For every forex broker, each and every trade entered into by its customers represents exposure to market risk.
Market risk is the risk of a loss in a position caused by adverse price movements.
Because the forex broker is always the counterparty to your trades, it may decide to execute your trades internally or hedge your trades externally.
The term “hedging” refers to the process where a forex broker reduces market risk exposure by entering into a parallel transaction with another entity (a “liquidity provider”).
Rather than hedge every single trade, the most popular hedging policy these days is for a broker to hedge customer exposure on a net basis.
This is where incoming trades are internalized before any trades are externally hedged.
This hedging policy gives aggregate customer exposure the opportunity to offset itself before being hedged in the underlying institutional FX market.
- When one customer trades in one direction and another trades in an equal and opposite direction….the market risk exposure is offset.
- However, when customers trade in the same direction, market risk builds up for the broker. This risk is then reduced by hedging in the underlying market.
Risk limits, governed and assessed by the broker’s overall risk management policies, determine the maximum market risk that a forex broker can undertake.
To make these hedges, the forex broker deposits collateral (margin) with a counterparty. (Similar to how you post margin with the forex broker.)
This is important to know because posting margin means the broker has to put up cash (“margin”) with LPs they trade with. If one of these LPs were to fail and not be able to return the broker’s margin, the broker may end up in a perilous financial position where it may not be able to fulfill its financial obligations with its customers (like you).
This is why, when selecting the hedging counterparties (“liquidity providers”), the broker considers the competitive quotes offered, credit rating, the efficiency of service, reliability of technology, reputation, and financial standing.
For smaller brokers, they may not be able to choose their LPs as they solely rely on the services of a Prime of Prime (PoP) to hedge their trades and are limited to the LPs that the PoP grants the broker access to.
Unless stated by your broker, it’s important to note that a broker’s hedging practice may not totally eliminate risk to its customers.
Ask your broker for a written copy of its hedging policy.
The hedging policy outlines the procedures that it adopts to manage its exposure to market risk and discloses the counterparties with which it transacts to hedge that risk.
By asking for this, it will provide you insight into its hedging procedures so that you are better informed to assess the counterparty risk in dealing with your broker.
Remember, if your broker goes bust, your money goes down with it.
We’ve discussed the perils of counterparty risk in detail in the previous lesson, Where Are You Trading?
If your broker doesn’t want to disclose any of these details, it might be a good time to find a broker who will.
The only way a broker should earn your trust is through transparency.
Be suspicious of any broker who isn’t transparent with its hedging policy which should detail not only its hedging practices but disclose its hedging counterparties (its “liquidity providers”).
Summary
We have explored the basic mechanics of how brokers hedge and manage market risk.
We introduced a number of risk management concepts like “A-Book”, “B-Book” and different variants of “C-Book” that retail FX and CFD trading platforms may use.
Due to the high levels of ambiguity at which brokers tend to operate, we hope we have shed some light on what happens “behind the scenes” regarding how they manage their risk and make money.
Now you know that all retail forex brokers take the opposite side of your trade.
Your broker is the counterparty to ALL of your trades.
When a broker executes your trade, it can:
- Offset your trade internally with another customer’s trade (Internalization)
- Offset your trade externally with a liquidity provider
- Not offset at all and accept market risk (B-Book)
- Partially offset your trade externally with a liquidity provider and B-Book the rest (C-Book)
- Offset more than 100% of the risk of your trade externally with a liquidity provider (C-Book)
- Not offset at all and accept market risk and also “reverse hedge” externally with a liquidity provider (C-Book)
While we covered multiple methods used by brokers to manage their risk, it’s important to know that every broker is different and each will adopt their own practices that suit their risk appetite.
Hedging is considered expensive and because brokers want to maximize profits, they prefer to hedge as little as possible.
Risk management practices also continue to evolve and there is no “standard” policy for how brokers manage their risk.
Traders may have some reservations about brokers who B-Book and think they should only trade with brokers who A-Book, but what ultimately matters is accurate pricing and the quality of execution you receive on your orders.