While your forex broker will always be your counterparty and take the opposite side of your trade, it does NOT mean it has to be stuck with the potential scenario of ending up on the losing end of the trade and incurring a loss.
If the broker does not want to “B-Book” or accept the market risk itself, it can find a third party and transfer the risk to them.
This is also known as “offloading” or “hedging” risk.
The broker wishes to offload or hedge its market risk to another market participant in the institutional FX market.
This might be a bank, non-bank electronic market maker, hedge fund, or even another forex broker.
Since the forex broker must always stand ready to accept trades from its customers at any time, if it wants to make sure it can hedge whenever a new trade arrives, it needs a market participant who will continually provide quotes that are tradeable at any time.
These market participants are known as liquidity providers (LPs).
Whenever the broker needs to buy, an LP will be willing to sell.
And whenever the broker needs to sell, an LP will be willing to buy.
When a broker takes the opposite of a customer’s trade and transfers the market risk, this is known as “A-Book execution”.
How does a broker transfer market risk?
When your broker receives an order from you (the customer), the broker will enter into a separate trade with a liquidity provider in the same direction as you.
The broker has “A-Booked” the customer’s trade and is now “covered” or “hedged”.
The broker’s position against the LP is known as a “cover position” or “hedge”.
A-Book Trade Example: Buy EUR/USD
Let’s see a trade example of how a broker would offload its risk.
Elsa is back and has decided to go long 3,000,000 EUR/USD at 1.2000.
This means that her broker now has a short position of 3,000,000 EUR/USD.
According to the broker’s risk management policy, this amount of market exposure exceeds the broker’s risk limit so it needs to offload the risk.
The broker finds an external counterparty and buys 3,000,000 EUR/USD from it.
This long EUR/USD position now directly offsets the short EUR/USD position it holds against Elsa.
It’s important to point out that Elsa is still only trading with her broker.
The broker remains her sole counterparty.
The broker did NOT send or route Elsa’s trade “directly to the liquidity provider” (which some forex brokers like to claim).
The reality is that the broker still takes the opposite side of Elsa’s trade.
In order to transfer its market risk, the broker makes a similar but completely separate trade with the liquidity provider.
What the broker did is essentially “copy” Elsa’s trade with somebody else. This “somebody else” is a third-party liquidity provider (LP).
The broker replicated its customer’s trade with an LP in the institutional FX market.
There are two separate transactions involved. The broker is a counterparty with two entirely separate counterparties.
- The broker is a counterparty to Elsa’s long position.
- The broker is a counterparty to the LP’s short position
Scenario #1: EUR/USD Rises
Let’s continue with the trade example and see what happens if EUR/USD rises.
As you can see, Elsa’s trade ended up with a profit, which means the broker ended up with an equivalent loss.
But…the A-Book broker ended up with a profit against the LP, who ended up with an equivalent loss.
The profit “covered” the loss so the broker’s final P&L was $0.
Scenario #2: EUR/USD Falls
Let’s see what would’ve happened if EUR/USD fell instead.
As you can see, Elsa’s trade ended up with a big loss, which means the broker ended up with an equivalent gain.
But…because the broker had offloaded its risk to the LP, the broker does not get to celebrate.
The broker ended up with a loss against the LP, who ended up with an equivalent gain.
The loss canceled out the profit so the broker’s final P&L was $0.
If you noticed n the two examples above, the broker did not make any money. 👎
So how does an A-Book broker make money? We’ll find out in the next lesson.