The Hedging Policy of Your Forex Broker is Something You Should Be Aware Of

Each and every trade entered into by a forex broker's customers exposes the broker to market risk.

Market risk refers to the possibility of losing money on a trade due to market fluctuations.

Because your forex broker is always the counterparty to your trades, it has the option of executing or hedging your contracts internally or externally.

The method by which a forex broker decreases market risk exposure by entering into a parallel transaction with another business (a “liquidity provider”) is referred to as “hedging.”

The most common hedging approach these days is for a broker to hedge customer exposure on a net basis, rather than hedging every single deal.

Before any transactions are externally hedged, incoming trades are internalized.

Before being hedged in the underlying institutional FX market, this hedging policy allows aggregate consumer risk to counterbalance itself.

· The market risk exposure is neutralized when one client trades in one direction and another trades in the opposite direction.

· When consumers trade in the same direction, still, the broker's market risk increases. Hedging in the underlying market helps to mitigate this risk. The maximum market risk that a forex broker can take is determined by risk limits, which are governed and assessed by the company's overall risk management rules.

The forex broker makes these hedges by depositing collateral (margin) with a counterparty. (It's similar to posting margin with a forex broker.)

This is vital to understand since posting margin requires the broker to put up cash (“margin”) with the LPs with whom he or she trades. If one of these LPs fails and does not refund the broker's margin, the broker may find itself in a precarious financial situation, unable to meet its financial obligations to its customers (like you).

As a result, the broker evaluates the competitive bids supplied, credit rating, efficiency of service, technology reliability, reputation, and financial position when selecting hedging counterparties (“liquidity providers”).

Smaller brokers may not have a choice of LPs since they rely on the services of a Prime of Prime (PoP) to hedge their transactions and are limited to the LPs that the PoP provides the broker access to.

It's crucial to note that, unless your broker states otherwise, a broker's hedging approach may not completely eliminate risk for its consumers.

Request a written copy of your broker's hedging policy.

The hedging policy defines the techniques it uses to manage its market risk exposure and identifies the counterparties with whom it trades to mitigate that risk.

By demanding this, you will have insight into its hedging operations, allowing you to better analyze the counterparty risk when working with your broker.

Keep in mind that if your broker goes bankrupt, your money goes with him.

In the last lesson, Where Are You Trading？, we went over the dangers of counterparty risk in great detail.

If your broker refuses to expose any of these facts, now is an excellent opportunity to find someone who will.

Transparency is the only way for a broker to win your trust.

Any broker who isn't clear with their hedging strategy, which should specify not only their hedging procedures but also their hedging counterparties (their “liquidity suppliers”), should be avoided.

Summary

We've looked at the fundamentals of how brokers hedge and manage market risk.

We discussed risk management techniques such as “A-Book,” “B-Book,” and several “C-Book” versions that retail FX and CFD trading platforms may employ.

We hope that, given the high amount of ambiguity with which brokers operate, we have cast some light on what goes on “behind the scenes” in terms of how they manage risk and generate money.

You now know that every retail forex broker is on the other side of your trade.

ALL of your trades have a counterparty, which is your broker.

When a broker executes your deal, it has the option to:

· Internally offset your trade with another customer's trade (Internalization)

· Externally offset your trade with a liquidity source.

· Pre-hedging is when you do this before your trade is confirmed (STP)

· Post-hedging is when you do this after your trade has been confirmed (A-Book)

· Not at all offset and willing to take market risk (B-Book)

· Externally offset a portion of your deal with a liquidity source and B-Book the rest (C-Book)

· Externally mitigate more than 100% of the risk of your deal with a liquidity provider (C-Book)

· Not offset at all and accept market risk, as well as “reverse hedge” with a liquidity provider externally (C-Book)

While we discussed a variety of risk management techniques utilized by brokers, it's crucial to remember that each broker is unique and will employ procedures that best suit their risk needs.

Hedging is regarded costly, and brokers try to hedge as little as possible in order to maximize earnings.

Risk management strategies are likewise evolving, and there is no “golden rule” for how brokers manage their risk.

Traders may have reservations about B-Book brokers and believe they should only trade with A-Book brokers, but what counts most is accurate pricing and the quality of execution you receive on your orders.