Let’s continue our discussion of internalization.
For example, the broker can see in its book that it has a total of 10 million units of long GBP/USD and 8 million units of short GBP/USD positions.
10M long - 8M short = net 2M long
The difference would leave the broker with a net long 2 million GBP/USD position.
This “difference” is also known as the “residual” since it’s what remains after they offset all trades.
What remains exposes the broker to market risk, which is why it’s also called “residual risk”.
The broker now has to decide how to manage this residual risk.
It has two choices:
Elsa buys and Ariel sells the same currency pair (GBP/USD) at the same time.
Under this scenario, the broker prefers to transfer its market risk to its LP.
The LP’s prices are marked up by 0.0011 or 1 pip:
Let’s see the difference between A-Book execution and internalization.
If the broker exercised A-Book execution, it “paid the spread of LP” and the broker’s P&L vs. LP would equal:
(1.2007 − 1.2010) x 1,000,000 = -300 USD
If the broker took advantage of the fact that the trades happened at the same time and didn’t hedge with an LP, then it wouldn’t have paid that cost.
The primary risk for a broker operating the Internalization model occurs when positions are not completely offset.
This leaves the broker with exposure to price movements which could result in a loss.
If a broker has customer orders that can offset each other partially, then the broker is left with a much smaller net position.
This leaves the broker exposed to market risk.
Again, this is known as “residual risk”.
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