchange to essentially detect the behaviour of the market. If the trades are filled instantly, the trader has revealed that there is likely a large amount of liquidity in the trade, often from a large investor. This can then be manipulated and used to make a profit.

The scale of toxic flow

All flow towarda a broker or market maker can be seen on a sliding scale from soft to toxic.  As stated earlier, toxic flow is subjective, as some brokers may be able to handle and profit from the activity of a client that another may consider toxic flow. This type of flow could be considered 'challenging' (but manageable) to some brokers, but 'toxic' to others who may not have the sophisticated tools to offset the risk generated.

Depending on the type of brokerage and market maker, as well as the specific sector, toxic flow may vary.

The safest form of flow is where there is no speculation and the processes are simple. For example, in the FX market, someone making a transaction via their bank because they are looking to purchase an asset abroad. This is considered 'natural' flow.  Here, the flow is organic and safe, the buyer is simply looking to make one transaction and make it efficiently, not necessarily at speed.

Sharp flow and high volume with multiple orders are where toxic flow generally occurs. What is agreed to be the most toxic form of flow is essentially anything that tries to game the system with either inefficiencies such as latency loopholes or market dominance with HFT. 

How to avoid toxic flow

Brokers can avoid toxic flow by implementing certain tools into their business. If the type of toxic flow can be identified, (using our broker risk management tools), then a solution can be identified.

Detection is a good way to avoid toxic flow before it happens. Trading algorithms can be used to detect and respond to potential arbitrage opportunities that traders could manipulate. Using these algorithms, the playing field can be levelled, and trades can be executed at the same time as latency arbitrage traders, and therefore mitigate their toxicity. 

Limits on trading times can also be effective when combatting latency arbitrage and HFT. As latency arbitrage and HFT take advantage of small price differences that exist for only a few milliseconds, limits on trading times (for example, trades closed within one minute), can be an effective way to block this type of trading.

If you are considering selling your brokerage, then identifying and eliminating toxic flow could be a necessity – although if you are offloading clients, then it might not be as much of a priority.

Aftermath charts are also often looked at by ECNs to determine whether a flow is toxic or not. Depending on the time and the ‘sharpness’ of the flow, the ECN will make an assessment of how toxic the flow is.

Conclusion

Brokers determine toxic flow based primarily on how it affects their business and the market. There are some clear examples of trading practices that create toxicity, but what is toxic to one broker may be acceptable to another broker. Toxic flow is slowly being weeded out by advanced detection tools that are able to identify toxic trading behaviours and put limits on particularly sharp trades.

At LiquidityFinder, we work to match you with the best liquidity provider possible. It takes just a few minutes to register with LiquidityFinder, and once you do, you’ll have immediate access to our exclusive network of liquidity providers, as well as gain access to tools such as our Match Matrix and our multi-provider request form. 

Stay up-to-date with our Insights too, where we update our audience on everything they need to know about liquidity, crypto and more.

Author

Caleb is a financial copywriter with a specialisation in fintech and forex. Former copywriter at Barclays and Paysafe. Contributing writer for LiquidityFinder. You can message Caleb here.