A-Book: How Do Forex Brokers Handle Risk?

While your forex broker will always be your counterparty and take the other side of your trade, it does not imply it has to bear the risk of being on the losing end of the trade and losing money.

If the broker does not want to “B-Book” or bear the market risk, a third party can be found and the risk can be transferred to them.

This is often referred to as “risk unloading” or “risk hedging.”

The broker wants to dump or hedge its market risk in the institutional FX market with another market player.

A bank, a non-bank electronic market maker, a hedge fund, or even another forex broker could be the source of this information.

Because the forex broker must always be ready to accept trades from its customers at any time, if it wants to ensure that it can hedge whenever a new transaction comes in, it requires a market participant who will give tradable quotes at all times.

Liquidity providers are market participants who supply liquidity to the market (LPs).

An LP will be willing to sell whenever the broker needs to buy.

An LP will be willing to buy whenever the broker needs to sell.

A-Execution by the Book

“A-Book execution” occurs when a broker takes the opposite of a customer's deal and transfers the market risk.

What is a broker's method for transferring market risk？

When your broker gets an order from you (the customer), he or she will make a separate trade with a liquidity provider in the same direction as you.

The customer's deal has been “A-Booked” and is now “covered” or “hedged” by the broker.

A “cover position” or “hedge” is a broker's position against the LP.

Example of A-Book Trade: Purchase EUR/USD

Let's look at an example of how a broker could unload its risk in a trade.

Elsa has returned to the market and has decided to buy 3,000,000 EUR/USD at 1.2000.

This means her broker now has a 3,000,000 EUR/USD short position.

This quantity of market exposure exceeds the broker's risk limit, thus it must unload the risk, according to the broker's risk management policy.

The broker locates a third-party counterparty and purchases 3,000,000 EUR/USD from them.

This long EUR/USD position has now completely offset its short EUR/USD position versus Elsa.

It's worth noting that Elsa continues to only trade with her broker.

Her only counterparty is the broker.

Elsa's trade was not sent or routed “straight to the liquidity provider” by the broker (which some forex brokers like to claim).

The broker, in fact, continues to take the other side of Elsa's trade.

The broker conducts a comparable but wholly different trade with the liquidity provider to shift its market risk.

The broker essentially “copied” Elsa's trade with another person. A third-party liquidity source is this “someone else” (LP).

The broker used an LP in the institutional FX market to replicate its customer's trade.

There are two distinct transactions at play. The broker acts as a counterparty to two distinct counterparties.

· Elsa's long position has a counterparty in the broker.

· The LP's short position has a counterparty in the broker.

Scenario 1: The EUR/USD Exchange Rate Rises

Let's keep the trade example going and see what happens if the EUR/USD climbs.

As you can see, Elsa's trade resulted in a profit, implying that the broker suffered a similar loss.

However, the A-Book broker made a profit while the LP suffered a loss of the same magnitude.

Because the profit “covered” the loss, the broker's final profit and loss was zero.

Scenario #2: The EUR/USD Depreciates

Let's have a look at what might have happened if EUR/USD had dropped instead.

As you can see, Elsa's trade resulted in a significant loss, although the broker made a similar profit.

The broker, on the other hand, does not get to celebrate because the LP took on the broker's risk.

The broker suffered a loss in comparison to the LP, who made a similar profit.

Because the profit was cancelled out by the loss, the broker's final P&L was $0.

The broker did not make any money in the two samples above, as you can see.

So, how does a broker that specializes in A-Books make money？ In the next lesson, we'll find out.