Where Does Forex Leverage Come from?
It is not uncommon to come across a Forex broker offering a leverage of 1:500. There are even Forex brokers offering a leverage of 1:3000. So, the immediate doubt that arises in the mind of a trader is how far are they real? Another query that is seldom answered is how can a Forex broker afford to give such a huge leverage? Let us first look at the factors which allow an increase in leverage, before running through a detailed example.
Spot Forex Transactions
A Forex transaction is completely different from an equity market transaction in the sense that there is no change of ownership at the time of entering a trade. When a trader exchanges the euro against the US dollar in a spot market, it simply means that there is an agreement to complete the transaction of a particular volume and price at the time of settlement without physical delivery of cash. All spot Forex transactions are settled two days later (should be a business day in both currencies), barring the USD/CAD pair which is normally settled on the next day. Thus, only a margin balance sufficient enough to cover the fluctuation in the contract value is required to open such a position.
Margin Requirement in Spot Market
Since a spot Forex transaction is merely an agreement to complete the exchange at a future date, there is only a need to have minimal amount of money that would cover the counterparty risk. If the value of a contract goes down after buying or selling a currency, a trader should not back down and put the counterparty at risk. The margin in a trader's account should cover that risk. A major currency pair rarely gains or loses more than 1% in a single day. So, how much is the mandatory margin and who decides it? The answer is a liquidity provider, as explained below.
Retail Forex brokers have accounts with multiple liquidity providers (LP) such as banks, hedge funds, and major financial institutions. An LP can provide a leverage ranging from 1:25 to 1:50 to brokers. The ratio may vary slightly, depending on the relationship between a given broker and a given LP.
A currency trade can be rolled over, extending the agreement to the next settlement date, by paying the swap rate. As long as the trader has enough money in his or her account to cover the margin of 2% and the swap fee, the Forex broker will roll over the positions automatically. The rollover mechanism enables a trader to avoid large capital, which would be otherwise required in a case of the trade's settlement.
Similar to the equity market where brokers offer short-term funding to the tune of 50% of the value of a stock, foreign exchange brokers do fund a portion of the margin requirements. This is basically intended to increase volumes, which is crucial not only in terms of profitability but also the smooth functioning of the Forex broking business (in-house settlements explained in the next paragraph). Funding increases leverage considerably is shown in the example farther below.
When broker's clients take mutually opposite positions in a currency pair, then an aggregator (a software program which manages feed from multiple LPs efficiently) ensures that such trades are settled in-house. Such a provision enables a Forex broker to avoid the need for large capital outlays when providing huge leverage.
We have discussed the factors that enable a Forex broker to offer high leverage. Now, let's look at an example to understand how it works in a real life situation.
Let's assume that 100 clients of a broker wish to trade one lot of USD/JPY each. If 60 clients wish to open a long position and 40 clients wish to open a short position, then the leverage offered by the broker would get stretched in the following manner:
- Value of one lot = $100,000
- Minimum margin required at the time of entering into a trade = 2–3% of $100,000 = $2,000–$3,000. 1:33–1:50 total leverage.
- Net long positions to be hedged with LP = 20.
- Capital required = $2,000 × 20 to $3,000 × 20 = $40,000–$60,000.
- Broker’s capital (50–75%) = $20,000–$30,000 or $30,000–$45,000.
- Client’s capital = $10,000–$20,000 or $15,000–$30,000.
- Capital per client = $100–$200 or $150–$300.
- Effective leverage = 1:500–1:1000 or 1:333–1:666.
The above example shows that low margin requirements, LP’s leverage, and FX broker’s own capital results in an enormous leverage. It is also seen that a broker needs to shell out more money to offer a leverage of 1:3000. However, considering a spread of 1–2 pips, higher leverage helps brokers to earn more by stimulating bigger trades.
Forex broker’s capital is primarily at risk. Unexpected news, if any, can create a jolt in the Forex market (similar to SNB’s decision to unpeg the Franc), resulting in a huge loss (for example, FXCM lost more than $225 million from SNB’s decision). Since ECN brokers route the orders directly and do not offset positions internally, the leverage is always considerably smaller.