The A-Book execution model comes with its own unique challenges.
An A-Book forex broker can only earn profits from markups IF the rates at which it trades with the LP are better than the prices at which the broker trades with its customers.
If not, the broker transfers the market risk but does NOT make any profit and quite possibly, may even incur a loss. 😬
Example: A-Broker Losing Money Due to Negative Markup
Here’s an example that shows what happens when a broker receives worse prices from a liquidity provider compared to prices the broker provides to its customer.
Elsa opens a long AUD/USD position at 0.7500.
Her position size is 1,000,000 units or 10 standard lots. This means a 1-pip move equals $100.
Immediately after, the broker offloads the risk by opening a long position with an LP at 0.7502.
Notice how the buy price provided by the broker to Elsa is BETTER than the buy price provided by the LP to the broker.
The broker is providing better rates to Elsa than it’s receiving from the LP!
From the broker’s perspective, this is not good.
AUD/USD rises in price.
Elsa decides to exit her position at 0.7550 which results in a gain of 50 pips or $5,000 ($100 x 50 pips).
The broker also exits its position with the LP at 0.7548.
The broker’s sell price to Elsa is BETTER than the LP’s sell price to the broker.
Once again, the broker has provided better rates to Elsa than it’s receiving from the LP.
As you can see, this is a money-losing operation for the broker.
The broker can’t continue to operate this way or it won’t stay in business for long.
If a broker is going to rely on price markups for its main revenue source, the price difference between what it receives from liquidity providers and what it sends to its customers must be in favor of the broker.
The broker accomplishes this by:
- Using the prices of the liquidity provider as the source for quoting its customers. Basically, the broker will only display quotes to customers where the markup is profitable.
- Entering into a trade with a liquidity provider at the same time as with its customer. This trade is also known as a “hedge”, “offset”, or “cover”.
If this trade is executed with a delay, the broker may still incur a loss if the price is changing rapidly.
Experiencing price slippage is the risk for A-Book execution for a broker.
When it displays a price to a customer, the A-book broker MUST execute on that price.
So when it comes time to hedge, it needs to make sure that it receives better prices from its liquidity providers. Otherwise, the broker will end up giving a better price to its customer and will lose money!
This is the equivalent of a grocery store selling a loaf of bread for $5 to its customers that it bought for $4.
If the store wants to make a profit selling bread, it needs to make sure if it promised its customer $5 bread…..that it can get it from its wholesale supplier for less than $5.
Otherwise, the grocery store won’t be in business for long.