How inventory got its bad rap
Traditionally, enterprises viewed inventory as a way for a company to store value, and as a safety feature to ride out market fluctuations. It was perceived to be a good thing. That view has changed dramatically with the advent of information technology that made just-in-time (JIT) delivery possible. As I will explain, reducing inventory also reduces market risk. In FX, just-in-time delivery of currency rates holds the promise for FX brokers to eliminate a major headache that has been a source of major risk taking in the past: Internalization of deal flow. I think JIT will fundamentally improve the risk structure of a broker. Given the reduced risk, brokers will begin to divert their energy to marketing and sales with the eventual goal to lower their prices to the optimal level to maximize market share and overall profits, not marginal profitability.
Why holding inventory equals holding market risk
The simple truth is that inventory is costing you money in more ways than one. Obviously, it is tying up capital because there are costs associated with you acquiring products and holding them. It might be less intuitive that you also just bought yourself market risk, i.e. you are now on the hook for your product to sell as predicted. If it doesn’t, you will have to discount it later just to get rid of it. Because companies know all this, their initial go-to-market price needs to be higher to account for said risk, in addition to covering costs and a profit margin.
How just-in-time changed the world of retail
Many corporations especially in manufacturing and retail have embraced just-in-time as their inventory strategy. This is how it works: Only after a customer ordered a product from a major retailer, the product will be built to specs somewhere in the world by a third party, picked-up by a shipping company and delivered to its destination, all with JIT principles in mind. Not only does the retailer not own any of the inventory required to make the product, in fact, he never touches the product. The retailer focuses on innovation, marketing and sales. When it comes to execution, it relies on an ecosystem of third-party providers to handle the logistics of manufacturing and delivery.
Because the retailer never incurs market risk due to inventory, his initial go-to-market price can be lower. The more transparent and competitive the market is, the greater is the incentive for the retailer to pass on such gains to customers. This is a long winded way of saying Wal-Mart tends to sells stuff cheaper.
The retailer’s CEO loves JIT because better risk management makes turning a profit so much more predictable and achievable. Think about it: The unit costs of producing and shipping a product are known. Taking inventory and assuming market risk — the large unknown factors from the old way of doing business — are no longer part of the equation. Therefore, the unit price can be set in a way that it covers the costs and also includes a profit margin. The retailer is virtually guaranteed to make some profit every time the customer orders off the website. The retailer’s profits will ebb and flow with the success of his marketing efforts, but the fact that a product is only being delivered after a customer ordered it, fundamentally changes the retailer’s risk structure.
The promise of just-in-time for foreign exchange markets
Imagine a FX broker in Anytown, US. Its staff is mainly made up of sales people. What is missing is a large operations and IT organization. The broker relies on white label solutions to design a number of offerings that are tailored to a range of very specific customer profiles. Delivered on demand, these solutions serve the needs of every trader out there, from retail to large institutional and everything in between, and are by design flexible enough to change quickly if need be. As a result, name recognition is high and business is booming. The broker is focused on signing up customers. The actual facilitation of all trades, operations and customer support is handled by a third-party. The broker acts just as an agent. It never holds any position since trades are executed through a trading system that ensures direct market access. Direct market access is another way to describe that the broker never holds inventory, never takes on market risk. Uninhibited by market risk and related capital requirements, the broker is free to grow as fast and big as circumstances allow. If that sounds like fiction to you, let’s look at the mechanism behind TrueFX.
Just-in-time delivery offered as an on demand service
At a first glance, TrueFX brokers benefit from direct market access to interbank FX markets. While this is true and a great advantage for them, as important is that brokers have the option to have all their trading operations, customer training and support, managed by Integral as well. Because every trade is routed straight through and executed in the market, the broker never has to take on market risk (no dealing desk model). To increase the probability of successful trade execution, Integral has lined up liquidity providers and organized their liquidity, built the delivery network and orchestrated netting and clearing. All that a broker needs to do to ensure some level of profitability is to adjust the spread or the fee he’s charging in a way that it covers all fixed costs and includes a profit margin. Every time the system displays rates on the screen of the broker or his customers, Integral as the facilitator in fact has all but guaranteed the delivery of a given currency pair at the displayed price to the entity ordering it.
JIT — don’t try this at home
While JIT is a simple idea, it is not easy to implement. Case in point is Wal-Mart, a company that became a leader in the JIT delivery business in retail, as it became — by necessity — a trailblazer in related IT development and in the tracking and forecasting of customer behavior. Also, it’s an ongoing effort in both innovation and capital. Wal-Mart was at the forefront of taking advantage of the universal bar code, of electronic scanners at checkouts, and is doing it again with RFID technology. The company’s computing and database capacity remains second only to that of the U.S. Department of Defense. Therefore, only the largest players like Wal-Mart successfully took it upon them to develop a proprietary JIT system. The vast majority relies on third-party vendors to achieve the same thing. The arithmetic that drives these decisions in manufacturing and retail is also valid in FX markets. Rent vs. build is the smart way to go.
The last word must be about costs
Let’s look at the broker in Anytown, USA, again. Without holding inventory, the broker can keep his capital requirements low. Because the broker’s operations and IT infrastructure is largely provided by Integral as a shared infrastructure to many, many market participants, the broker’s operations costs are equally low. Since that infrastructure is delivered on demand as a service, its costs are a fixed fee. Setting a spread so that the broker’s fixed costs are covered is all that is required for the broker to start making money, every time a customer clicks on the buy or sell button. This puts the broker finally in a position to squarely focus on marketing and building their businesses.