When a broker takes the opposite of a customer’s trade they are transfering the market risk.
This is known as “A-Book execution”.
How does a broker transfer market risk?
When your broker receives an order from you (the customer), the broker will enter into a separate trade with a liquidity provider in the same direction as you.
The broker has “A-Booked” the customer’s trade and is now “covered” or “hedged”.
The broker’s position against the LP is known as a “cover position” or “hedge”.
Let’s see a trade example of how a broker would offload its risk.
Elsa is back and has decided to go long 3,000,000 EUR/USD at 1.2000.
This means that her broker now has a short position of 3,000,000 EUR/USD.
According to the broker’s risk management policy, this amount of market exposure exceeds the broker’s risk limit.
So, the broker needs to offload the risk.
The broker finds an external counterparty and buys 3,000,000 EUR/USD from it.
This long EUR/USD position now directly offsets the short EUR/USD position it holds against Elsa.
Note that Elsa is still only trading with her broker.
The broker remains her sole counterparty.
The broker did NOT send or route Elsa’s trade “directly to the liquidity provider” (which some forex brokers like to claim).
The reality is that the broker still takes the opposite side of Elsa’s trade.
To transfer its market risk, the broker makes a similar but completely separate trade with the liquidity provider.
What the broker did is essentially “copy” Elsa’s trade with somebody else. This “somebody else” is a third-party liquidity provider (LP).
The broker replicated its customer’s trade with an LP in the institutional FX market.
There are two separate transactions here.
The broker is a counterparty with two entirely separate counterparties.
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