In the previous lesson, we talked about why forex brokers are attracted to B-Book execution more than A-Book execution, even though it’s riskier because the broker can blow up if it
doesn’t know WTH it’s doing has poor risk management.
But what if brokers could get the best of both worlds?
So far, we’ve learned that when a broker executes your order, it can choose to fill the order:
- Before hedging (A-Book)
- By not hedging at all (B-Book)
- By internalizing first and then choosing one of the above
- By hedging first (STP)
But a forex broker is not limited to just one form of hedging.
It can choose any of the above depending on the order and/or customer.
How a broker determines who to choose for which model depends on different factors like trade size and a customer’s profitability profile.
A broker can generate independent price streams and hedging models for social traders, news traders, API traders, or screen traders.
Most brokers operate at least an A and B-Book, selecting which trades are internalized vs. hedged with an LP.
This is known as the “hybrid model“.
While your forex broker is always the counterparty to your trades, a hybrid approach is where the broker may decide to execute your trades internally OR offset your trades externally to a liquidity provider.
A “hybrid” approach allows a broker to:
- Offset orders with other customers
- Hedge orders with an external counterparty (liquidity providers)
- Or not hedge and accept full market risk
Market risk is the risk of a loss in a position caused by adverse price movements. Learn more about the perils of market risk here.
Here are two examples of how a broker operates when taking the hybrid approach:
- The broker can divide its customers and hedge the trades of some of the customers to an LP (A-Book or STP) and keep the rest “in-house” (B-Book).
- The broker can decide to hedge all trades of a certain size or larger to a liquidity provider and keep the rest “in-house” (B-Book).
In the hybrid model, the forex broker has to decide which customers go to A-book and which go to B-book? And why?
Once these rules and criteria are set, the broker will have an “order routing system” or “order execution engine” whose purpose is to manage orders by sending them to A-Book or B-Book automatically.
The broker will most likely hold the trades of losing traders for themselves and hedge against the trades of profitable traders.
This means that successful traders will be A-Booked, while the small unprofitable traders will be B-Booked, where the market risk is kept “in house”
To successfully identify profitable and unprofitable traders, forex brokers have software that analyzes how customers trade.
They can profile traders by the amount of their deposit, the notional value of each trade, the leverage used, the risk taken with each trade, the use or non-use of protective stops, etc.
For example, there seems to be a common pattern of behavior among losing traders. These behaviors include:
- Depositing a tiny amount of cash which means a tiny starting account balance (usually less than $1,000).
- Risking 10% or more of their tiny account balance per trade.
- Not using stop losses.
- Adding to losing trades.
- Using high leverage on their tiny accounts making them frequently susceptible to margin calls and stop outs.
With the use of computer algorithms, brokers are able to analyze trading patterns to profile the trades of each customer.
Brokers can be different “brokers” to different customers.
It can be a B-Book broker to some and an A-Book broker to others.
The reasons behind customer profiling are simple.
The customers who are A-Booked are more successful and will generally be trading in larger lot sizes, so fully offsetting these orders with an external counterparty eliminates exposure to market risk while still earning a (small) fee from the spread.
On the other hand, the customers who are B-Booked will generally be small orders, mostly losing trades, and the broker can warehouse the market risk since the risk is small because the trade size is small.
This allows the broker to profit from losing trades from its B-Book customers, and also earn from the price markup from its A-Book customers.
Large Forex Brokers
For larger forex brokers, because they have a large number of customers opening trades in both (long and short) directions, they are able to internally offset (“internalize”) a great deal of their order flow, which allows them to minimize their market risk WITHOUT having to hedge with an external counterparty.
When not all of the positions are able to be hedged, the excess market risk exposure is then hedged externally.
A large customer base allows most large forex brokers to theoretically offset most of their customers’ trades with each other.
This allows revenue to be earned from customers’ transaction fees (from the spread), which means that it is the volume of customer trading that drives revenue, not from customers’ losses.
For smaller brokers, if they are unable to hedge your trade with another one of its customers, they “B-Book” (take the other side of) the trade, up to their market risk limit. Anything above this limit would be hedged externally.
The use of B-Book combined with only externally hedging beyond a certain risk limit provides better order execution (because it allows the broker to immediately execute your trade) while keeping latency and its costs to a minimum (because it doesn’t have to A-Book or STP every trade which would mean paying the LP’s spread every time).
Most Forex Brokers Use a Hybrid Approach
We don’t see anything wrong with a broker operating both A-Book and B-Book. The reality is that most brokers do use a hybrid approach.
The profits gained from traders placed in the B-Book allow brokers who use a hybrid approach to provide all their customers with very competitive spreads.
The main disadvantage with this approach is that if the broker manages the risk of B-Book poorly. The broker could end up blowing up and going out of business.
Trades from new retail traders will most likely be B-Booked. This makes sense since most new traders lose. It’s easy money for the broker.
It’s very rare for a retail forex broker to be 100% A-Book. It’s a tough business model.
The A-Book model is a much lower margin business than B-Book and requires brokers to focus on customers who trade frequently in large quantities while trying to keep costs as low as possible.
With so many unprofitable traders, a B-Book model provides an additional source of revenue.
There is nothing wrong with a retail broker having a hybrid of both A-Book and B-Book. What is wrong is when a forex broker starts to manipulate trades in its favor.
The most important consideration for a retail broker, at least in a well-regulated jurisdiction, should be ensuring fair pricing and the best order execution for their customers, regardless of whether it adopts an A or B book model.
Regardless of the broker’s execution model, what’s most important is that retail traders receive transparent prices that track the “real”(institutional )FX market in real-time AND be able to get their orders filled at these prices (or better) without any delays.
We will discuss pricing and order execution quality in more detail in later lessons, but first, let’s learn one more “risk management” approach that forex brokers use.