{"id":9499,"date":"2022-10-12T06:59:28","date_gmt":"2022-10-12T06:59:28","guid":{"rendered":"https:\/\/mdr.foobrdigital.com\/?p=9499"},"modified":"2022-10-12T06:59:28","modified_gmt":"2022-10-12T06:59:28","slug":"the-hybrid-model-used-by-forex-brokers","status":"publish","type":"post","link":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/2022\/10\/12\/the-hybrid-model-used-by-forex-brokers\/","title":{"rendered":"The \u201cHybrid Model\u201d Used By Forex Brokers"},"content":{"rendered":"\n<p>In the\u00a0previous lesson, we talked about why forex brokers are attracted to B-Book execution more than A-Book execution, even though it\u2019s riskier because the broker can blow up if it\u00a0<del>doesn\u2019t know WTH it\u2019s doing<\/del>\u00a0has poor risk management.<\/p>\n\n\n\n<p>But what if brokers could get the best of both worlds?<\/p>\n\n\n\n<p>So far, we\u2019ve learned that when a broker executes your order, it can choose to&nbsp;<strong>fill the order<\/strong>:<\/p>\n\n\n\n<ul><li><em>Before<\/em>&nbsp;hedging (A-Book)<\/li><li>By&nbsp;<em>not<\/em>&nbsp;hedging at all (B-Book)<\/li><li>By&nbsp;<em>internalizing<\/em>&nbsp;first and then choosing one of the above<\/li><li>By hedging&nbsp;<em>first<\/em>&nbsp;(STP)<\/li><\/ul>\n\n\n\n<p>But a&nbsp;forex broker is not limited to just one form of hedging.<\/p>\n\n\n\n<p>It can choose any of the above depending on the order and\/or customer.<\/p>\n\n\n\n<p>How a broker determines who to choose for which model depends on different factors like trade size and a customer\u2019s profitability profile.<\/p>\n\n\n\n<p>A broker can generate independent price streams and hedging models for social traders, news traders, API traders, or screen traders.<\/p>\n\n\n\n<p>Most brokers operate at least an A and B-Book, selecting which trades are internalized vs. hedged with an LP.<\/p>\n\n\n\n<p>This is known as the \u201c<strong>hybrid model<\/strong>\u201c.<\/p>\n\n\n\n<figure class=\"wp-block-image\"><img decoding=\"async\" src=\"https:\/\/bpcdn.co\/images\/2021\/05\/31173411\/forex-hybrid-model-284x360.png\" alt=\"Forex Broker Hybrid Model\" class=\"wp-image-203748\" title=\"Forex Broker Hybrid Model\"\/><\/figure>\n\n\n\n<p>While your forex broker is always the counterparty to your trades, a hybrid approach is where the broker may decide to execute your trades internally OR offset your trades externally to a liquidity provider.<\/p>\n\n\n\n<p>A \u201chybrid\u201d approach allows a broker to:<\/p>\n\n\n\n<ul><li>Offset orders with other customers<\/li><li>Hedge orders with an external counterparty (liquidity providers)<\/li><li>Or not hedge and accept full market risk<\/li><\/ul>\n\n\n\n<pre class=\"wp-block-code\"><code><strong>Market risk<\/strong>\u00a0is the risk of a loss in a position caused\n by adverse price movements. <\/code><\/pre>\n\n\n\n<p>Here are two examples of how a broker operates when taking the hybrid approach:<\/p>\n\n\n\n<ul><li>The broker can&nbsp;<strong>divide its customers&nbsp;<\/strong>and hedge the trades of some of the customers to an LP (A-Book or STP) and keep the rest \u201cin-house\u201d (B-Book).<\/li><li>The broker can decide to hedge all trades of a&nbsp;<strong>certain size or larger<\/strong>&nbsp;to a liquidity provider and keep&nbsp;the rest \u201cin-house\u201d (B-Book).<\/li><\/ul>\n\n\n\n<h2 class=\"wp-block-heading\">Customer Profiling<\/h2>\n\n\n\n<p>In the hybrid model,&nbsp;the forex broker has to decide&nbsp;<strong>which customers go to A-book and which go to B-book<\/strong>? And why?<\/p>\n\n\n\n<p>Once these rules and criteria are set, the&nbsp;broker will have an \u201c<strong>order routing system<\/strong>\u201d or \u201c<strong>order execution engine<\/strong>\u201d whose purpose is&nbsp;to manage orders by sending them to A-Book or B-Book automatically.<\/p>\n\n\n\n<p>The broker will most likely&nbsp;<strong>hold the trades of losing traders<\/strong>&nbsp;for themselves and<strong>&nbsp;hedge against the trades of profitable traders<\/strong>.<\/p>\n\n\n\n<p>This means that successful traders will be A-Booked, while the small unprofitable traders will be B-Booked, where the market risk is kept \u201cin house\u201d<\/p>\n\n\n\n<p>To successfully identify profitable and unprofitable traders, forex brokers have software that analyzes how customers trade.<\/p>\n\n\n\n<figure class=\"wp-block-image\"><img decoding=\"async\" src=\"https:\/\/bpcdn.co\/images\/2021\/05\/31173501\/customer-profile-360x360.png\" alt=\"Customer Profiling by Forex Broker\" class=\"wp-image-203749\" title=\"Customer Profiling by Forex Broker\"\/><\/figure>\n\n\n\n<p>They can profile traders by the amount of their deposit, the notional value of each trade, the leverage used, the risk taken with each trade, the use or non-use of protective stops, etc.<\/p>\n\n\n\n<p>For example, there seems to be a common pattern of behavior among losing traders.&nbsp;These behaviors include:<\/p>\n\n\n\n<ul><li>Depositing a tiny amount of cash which means a tiny starting account balance (usually less than $1,000).<\/li><li>Risking 10% or more of their tiny account balance per trade.<\/li><li>Not using stop losses.<\/li><li>Adding to losing trades.<\/li><li>Using high leverage on their tiny accounts making them frequently susceptible to\u00a0margin calls\u00a0and\u00a0stop outs.<\/li><\/ul>\n\n\n\n<p>With the use of computer algorithms, brokers are able to analyze trading patterns to profile the trades of each customer.<\/p>\n\n\n\n<p><strong>Brokers can be different \u201cbrokers\u201d to different customers.<\/strong><\/p>\n\n\n\n<p>It can be a B-Book broker to some and an A-Book broker to others.<\/p>\n\n\n\n<p>The reasons behind customer profiling are simple.<\/p>\n\n\n\n<figure class=\"wp-block-image\"><img decoding=\"async\" src=\"https:\/\/bpcdn.co\/images\/2021\/05\/31174150\/profile-trader-296x360.png\" alt=\"Forex Broker Profiles Trader\" class=\"wp-image-203751\" title=\"Forex Broker Profiles Trader\"\/><\/figure>\n\n\n\n<p>The customers who are A-Booked are more successful and will generally be trading in larger lot sizes, so fully offsetting these orders with an external counterparty eliminates exposure to market risk while still earning a (small) fee from the spread.<\/p>\n\n\n\n<p>On the other hand, the customers who are B-Booked&nbsp;will generally be small orders, mostly losing trades, and the broker can warehouse the market risk since the risk is small because the trade size is small.<\/p>\n\n\n\n<p>This allows the broker to profit from losing trades from its B-Book customers, and also earn from the price markup from its A-Book customers.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Large Forex Brokers<\/h2>\n\n\n\n<p>For larger forex brokers, because they have a large number of customers opening trades in both (long and short) directions, they are able to internally offset (\u201cinternalize\u201d) a great deal of their order flow, which allows them to minimize their market risk WITHOUT having to hedge with an external counterparty.<\/p>\n\n\n\n<p>When not all of the positions are able to be hedged, the<strong>&nbsp;excess market risk<\/strong>&nbsp;exposure is then hedged externally.<\/p>\n\n\n\n<p>A large customer base allows most large forex brokers to theoretically offset most of their customers\u2019 trades with each other.<\/p>\n\n\n\n<p>This allows revenue to be earned from customers\u2019 transaction fees&nbsp; (from the spread), which means that<strong>&nbsp;it is the volume of customer trading that drives revenue, not from customers\u2019 losses<\/strong>.<\/p>\n\n\n\n<p>For smaller brokers, if they are unable to hedge your trade with another one of its customers, they \u201cB-Book\u201d (take the other side of) the trade,&nbsp;<strong>up to their market risk limit<\/strong>. Anything above this limit would be hedged externally.<\/p>\n\n\n\n<p>The use of B-Book combined with only externally hedging beyond a certain risk limit provides&nbsp;<strong>better order execution<\/strong>&nbsp;(because it allows the broker to immediately execute your trade) while keeping<strong>&nbsp;latency and its costs to a minimum<\/strong>&nbsp;(because it doesn\u2019t have to A-Book or STP every trade which would mean paying the LP\u2019s spread every time).<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Most Forex Brokers Use a Hybrid Approach<\/h2>\n\n\n\n<p>We don\u2019t see anything wrong with a broker operating both A-Book and B-Book. The reality is that most brokers do use a hybrid approach.<\/p>\n\n\n\n<p>The profits gained from traders placed in the B-Book allow brokers who use a hybrid approach to provide all their customers with&nbsp;<strong>very competitive spreads<\/strong>.<\/p>\n\n\n\n<p>The main disadvantage with this approach is that if the broker&nbsp;<strong>manages the risk of B-Book poorly.<\/strong>&nbsp;The broker could end up blowing up and going out of business.<\/p>\n\n\n\n<p>Trades from new retail traders will most likely be B-Booked. This makes sense since most new traders lose. It\u2019s easy money for the broker.<\/p>\n\n\n\n<figure class=\"wp-block-image\"><img decoding=\"async\" src=\"https:\/\/bpcdn.co\/images\/2021\/05\/31175847\/trader-profitability-360x298.png\" alt=\"Trader Profitability Profile\" class=\"wp-image-203752\" title=\"Trader Profitability Profile\"\/><\/figure>\n\n\n\n<p>It\u2019s very rare for a retail forex broker to be 100% A-Book. It\u2019s a tough business model.<\/p>\n\n\n\n<p>The A-Book model is a much lower margin business&nbsp;than B-Book&nbsp;and requires brokers to focus on&nbsp;<strong>customers who trade frequently in large quantities<\/strong>&nbsp;while trying to keep costs as low as possible.<\/p>\n\n\n\n<p>With so many unprofitable traders, a B-Book model&nbsp;provides an additional source of revenue.<\/p>\n\n\n\n<p>There is nothing wrong with a retail broker having a hybrid of both A-Book and B-Book.&nbsp;<strong>What is wrong is when a forex broker starts to manipulate trades in its favor.&nbsp;<\/strong><\/p>\n\n\n\n<p>The most important consideration for a retail broker, at least in a well-regulated jurisdiction, should be ensuring<strong>&nbsp;fair pricing and the&nbsp;best order execution for their customers<\/strong>, regardless of whether it adopts an A or B book model.<\/p>\n\n\n\n<pre class=\"wp-block-code\"><code>Regardless of the broker\u2019s execution model, what\u2019s \nmost important is that retail traders<strong>\u00a0receive <\/strong>\n<strong>transparent prices that track the <\/strong>\n<strong>\u201creal\u201d(institutional )FX market in <\/strong>\n<strong>real-time<\/strong>\u00a0AND be able to\u00a0<strong>get their orders <\/strong>\n<strong>filled at these prices<\/strong>\u00a0(or better) without \nany delays.<\/code><\/pre>\n","protected":false},"excerpt":{"rendered":"<p>In the\u00a0previous lesson, we talked about why forex brokers are attracted to B-Book execution more than A-Book execution, even though it\u2019s riskier because the broker can blow up if it\u00a0doesn\u2019t know WTH it\u2019s doing\u00a0has poor risk management. But what if brokers could get the best of both worlds? So far, we\u2019ve learned that when a [&hellip;]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[768],"tags":[],"_links":{"self":[{"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/posts\/9499"}],"collection":[{"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/comments?post=9499"}],"version-history":[{"count":0,"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/posts\/9499\/revisions"}],"wp:attachment":[{"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/media?parent=9499"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/categories?post=9499"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/mudassirbackup.infinitycodestudio.com\/index.php\/wp-json\/wp\/v2\/tags?post=9499"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}