Retail forex trading can seem mysterious, especially when it comes to understanding how brokers handle orders and manage risk.
This lesson provides insight into the mechanics behind retail forex trading, helping traders make informed decisions when choosing a broker.
Let’s dive in!
Counterparties in Forex Trading
When you place a trade on your broker’s platform, what actually happens?
Surprisingly, your trade doesn’t reach the broader forex market. Instead, your broker acts as the counterparty to your trade.
Broker or Dealer?
While the term "forex broker" is commonly used, most retail forex brokers are technically dealers.
Broker: Executes trades on behalf of clients.
Dealer: Trades on its own account, taking the opposite side of your trade.
Retail forex brokers are dealers, not intermediaries. For example, in the U.S., they are formally called Retail Foreign Exchange Dealers (RFEDs).
Client vs. Customer
Are you a client or a customer of your forex broker?
A client implies a fiduciary relationship, where the broker acts in your best interest.
A customer is someone who buys a service, without the broker having a fiduciary duty.
Forex brokers provide a service that allows you to speculate on currency price movements.
They take the opposite side of your trade but are not obligated to act in your best interest.
In this sense, you are a customer, not a client.
How Brokers Execute Trades
When you place an order:
Your broker takes the opposite side of your trade.
If you buy, the broker sells.
If you sell, the broker buys.
This is called a bilateral transaction, meaning the trade involves only you and your broker.
Your broker becomes your counterparty, and your trade does not enter the broader forex market.
Example: Single Trader and Broker
Suppose you buy 100,000 GBP/USD (a long position):
You are exposed to the risk of GBP/USD decreasing.
Your broker takes the opposite position (short), exposing it to the risk of GBP/USD increasing.
This mutual exposure is known as market risk, which refers to potential losses due to adverse price movements.
Market Risk and Broker Strategies
To manage market risk, brokers may:
Internalize Trades: Keep trades in-house, balancing risk with other customers’ positions.
Hedge Positions: Offset risk by trading in the institutional FX market.
By understanding how brokers operate, you can evaluate their practices and make informed choices about where to trade.
Retail forex trading is not as transparent as it seems, but knowing how brokers manage risk and execute trades can help you navigate the market more effectively.