Market risk is the risk of a loss in a position caused by adverse price movements.
Because the forex broker is always the counterparty to your trades, it may decide to execute your trades internally or hedge your trades externally.
The term “hedging” refers to the process where a forex broker reduces market risk exposure by entering a parallel transaction with another entity (a “liquidity provider”).
Rather than hedge every single trade, the most popular hedging policy these days is for a broker to hedge customer exposure on a net basis.
This is where incoming trades are internalized before they externally hedged any trades.
Offsetting Exposure with a Hedging Policy
This hedging policy gives aggregate customer exposure the opportunity to offset itself before being hedged in the underlying institutional FX market.
- When one customer trades in one direction and another trades in an equal and opposite direction….the market risk exposure is offset.
- However, when customers trade in the same direction, market risk builds up for the broker. This risk is then reduced by hedging in the underlying market.
Risk limits, governed and assessed by the broker’s overall risk management policies, determine the maximum market risk that a forex broker can undertake.
To make these hedges, the forex broker deposits collateral (margin) with a counterparty. (Similar to how you post margin with the forex broker.)
This is important to know because posting margin means the broker has to put up cash (“margin”) with LPs they trade with. If one of these LPs were to fail and not be able to return the broker’s margin, the broker may end up in a perilous financial position where it may not fulfill its financial obligations to its customers (like you).
So, when selecting the hedging counterparties (“liquidity providers”), the broker considers the competitive quotes offered, credit rating, the efficiency of service, reliability of technology, reputation, and financial standing.
For smaller brokers, they may not choose their LPs as they solely rely on the services of a Prime of Prime (PoP) to hedge their trades and are limited to the LPs that the PoP grants the broker access to.
Unless stated by your broker, it’s important to note that a broker’s hedging practice may not eliminate risk to its customers.