How Forex Brokers Manage Their Risk and Make Money

A lot of retail traders have no idea of how an order is processed or how forex brokers or CFD providers really operate.

This lesson is intended as an introduction to the mechanics behind retail forex trading.

It is aimed at forex traders wishing to gain a practical understanding of how forex brokers manage their risk and make money.

The trading process is not always transparent, and there are multiple ways in which an order can be executed with different risks associated with each.

If you take the time to understand how orders are executed, then youll be able to differentiate between forex brokers and can make a more informed decision when choosing one.

Let's begin!

Counterparties

When you place a trade order in your brokers trading platform, and the order gets executed or “filled”, where does the trade go？

It actually goes nowhere.

The definition of a broker is an intermediary that executes a trade on behalf of its clients. While the definition of a dealer is a person or entity that trades on its own account.

Retail forex brokers do NOT trade on behalf of their customers. They are dealers.

A retail forex broker trades on its own account by taking the opposite side of its customers trades.

The term “forex broker” is really a marketing phrase since retail forex “brokers” are actually retail forex dealers.

For example, all retail forex brokers regulated in the U.S. are formally referred to as “Retail Foreign Exchange Dealers” or RFEDs.

So why do retail forex dealers market themselves as “forex brokers”？

Maybe because it sounds better？ Sounds friendlier？

Who knows. ¯\_(ツ)_/¯

The main point is if we wanted to be technically accurate, we should be using the phrase, “forex dealers”.

But since the phrase, “forex brokers” is so popular and has been seared into everyone‘s minds already due to effective marketing, going forward we’ll still refer to them as “forex brokers”. (Good job marketing folks from the retail forex industry!

CLIENT or CUSTOMER？

Are you a client of a forex broker？ Or are you a customer of a forex broker？

“Client” and “customer” are words that are often used interchangeably.

For our purposes, we think theres a distinct difference between being a client and being a customer.

Being a client of a company means there is a fiduciary relationship between you and the company. This means that the company acts on your behalf and is obligated by law to act in your best interest.

But a forex broker does not act on your behalf, nor is it obligated to act in your best interest.

So if we go by the definition that being a client means there is a fiduciary relationship, then this means that you are NOT a client of your “forex broker”.

You are a customer.

If you want to buy, the service it provides isn‘t to act on your befall and find you a seller. It’s the one selling to you.

How can you be a “client” when it is the broker itself selling to or buying from you？

You are a customer of your “forex broker” who provides a service that enables you to speculate (make bets) on the price movements of currency pairs.

Since you cant trade directly in the (institutional) FX market, it “makes” a trading market for you.

It provides you a way to make bets on currency prices by always taking the opposite of your bets whenever you want to make one. Its not trying to find someone to take the other side of the bet, it simply takes the bet on itself.

But the “forex broker” does not have the fiduciary duty to act for your benefit.

That said, even though there is NOT a fiduciary relationship with the customer, the forex broker should act honestly and fairly with all of its customers.

Going forward, we will use the term “customers” when referring to traders using the services of a retail forex broker or CFD provider.

All orders and trades entered through your brokers trading platform are NOT executed on an external trading venue but are executed by the broker itself.

Your “broker” is taking the opposite side of your trade.

This is known as being the counterparty.

Think about it. If you want to buy, someone has to sell. And if you want to sell, someone has to buy.

Every buyer must be paired with a seller and vice versa.

You need a counterparty.

When you trade with a broker, both you and the “broker” hold positions against each other.

You are each others counterparties.

You are your brokers counterparty. Your broker is your counterparty.

This means that if you want to buy or “go long”, the broker will take the opposite side of your trade and sell to you or “go short”.

The same thing happens if you want to sell or “go short”, the broker will take the opposite side of your trade and buy from you or “go long”.

Your order is known as a bilateral transaction with your broker. “Bilateral” is just a fancy word that just means “involving two parties”.

All retail forex trades are bilateral since your retail forex “broker ”is the counterparty to ALL of your trades.

Example 1: Single Trader and Broker

For example, if you buy 100,000 GBP/USD, or open a “long” position, your broker takes the opposite side of your trade.

This means it will sell 100,000 GBP/USD or hold a “short” position against you.

Since you are now “long” GBP/USD, you are now exposed to the potential risk that the price for GBP/USD will decrease and you end up having to close your position by selling at a lower price than you bought it for, resulting in a loss.

The broker who is now “short” GBP/USD, is also exposed to risk. But in its case, the risk is that the price for GBP/USD will increase. If GBP/USD continues to rise, the more the brokers loss grows.

This risk is called market risk.

Market risk is the risk of a loss in a position caused by adverse price movements.

When you initiate a trade with your broker, both you (the trader) and the broker are exposed to market risk.

As you can see, your trade never reaches the “market”. It stays as a private agreement between you and your “broker”.

This why your forex broker is not really a broker. It is a DEALER.

If it was a true broker, it would find and match your trade with another counterparty. For example, if you want to buy, the broker would find someone who wants to sell.

But it doesnt do this. If you want to buy, It is the one that sells to you.

Since a retail forex broker is THE counterparty for ALL of its traders (“customers”), this means that it holds A LOT of positions for different currency pairs.

In order to understand the market risk for a specific currency pair, we need to add ALL of the brokers positions against traders in this currency pair.

Example 2: Two Traders and Broker

Lets pretend that there are two traders: Elsa and Ariel.

They both trade GBP/USD but have different opinions on where the price is headed.

Elsa goes long GBP/USD, while Ariel goes short GBP/USD.

The broker takes the opposite side of each trade.

Remember, the broker is the sole counterparty to all its customers trades.

Each trader trades directly (“bilaterally”) with the broker, and only the retail broker. Retail forex traders do not trade with each other.

Let‘s see how Elsa’s and Ariel‘s trades affect the broker’s trading book.

A trading book, or “book” for short, keeps track of all the open positions that a broker holds.

Whenever its customers trade, the broker has to take the opposite side of the trade. This causes the trading book to constantly change and “net” long (or short) positions in individual currencies to arise.

The broker must continuously keep track of its long and short positions and know its net positions precisely at all times.

A “book” is a record of all the positions held by a trader. Retail traders may also refer to their own positions as a book, although the term is mostly associated with institutional traders.

As a trader, you have your own “book” as well. Your book is simply all your open positions as well.

As you can see above, even though both Elsa and Ariel have open positions against the broker, the brokers net position is zero.

The broker has a short position against Elsa‘s trade but also has a long position against Ariel’s trade.

The two trades offset each other which results in the brokers exposure to market risk being eliminated.

Assuming this is all the GBP/USD positions that the broker has on its book, its market risk exposure is zero.

Of course, the broker has to make money so it quotes a different price depending on whether the customer wants to buy or sell. The difference between the two prices is known as the spread.

In the example above, Elsa bought GBP/USD at 1.2503, known as the “ask” price, while Ariel sold GBP/USD at 1.2500, known as the “bid” price.

This means the brokers spread was 3 pips or 0.0003 (1.2503 – 1.2500).

Basically, the broker bought GBP/USD from Ariel at 1.2500 and turned right around and sold GBP/USD to Elsa at the higher price of 1.2503, pocketing the spread.

This spread is the brokers profit, which equals $30 (0.0003 x 100,000).

At this point, it doesn‘t matter if the market fluctuates widely since the broker’s net position is zero, The market is locked in due to the offsetting trades.

For example, Elsa bought GBP/USD at 1.2503 and Ariel sold GBP/USD at 1.2500 and the current market price is now 1.3100.

Let‘s calculate the broker’s P&L (profit and loss):

P&L = 100,000 (1.2503 - 1.3100) + 100,000 (1.3100 - 1.2500)

P&L = -5,970 + 6,000

P&L = 30

The broker has a profit of $30.

Lets see what happens if the current market price plunges to 1.2900.

P&L = 100,000 (1.2503 - 1.2900) + 100,000 (1.2900 - 1.2500)

P&L = -3970 + 4000

P&L = 30

As you can see, even when the price moved 200 pips (from 1.3100 to 1.2900) because the two trades offset each other, the broker was NOT exposed to market risk and its profit remained at $30.

Example 3: Many Traders and Broker

Now instead of just two traders, lets add more traders.

There are 1,000 traders and ALL of them go long 1 standard lot (or 100,000 units) of GBP/USD each.

Let‘s see how the broker’s book looks now.

As you can see, the broker is net short 100 million units of GBP/USD.

(1,000 traders x 100,000 units = 100,000,0000 units)

There weren‘t any other traders who wanted to short GBP/USD so the broker wasn’t able to offset any positions to help reduce his net short position.

That kind of exposure to market risk is pretty BIG.

How big？

If a 1-pip move for a standard lot or a 100,000 unit position equals $10, this means that for a 10M unit position, every pip increase that GBP/USD makes, the broker experiences a $10,000 unrealized loss.

Lets repeat that: 1 pip increase = $10,000 unrealized loss.

So if GBP/USD rises 100 pips, the broker would be down $1,000,000!

In theory, the broker could stop accepting the trades if it didn‘t want to expose itself to such risk but then that would mean that all of its customers couldn’t enter into any more trades.

That‘s the equivalent of a store hanging up a “Closed” sign in the middle of the day when its customers expect the store to be open for business. If all of a sudden, traders couldn’t open trades on the broker‘s trading platform, they’d be like “WTF？” and be pissed.

So not accepting trades is out of the question. The broker must stay “Open” or it would lose customers. It must continue to accept trades.

Lets pretend EVERY trader closed their trade after GBP/USD rose 100 pips.

Each trader would have a $1,000 profit (100 pips x $10).

And since the broker was the counterparty to all 1,000 traders, it would have a realized loss of $1,000,000 ($1,000 x 1,000 customers).

The question then arises…

Does the broker actually have a $1M to pay out to its winning customers？

If it doesnt, along with some very angry customers, it will be out of business.

In this scenario, if the broker doesnt have the funds, it did not manage its market risk properly.

The price moved against the broker‘s net position so much that it wasn’t able to fulfill its obligations to its customers and pay out their profits.

The brokers overexposure to market risk has now exposed the traders (its customers) to counterparty risk.

Counterparty risk is when one party fails to deliver on its end of the deal.

In this scenario, when the traders exited their long positions, they expected to receive their profit in their account.

But the broker took on too much risk and doesnt have enough money to pay out.

In casino lingo, “The house has gone bust.”

This is why its important to know how your broker manages the risk on the other side of your trade.

There are three ways for the broker to manage market risk:

00001. It can offset opposing trades from its customers.

00002. It can transfer or “offload” the risk to another market participant.

00003. It can accept or “warehouse” the risk.

HOW a forex broker manages market risk determines what type of broker it is and how it operates as a business.

Understanding the concept of your broker “taking risk” on your order is critical to your success as a trader.

If your broker is taking the other side of your order and not passing it onto an external counterparty, your broker is taking 100% of the market risk associated with your order.

So if you can understand how your broker manages its risk when it takes the opposite of your trade, you‘ll know what type of broker you’re actually dealing with and if there are any potential conflicts of interest.

Lets now go into further detail on the different ways that brokers manage their risk and make money.