Continuing our discussion on how forex brokers make money and manage their risk, here is a third example.
Now instead of just two traders, let’s add more traders.
There are 1,000 traders and ALL of them go long 1 standard lot (or 100,000 units) of GBP/USD each.
Let’s see how the broker’s book looks now.
As you can see, the broker is net short 100 million units of GBP/USD.
(1,000 traders x 100,000 units = 100,000,0000 units)
There weren’t any other traders who wanted to short GBP/USD so the broker wasn’t able to offset any positions to help reduce his net short position.
That kind of exposure to market risk is pretty BIG.
If a 1-pip move for a standard lot or a 100,000 unit position equals $10, this means that for a 10M unit position, for every pip increase that GBP/USD makes, the broker experiences a $10,000 unrealized loss.
Let’s repeat that: 1 pip increase = $10,000 unrealized loss.
So if GBP/USD rises 100 pips, the broker would be down $1,000,000!
In theory, the broker could stop accepting the trades if it didn’t want to expose itself to such risk but then that would mean that all of its customers couldn’t enter into any more trades.
That’s the equivalent of a store hanging up a “Closed” sign in the middle of the day when its customers expect the store to be open for business. If all of a sudden, traders couldn’t open trades on the broker’s trading platform, they’d be like “WTF?” and be pissed.
So not accepting trades is out of the question. The broker must stay “Open” or it would lose customers. It must continue to accept trades.
Let’s pretend EVERY trader closed their trade after GBP/USD rose 100 pips.
Each trader would have a $1,000 profit (100 pips x $10).
And since the broker was the counterparty to all 1,000 traders, it would have a realized loss of $1,000,000 ($1,000 x 1,000 customers).
The question then arises…
Does the broker actually have $1M to pay out to its winning customers?
If it doesn’t, along with some very angry customers, it will be out of business.
In this scenario, if the broker doesn’t have the funds, it did not manage its market risk properly.
The price moved against the broker’s net position so much that it wasn’t able to fulfill its obligations to its customers and pay out its profits.
The broker’s overexposure to market risk has now exposed the traders (its customers) to counterparty risk.
Counterparty risk is when one party fails to deliver on its end of the deal.
In this scenario, when the traders exited their long positions, they expected to receive their profit in their account.
But the broker took on too much risk and doesn’t have enough money to pay out.
In casino lingo, “The house has gone bust.”
Therefore it’s important to know how your broker manages the risk on the other side of your trade.
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