The “carry trade” is a strategy for using a long trend in positive swaps to capture daily profits from interest rate differentials. The question you are asking is really about swaps in general, not about the carry trade in particular.
In other words, you are asking why retail forex traders are paid (or charged) positive (or negative) swaps, in the first place, considering the fact that retail forex traders do not buy or sell foreign currencies, and do not own (or owe) the underlying assets (individual currencies) that represent the interest rate differentials.
Good question! Let’s try to answer it.
A rational explanation of why swaps are paid (or charged) to you, as a retail forex trader, requires assuming a very oversimplified retail broker business model.
A true broker – in contrast to a dealer – does not act as a counterparty to his customers. Instead, a true broker simply acts as a middleman, passing business between customers (downstream) and liquidity providers (upstream).
If your retail forex “broker” were a true broker, and operated in this fashion, then when you place a trade with him, he would simultaneously place the same trade with his liquidity provider, keeping himself in a “flat” position, in which he would be neither LONG nor SHORT.
In the oversimplified retail broker business model which we are assuming (in order to make sense of swaps) your broker would transact directly with the interbank market, every time a retail trader placed a trade with him. His transactions with the interbank market would be actual purchases and sales of actual currencies, charged (or credited) to his line of credit at full cash-value.
In other words, in this model, your trade would trigger the buying and selling of actual currency at the interbank level, and that buying and selling would involve interest-rate accounting. If the actual transaction of your trade at the interbank level resulted in a net interest charge to your broker, he would pass that charge on to you. Conversely, if your trade resulted in a net interest credit to your broker, he would pass that credit on to you.
If the world were actually this simple and orderly, then understanding swaps would be a no-brainer.
But, in actual fact, hardly any retail forex broker operates according to the oversimplified model described above.
Some brokers are pure STP (straight-through processing) brokers, which means that every retail trade they handle is immediately offset upstream. But, these offsets typically are not made directly with the interbank market. Instead, they are made with prime brokers, or ECN’s (electronic communications networks), where most small, retail trades are aggregated (offset against each other).
Your own broker may (and probably does) aggregate retail trades (offsetting LONG’s against equal and opposite SHORT’s), before transacting the resulting “aggregate” upstream.
These aggregated trades never reach the interbank market, never result in actual buying or selling of individual currencies, and never incur interest costs. But, every retail trade, if held overnight, will be paid (or charged) positive (or negative) swap, regardless of whether it actually reached the real (interbank) market.
Why do brokers operate this way? – Because they profit by marking up, or marking down, the computed interest differentials associated with the trades you hold overnight.
As an exercise, you should look up the published central bank interest rates for the individual currencies in the pairs you trade. Then you can easily compute the interest-rate differential for any trade you are contemplating. Next, compare this differential to the positive and negative swaps quoted by your broker. You will find in every case that the positive swaps have been marked down, and the negative swaps have been marked up. In other words, you (and every other retail trader) earn less than the full interest-rate differential when you are paid positive swap, and you pay more than the actual interest-rate differential when you are charged negative swap.
Swaps, like spreads, can eat your lunch, if not managed prudently. Short-term traders typically focus intently on spreads, and ignore swaps. Long-term traders, by contrast, tend to care less about spreads, but they ignore swaps at their peril.
Given your broker’s listed swaps, it’s a simple matter to calculate how many pips a particular position would have to earn over the course of a typical swing trade, or a typical position trade, in order to offset the cost of negative swap.
Finally, swap-free accounts have been around for a long time, for Islamic traders (for whom earning or paying interest is haram). Recently, a number of brokers have begun to advertise swap-free accounts for all customers (regardless of religion). Be aware, that such accounts are not free of carry costs for long-term traders. Typically, these accounts carry a daily “fee” or “commission” in lieu of “interest”.
It’s a legalistic word-game, played in order to avoid the haram-thing in Islamic law.
Lastly, the heyday of carry trades was back in the first decade of this century, when AUD/JPY and NZD/JPY trades were in long-term, profitable trends. Nowadays, it’s much tougher to find durable trends in pairs with large positive interest-rate differentials. So, take to heart the warning that swaps can eat your lunch.