At the end of every trade, a Forex trader can see his account balance getting updated. While this is a standard process, a beginner trader may wonder where the money had come from (in a case of profit) or had gone (in a case of loss). This article explains the flow of money in and out of a trader’s account.
In the OTC Forex market, a broker can either pass the order directly (STP - Straight Through Processing) to a liquidity provider (Credit Suisse, Goldman Sachs, Nomura, Citigroup, UBS, Bank of America, etc.) or act as counter-party (market maker) to the trade.
Where does the money go in case of a retail Forex trader who has an account with an STP broker? Let's assume that the client places an order to buy 1 standard lot (100,000 units) of the EUR/USD currency pair at 1.1120. The order is now routed directly to the liquidity pool. If the limit order gets executed, then the capital required to open the trade is blocked in the client’s account and shown as equity value. If the client uses a leverage of 1:100, then $1,120 would be blocked in the trading account and shown as equity value. The equity value would get updated on a real-time basis, as per the price movement. STP Forex brokers generally receive a leverage of about 1:100 from their liquidity providers. Thus, in our case, the Forex broker’s $1,120 would also get blocked.
Let us assume that the client liquidates the long EUR/USD position at 1.1130. The sell order is routed to the liquidity provider where it would be matched with a buy order. The liquidity provider would now release $1,120 + $100 profit in favor of the Forex broker. In turn, the Forex broker would release the $1,120 blocked in the trader’s account and also credit $100 gain to their account. In this transaction, the liquidity provider may or may not be the counterparty. The liquidity provider may be opening a new trade with the hope of selling it further higher to somebody else. Alternatively, the liquidity provider could be covering the short position opened at a higher level. So, the transaction cannot be construed as a loss for the liquidity provider.
If the trader closes the same position at 1.1110, then the liquidity provider would release only $1,020 ($1,120 - $100 loss) of the Forex broker’s capital. The Forex broker, on the other hand, would release only $1,020 out of the $900 blocked while opening the trade. So, the Forex broker would get back his lost capital and business would continue as usual.
Now, let us consider a similar case with a Forex broker who acts as a market maker. Whenever an order is placed, the broker simply locks up the requisite capital (on the basis of leverage used) and confirms the trade. Depending on the nature of risk management used by the Forex broker, the orders will be grouped together and sent to the liquidity provider. An internal matching is done whenever there are equal numbers of buy and sell orders for a currency pair. When a client closes the order, a simple ledger transfer is done on the basis of net equity value. Depending on the mechanism used, the Forex broker’s position as a counter party may or may not be closed at the same instant with the liquidity provider.
Buying and selling a currency pair is similar to buying a tangible asset where the actual cost of the product passes through various hands before reaching the manufacturer. The retailers and distributors take their portion of profits in between. Likewise, the Forex brokers take their due profit in the form of spread and pass on the actual price to the counter party.