A Forex trader can view an update to their account balance at the conclusion of every transaction. Even though this is a typical procedure, a novice trader would question where the money had gone (in the event of a profit) or where it had come from (in a case of loss). It is no secret that a majority of retail forex traders lose money, so where does that money go? The inflow and outflow of funds from a trader’s account are described in this article.
Where does forex money come from?
In the OTC Forex market, a broker has two options: either participate as a counter-party (market maker) to the trade or send the order straight (STP, or Straight Through Processing) to a liquidity provider (such as Credit Suisse, Goldman Sachs, Nomura, Citigroup, UBS, Bank of America, etc.).
Straight-through processing (STP)
When a retail Forex trader opens an account with a STP broker, where does their money go? Assume for the moment that the client orders to purchase 1 standard lot (100,000 units) of the EUR/USD currency pair at 1.1120. The order is currently being sent straight to the liquidity pool. The money needed to open the trade is locked in the client’s account and displayed as equity value if the limit order is completed. $1,120 would be blocked in the trading account and presented as equity value if the client applies a leverage of 1:100. Real-time updates would be made to the equity value based on price changes. The typical leverage that STP Forex brokers receive from their liquidity providers is around 1:100 but can vary depending on who you use. You can even trade forex without leverage to reduce risks.
Assume for the moment that the client sells their long EUR/USD trade at 1.1130. The buy order would be matched with the sell order by the liquidity provider. In favor of the Forex broker, the liquidity provider would now release $1,120 plus $100 in profit. The Forex broker would then unblock the trader’s account of $1,120 and credit their account with a $100 profit. The counterparty may or may not be the liquidity provider in this transaction. The liquidity provider can be starting a fresh trade in the hopes of selling it to someone else for a greater price. Another possibility is that the liquidity provider is covering the short position that was initiated at a higher price. Therefore, the transaction cannot be interpreted as representing a loss for the liquidity provider.
The liquidity provider would only refund $1,020 ($1,120 – $100 loss) of the Forex broker’s capital if the trader cancels the same position at 1.1110. On the other side, the Forex broker would only release $1,020 of the $900 locked while opening the trade. The Forex trader would so recover their lost funds, and business would go as usual.
Let’s now take a similar scenario with a market maker Forex broker into consideration. Every time an order is made, the broker simply confirms the trade by locking up the necessary capital (based on the leverage employed). The orders will be gathered and transmitted to the liquidity provider in accordance with the type of risk management the Forex broker employs. When there are equal quantities of buy and sell orders for a currency pair, an internal matching is performed.
A straightforward ledger transfer is carried out based on net equity value when a client closes the order. The Forex broker’s position as a counter party may or may not be closed at the same time as the liquidity provider, depending on the mechanism being used. This basically means that you are trading against your broker. If you win they lose and vice versa. For this reason, many traders would avoid using a market maker broker as there can be a conflict of interest.
Where does money go when you lose a forex trade?
It will either go the liquidity provider who was willing to provide a bid/ask price for you to buy or sell the currency pair, or it will go to the market maker who had inhouse liquidity available to match your trade with. It is possible that your forex trade can get matched with another retail forex trader. In this instance, if you were to lose money on a forex trade, they would be pocketing the profits. Keep in mind that the forex broker will usually make money from forex trades via the spread and commissions which can account for where some of the other money goes.
Trading in currency pairs is comparable to purchasing a physical good where the cost of the item is passed through several hands before being purchased from the maker. Between the two, the merchants and distributors take their cut of the revenues. In a similar vein, Forex brokers deduct their fair share in the form of spread (and or commission) and pass on the actual price to the other party. You will even make a profit or loss on your trade (after broker fees), depending on if you anticipated the correct direction the market headed. I prefer ECN forex brokers because they do not take the opposite side of my trades and usually provide access to the best prices on the fx market at all times, along with rapid trade execution speeds.
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