Many retail traders have no understanding how orders are handled or how forex brokers or CFD providers actually work.
This lecture is intended to provide an overview of the mechanics of retail FX trading.
It is intended for forex traders who want to obtain a practical grasp of how forex brokers manage risk and profit.
The trading process is not always visible, and there are several ways an order might be executed, each with its own set of dangers.
If you take the time to learn how orders are processed, you’ll be able to tell the difference between forex brokers and make a more informed selection when selecting one.
Counterparties
What happens when you make a trade order in your broker’s trading platform and the order is executed or “filled”? It actually has no effect.
A broker is defined as an intermediary who performs trades on behalf of its clients. A dealer is defined as a person or entity that trades on its own account.
Retail forex brokers DO NOT trade on their clients’ behalf. They are merchants.
A retail forex broker trades on its own account by taking the opposing side of trades made by its customers. Because retail forex “brokers” are actually retail forex traders, the name “forex broker” is merely a marketing word.
For example, in the United States, all retail forex brokers are legally known as “Retail Foreign Exchange Dealers,” or RFEDs.
The essential point is that, in order to be technically correct, we should use the word “forex dealers.”
However, because the phrase “forex brokers” is so famous and has already been scorched into everyone’s consciousness as a result of effective brainwashing marketing, we will continue to refer to them as such in the future.
Client or Customer?
Are you a forex broker’s client? Or are you a forex broker’s customer?”
The terms “client” and “customer” are frequently used interchangeably.
For our purposes, we believe there is a significant distinction between being a client and being a customer.
Being a client of a company implies that you and the company have a fiduciary relationship. This means that the company acts on your behalf and is legally required to do so.
However, a forex broker does not operate on your behalf and is not required to behave in your best interests.
So, if we accept the concept that being a client implies a fiduciary relationship, you are NOT a client of your “forex broker.”
You are a customer.
If you wish to buy, its service isn’t to act on your behalf and find you a vendor. It is the one who is selling to you.
How can you be a “client” if the broker is the one selling or purchasing from you?
You are a customer of your “forex broker,” who provides a service that allows you to speculate (make bets) on currency pair price changes.
Because you can’t trade directly in the (institutional) FX market, it “creates” one for you.
It allows you to bet on currency prices by constantly taking the inverse of your bets whenever you want to make one. It is not looking for someone to take the opposing side of the bet; it just accepts the bet.
However, the “forex broker” does not have a fiduciary duty to work in your best interests. Having said that, even if there is no fiduciary connection with the consumer, the forex broker should treat all of its customers honestly and fairly.
In the future, we shall refer to traders who use the services of a retail forex broker or CFD provider as “customers.”
All orders and trades submitted through your broker’s trading interface are NOT executed on an external trading platform, but rather by the broker.
Your “broker” is betting against you in the trade.
This is referred to as being the counterparty.
Consider this. Someone has to sell if you want to purchase. And someone has to buy if you want to sell.
Every buyer must be linked with a seller, and the reverse is true.
You require a counterparty.
When you trade using a broker, you and the “broker” are both holding positions against one another.
You are one another’s counterparts. You are the counterparty to your broker. Your counterparty is your broker. This means that if you want to buy, or “go long,” the broker will sell to you, or “go short.” If you want to sell or “go short,” your broker will take the opposite side of your trade and buy from you or “go long.”
Your order is referred to as a bilateral transaction between you and your broker. “Bilateral” is basically a fancy word for “involving two parties.”
Because your retail forex “broker” is the counterparty to ALL of your trades, all retail forex trades are bilateral.
Example 1: Single Trader and Broker
If you buy 100,000 GBP/USD, for example, or initiate a “long” position, your broker will take the opposite side of your trade.
This suggests that it will sell 100,000 GBP/USD or be “short” against you.
Because you are now “long” GBP/USD, you are now exposed to the risk that the price of GBP/USD will fall and you will be forced to close your position by selling at a lower price than you paid for it, resulting in a loss.
The broker that is now “short” the GBP/USD is likewise in danger. However, in this situation, the danger is that the price of GBP/USD will rise. If GBP/USD continues to rise, the broker’s loss will increase.
This risk is called Market Risk
Market risk is the risk of losing a position due to unfavourable market fluctuations.
When you initiate a trade with your broker, both you (the trader) and the broker are subject to market risk. As you can see, your deal never reaches the “market.” It remains a private deal between you and your “broker.” This is why your forex broker is not a broker. It is a DEALER.
If it were a genuine broker, it would locate and match your transaction with another counterparty. If you want to buy, for example, the broker will identify someone who wants to sell.
However, this is not the case. It is the one who sells to you if you desire to buy. Because a retail forex broker is THE counterparty for ALL of its traders (“clients”), it maintains A LOT of positions in various currency pairings. To assess the market risk for a particular currency pair, we must add ALL of the broker’s positions against traders in that currency pair.
Example 2: Two Traders and Brokers
Let us imagine there are two traders: Elsa and Ariel.
They both trade GBP/USD, but they have opposing views on where the price is headed. Elsa goes long on the GBP/USD, while Ariel goes short on the GBP/USD.
Each trade is taken on the opposing side by the broker.
Keep in mind that the broker is the sole counterparty to all of its customers’ trades.
Each trader deals with the broker directly (“bilaterally”) and solely with the retail broker. Retail forex traders do not interact with one another. Let’s take a look at how Elsa and Ariel’s deals impact the broker’s trading book.
A trading book, often known as a “book,” keeps track of all the open positions that a broker has.
Every time one of its customers trades, the broker must take the opposing side of the trade. As a result, the trading book is continually changing, resulting in “net” long (or short) positions in specific currencies.
The broker must constantly monitor its long and short positions and be aware of its net positions at all times. As a trader, you have your own “book.” Your book is just all of your open positions.

Even if both Elsa and Ariel have open positions against the broker, the broker’s net position is zero, as seen above. The broker holds a short position on Elsa’s trade but a long position on Ariel’s transaction.
The two trades cancel each other out, reducing the broker’s exposure to market risk. Assuming that this is the broker’s only GBP/USD position, its market risk exposure is zero.
Of course, the broker must make a profit, therefore the price quoted varies depending on whether the customer want to purchase or sell. The spread is the difference between the two prices.

Elsa purchased GBP/USD at 1.2503, known as the “ask” price, while Ariel sold GBP/USD at 1.2500, known as the “bid” price.
This indicates that the broker’s spread was 3 pips (0.0003). (1.2503 – 1.2500).
Essentially, the broker purchased GBP/USD from Ariel at 1.2500 and then sold GBP/USD to Elsa at the higher price of 1.2503, pocketing the spread. This spread represents the broker’s profit of $30. (0.0003 x 100,000).
It makes no difference if the market moves widely at this stage because the broker’s net position is zero; the market is locked in due to the offsetting deals.
Elsa, for example, purchased GBP/USD at 1.2503, Ariel sold GBP/USD at 1.2500, and the current market price is 1.3100.
Let’s figure out the broker’s profit and loss:
P&L = 100,000 (1.2503 - 1.3100) + 100,000 (1.3100 - 1.2500) P&L = -5,970 + 6,000 P&L = 30
The broker has made a $30 profit.
Let’s see what happens if the market price falls to 1.2900.
P&L = 100,000 (1.2503 - 1.2900) + 100,000 (1.2900 - 1.2500) P&L = -3970 + 4000 P&L = 30 As you can see, even if the price moved 200 pips (from 1.3100 to 1.2900) due to the two trades offsetting each other, the broker was NOT exposed to market risk and its profit remained at $30.
Example 3: Many Traders and Broker
Let us now increase the number of dealers from two to three.
There are 1,000 traders, and each trades one standard lot (or 100,000 units) of GBP/USD.
Let’s take a peek at the broker’s book right now.

As you can see, the broker is net short 100 million GBP/USD units.
(1,000 merchants multiplied by 100,000 units Equals 100,000,0000 units)
Because no other traders chose to short GBP/USD, the broker was unable to offset any contracts in order to reduce his net short position.
That level of market risk is significant.
If a 1-pip rise for a regular lot or a 100,000 unit position equals $10, this means that for a 10M unit position, every pip gain in GBP/USD results in a $10,000 unrealized loss for the broker.
Repeat after me: 1 pip rise = $10,000 unrealized loss.
So, if the GBP/USD rises 100 pips, the broker will lose $1,000,000.
In theory, the broker could stop accepting trades if it didn’t want to expose itself to such risk, but it would imply that no more trades could be entered into by its customers. That’s the equivalent of a store posting a “Closed” sign in the middle of the day when people expect it to be open. If traders couldn’t open transactions on the broker’s trading platform for some reason, they’d be upset.
So refusing transactions is out of the question. The broker must remain “Open” or risk losing customers. It must keep accepting deals. Assume that EVERY trader closed their position once the GBP/USD climbed 100 pips.
Each trader would profit $1,000 (100 pips x $10).
And, because the broker was the counterparty for all 1,000 traders, the realized loss would be $1,000,000 ($1,000 x 1,000 customers).
Is the broker really going to pay out $1 million to its lucky customers? If it does not, it will go out of business, along with some very disgruntled clients.
If the broker does not have the funds in this circumstance, it has not adequately managed its market risk.
The price moved so much against the broker’s net position that it was unable to meet its obligations to its customers and distribute their winnings.
Because of the broker’s overexposure to market risk, the traders (its customers) are now exposed to counterparty risk.
Counterparty risk occurs when one party fails to fulfill its end of the bargain. When the traders withdrew their long bets in this scenario, they expected to get their profit in their account. However, the broker took on too much risk and now lacks the funds to pay up.
“The house has gone bust,” as the saying goes in the casino.
This is why it’s critical to understand how your broker controls risk on the other side of your trade. The broker can mitigate market risk in three ways:
- It can offset opposing trades from its customers.
- It can transfer or “offload” the risk to another market participant.
- It can accept or “warehouse” the risk.

The way a forex broker manages market risk defines the sort of broker and how the business functions. Understanding how your broker “takes risk” on your order is crucial to your trading performance.
If your broker takes the other side of your order and does not pass it on to an external counterparty, your broker bears the entire market risk connected with it.
So, if you understand how your broker controls risk while doing the opposite of your transaction, you’ll know what kind of broker you’re working with and whether there are any potential conflicts of interest.
Next Lesson: 3 Types of Forex Market Analysis