How Forex Brokers Aggregating Orders and Hedging Residual Risk
Article 10 from 12
In the previous article, we discussed how forex brokers employ hedging strategies to manage risk. But what happens when traders open both long and short positions on the same currency pair around the same time? It can create a bit of a puzzle for brokers to solve, right?
That’s where the concept of aggregating or internalizing orders comes into play.
Aggregating or Internalization
When traders place orders with a forex broker, the broker collects and combines these orders to form a consolidated position. This aggregation allows the broker to assess the overall exposure and potential risk associated with the collective positions.
For example, let’s say there are a total of 100 million units of a currency pair in long positions and 80 million units in short positions. The difference between these two positions, which in this case is 20 million units, is known as the residual. This residual represents the net position that the broker needs to address.
To manage the residual risk, brokers have a couple of options. They can choose to accept the risk and hold the position within their own trading portfolio. This means they would be exposed to any potential gains or losses resulting from the residual position.
Alternatively, brokers can opt to hedge the residual risk. Hedging involves taking offsetting positions in the market to neutralize the exposure. For example, if the residual is in a long position, the broker may choose to enter a corresponding short position to balance out the risk.
By aggregating orders and effectively managing residual risk through hedging or acceptance, brokers aim to maintain a balanced and controlled risk profile.
Now that we’ve explored how forex brokers aggregate orders and hedge residual risk let’s take a closer look at two different execution approaches: A-Book Execution and Internalization.
A-Book Execution vs. Internalization (Full Offset)
1. A-Book Execution
Let’s say Trader A wants to buy 100,000 units of a particular currency pair. They place the order with their forex broker, who acts as the intermediary between Trader A and the interbank market. The broker’s A-Book execution involves immediately passing on the order to the liquidity providers in the interbank market. The broker does not take the opposite side of the trade but rather facilitates the direct execution of the order. In this scenario, the broker earns their revenue from commissions or spreads charged to the trader.
2. Internalization (Full Offset)
Now, consider Trader B, who also wants to buy 100,000 units of the same currency pair. Instead of immediately passing on the order to the liquidity providers, the broker chooses to internalize or fully offset the trade. In this case, the broker acts as the counterparty to Trader B’s trade, taking the opposite position. The broker hedges this position by executing an equal and opposite trade in the interbank market. By fully offsetting the trade, the broker eliminates their exposure to market risk. In this scenario, the broker’s revenue is generated from the spread or markup applied to the prices they offer to Trader B.
By comparing A-Book Execution and Internalization (Full Offset), it becomes evident that the approach differs in terms of whether the broker acts as a facilitator or counterparty to the trade.
Article Summary
- To ensure fair pricing, choose reputable brokers, verify their price sourcing, and understand any spreads or markups applied to the prices.
- They can accept or hedge residual risk through offsetting positions.
- Execution approaches include A-Book (passing orders to liquidity providers) and Internalization (acting as the counterparty and hedging).
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