When a retail forex trader places an order to buy or sell a currency pair, his broker is the counterparty to his trade. This is true regardless of whether the broker is FOREX.com or any other retail forex broker. To confirm this, simply review customer agreement of any well-regulated broker.
For example, in the US, retail forex is regulated by the CFTC/NFA and all regulated brokers are required to include the following risk disclosure statement which can be found on page 12 of latest version of our customer agreement which was last updated on 1 January 2018:
OFF-EXCHANGE FOREIGN CURRENCY TRANSACTIONS INVOLVE THE LEVERAGED TRADING OF CONTRACTS DENOMINATED IN FOREIGN CURRENCY CONDUCTED WITH A FUTURES COMMISSION MERCHANT OR A RETAIL FOREIGN EXCHANGE DEALER AS YOUR COUNTERPARTY.
What is a “Counterparty”?
Investopedia defines it like this:
A counterparty is the other party that participates in a financial transaction, and every transaction must have a counterparty in order for the transaction to go through. More specifically, every buyer of an asset must be paired up with a seller who is willing to sell and vice versa.
All trades require some sort of counterparty, so for example, the counterparty to an option buyer would be an option writer. One of the risks involved in any transaction is counterparty risk, which is the risk that the counterparty will be unable to fulfill his duties.
The last point above highlights why a retail forex trader always has a retail forex broker as his counterparty. While retail forex brokers are willing to assume the counterparty risk of retail forex traders (the risk that these retail traders are unable to cover their losses), the largest banks in the world (those which trade forex with each other in the interbank market) are not willing to assume the counterparty risk of individual retail forex traders or even the counterparty risk of smaller retail forex brokers.
However, big banks are willing to assume the counterparty risk of retail forex brokers like FOREX.com. These retail forex brokers will in turn act as counterparty to the trades of smaller retail forex brokers and individual retail forex traders.
Therefore, the fact that your retail forex broker is the counterparty to your retail forex trades is neither good nor bad. What matters is the quality of your broker.
It seems you are asking how your retail forex broker executes your orders. We established above that your broker is the counterparty for your retail forex trades regardless of the particular broker you choose. This means that, one way or another, your broker has to manage the risk on the other side of your trade. In fact, all retail forex brokers regulated in the US are referred to as Retail Foreign Exchange Dealers by the CFTC/NFA.
For our part, FOREX.com has always been open about our role as the market maker (AKA dealing desk) for the trades placed by our retail clients. We feel no reason to hide this fact, because at retail trade sizes, we believe market making is the best way to provide customers with reliable pricing while effectively managing our own risk. We are fully accountable for every execution and don’t outsource that responsibility to a third party.
Not always. Retail forex brokers rely on the big banks for liquidity, either directly as FOREX.com does, or indirectly as some smaller brokers do by clearing their own orders through larger firms like ours. Since all retail forex brokers, big and small, are dependent on the big banks for their liquidity, retail forex is generally open for trading 24 hours a day, 5 days a week, from 5pm Sunday to 5pm Friday New York Time.
When it’s 5pm in New York, it’s already the morning of the next day in Asia. Therefore, aside from the weekend (5pm Friday to 5pm Sunday), there are dealers manning forex desks of the big banks day and night to quote prices and provide liquidity to firms like FOREX.com. We in turn can provide liquidity to retail forex traders like you, while our institutional arm GTX provides liquidity to smaller retail forex brokers so their clients can also place trades.
Retail forex brokers can manage the risk on the other side of your trades in one of three ways, and each method has its pros and cons.
Option 1: Your broker can offset your buy orders with the sell orders of their other clients, and offset your sell orders with other buy orders). This is known as natural hedging and relies on a broker’s internal liquidity of buy and sell orders from clients.
Pro: This is a win-win scenario for trader and broker, because your order can be filled without having to depend on an external liquidity provider, and your broker gets to earn the full spread and be fully hedged (buyers offsetting sellers). Generally speaking, the larger a broker is, the more buy and sell orders its clients will place and the more internal liquidity in normal market conditions.
Con: For some smaller brokers, their internal liquidity might not be sufficient for natural hedging to occur as often. Even for larger brokers like FOREX.com, there are times the imbalance between buyers and sellers can be so great that natural hedging with internal liquidity is not possible. In either case, when internally liquidity is not sufficient for natural hedging, a broker must turn to option 2 or 3.
Option 2: Your broker can offset the risk with their external liquidity providers. For example, FOREX.com does this by looking at our net exposure to see if there are more buyers than sellers or vice versa. If there are more buy (sell) orders within our retail client base, then we can offset our net long (short) exposure placing a large buy (sell) order with a bank. Similarly, smaller retail brokers can offset their own exposure with a larger firm like our institutional arm GTX.
Pro: Your order is filled. Your broker is able to hedge its risk on the other side with a bank or a larger broker. Your broker’s external liquidity provider benefits from the order flow which they can use for their own internal liquidity to offset other institutional orders. This highlights how retail traders are connected to and contribute liquidity to the larger market even if it is indirectly through their retail broker.
Con: There is an another layer of dependency between your broker and their liquidity provider added to the process of offsetting the risk from your trade. Depending on how and how effectively your broker manages this risk, any price moves that occur in the interim can affect you (slippage), them (broker losses), or both. An extreme example of this was when the Swiss National Bank decided to scrap its currency ceiling 3 years ago.
- Another con with Option 2 which may not seem as important to you as a trader at first glance is that your broker stands to make less money than with Option 1, since they have to pay their liquidity provider’s spread to offset the exposure. You want to know that your broker has a sustainable business model. Consider how some brokers have tried to use Option 2 for all orders and ended up having to raise their account minimums as a result. Others found they could not stay in business at all and were acquired by brokers that have the flexibility and internal liquidity to use Option 1.
Option 3: Your broker might decide not to offset the risk either internally (Option 1) or externally (Option 2).
Pro: Your order can be filled without having to depend on an external liquidity provider as with Option 1. Your broker avoids paying their liquidity provider’s spread.
Con: Since your broker acts as the buyer when you sell and the seller when you buy, their interests may be in conflict with yours meaning a profit for you might mean a loss for them, or vice versa.
- This is the biggest concern traders tend to have with Option 3. While we won’t speak for other brokers, in 2016 which is the latest full-year data we have compiled, approximately 98% of FOREX.com’s average daily retail segment trading volume was either naturally hedged (Option 1) or hedged by us with one of our liquidity providers (Option 2). Therefore, Option 3 represented about 2% of FOREX.com’s average daily retail segment trading volume for the year.