Riskless Principal.

When a trade is executed via STP, this type of transaction is known as a “riskless principal” or “matched principal” transaction.

What is a “principal”?

A “principal” is a party to a transaction. For example, the buyer and seller. It’s basically a fancy word for “counterparty“.

Remember, your forex broker is always taking the opposite of your trade. When you buy, it sells to you. And when you sell, it buys from you.

It is the sole counterparty to all your trades.

This is known as a “principal” transaction.

As you’ve learned earlier, as your counterparty (principal), the forex broker exposes itself to market risk.

But with STP execution, a “riskless principal” transaction is possible.

Back-to-Back Orders

When you place an order with an STP broker, it immediately attempts to place an identical order (a “back-to-back order”) with an external liquidity provider.

Upon this “back-to-back” order being matched or filled in whole, the broker opens (or closes) the order on your account.

This is how it’s able to act as a “riskless principal” to every trade opened or closed in your account.

A broker acts as a riskless principal because once you submit your order:

• It first buys from an external liquidity provider for its own account (as principal), then
• Records that transaction in its own trading book, and then
• More or less immediately, sells to you (also as principal),
• Either at the same price (with a “commission”) or at a markup (with no commission).

As a result, there are TWO transactions:

1. One between you and riskless principal (forex broker)
2. One between the riskless principal (forex broker) and the “market” (third-party LP).

Example

For example, a broker receives a customer’s order to buy 100,000 units of GBP/USD at the prevailing market price of 1.4000 would immediately buy the 100,000 units from a third-party liquidity provider (LP).

Since both trades were executed at the same price (excluding any previously disclosed markup, fees, or commission), this would qualify as a riskless principal transaction.

As you can see, your trade with the broker and the broker’s trade with the LP matches. Hence, the term “matched principal“.

The concept of “riskless principal” and “matched principal” is important to know because it’s the closest thing a forex “broker” can do to act like a true broker.

They can “act” like a broker by being a riskless principal. Still, unlike a true broker or agent, who plays the role of a matchmaker by facilitating a transaction between two separate counterparties, a riskless principal is still your counterparty.

Agency vs. Principal Trades

Agency vs. Principal Trades: In an agency trade, you’re acting as an agent for a client, and DO NOT take part in the trade. You merely facilitate.

This is what true brokers do. In a principal trade, you’re acting as principal and DO take part in the trade. You are the seller to a buyer….and the buyer to a seller. This is what dealers do.

When you enter a market order on your broker’s trading platform, it still takes the opposite side of your trade, but it acts as a riskless principal by simultaneously entering into offsetting trades with both you and an external liquidity provider.

Your broker makes money by adding a markup to the price provided by the liquidity provider and/or charging you a commission.

This means that it generates its trading revenues based on the volume of transactions, and not trading profits or losses.

It doesn’t expose itself to market risk, which means it doesn’t profit when you lose.

The only money it makes when executing your order is from a previously disclosed price markup or commission.

Brokers who operate this way are designated as “riskless principal” or “matched principal” brokers. 

You can verify if your broker is one by looking at its registration listing on its regulatory agency’s website.

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