In the previous lessons, you've explored the different execution levels forex brokers use with your order. Essentially, there are two main types: A-book and B-book trading.
Let's review,
- A-book trading means that the broker either routes your trade to the market or liquidity provider (LP) or takes the opposite of your trade and offloads the market risk to its LP.
- B-book trading is when the broker takes the opposite of your trade, making it the transaction's counterparty. Essentially, the broker incurred losses when your position gained profit, and vice versa.
Now, let's look at the last execution model, the C-Book trading.
Lesson Highlights
- C-Book brokers combine A-Booking and B-Booking by either passing their clients' trade to liquidity providers or keeping them in-house.
- C-Booking includes partial hedging, overhedging, and reverse hedging. The decision of which type of execution to perform is based on profiling to see whether the clients are profitable or not.
Do C-Book Brokers Even Exist?
Yes, brokers that C-Book their clients' trades are in the market. In fact, this is a common yet unknown practice of forex brokers.
Why? It brings the brokers more money than what they'll get if they A-Book or B-Book a trade. It's deemed a money maker rather than a risk management technique for brokers.
C-Book brokers profile their clients' past performance and take advantage of their open positions. With its purpose to monetize the client's trade, this type of trading tends to receive controversies.
What Do C-Book Brokers Do?
As you already know, the broker checks client data, profiles them, and figures out whether the trader is an informed trader or a losing one.
After getting enough data, the broker has three common practices to capitalize on its client's trade. These are known as partial hedging, overhedging, and reverse hedging.
Partial Hedging
This C-Book trading practice is the most common among the three. Look at this as a combination of A-Book and B-Book trading, where the broker hedges half of your trade and accepts half of its market risk.
You can assume that this is the least questionable of all. The broker accepts the residual risk, hoping to profit from it while hedging the other portion to avoid suffering from the entire market risk.
To put it into perspective, here's how Broker X C-Book the trade of Sean
Partial Hedging Scenario
Sean trades with Broker X and goes long 100,000 EUR/USD at 1.2000. As the trade's counterparty, Broker X is subject to market risk if the market moves in favor of Sean's position.
What Broker X decided to do is to hedge Sean's position with its liquidity provider partially. Broker X traded only 50% of Sean's trade, going short 50,000 EUR/USD. This way, the broker capitalizes on Sean's position while managing the risk.
One moment, the EUR/USD had a 100-pip upward movement, which resulted in Sean getting a profit of $1,000. Consequently, Broker X has lost $1,000 by being a trade counterparty.
Since Broker X offloads 50% of the market risk, he made a profit of $500 from his short position with its liquidity provider. Considering this $500 profit and $1,000 loss, the broker managed its risks to only $500.
Overhedging
When the broker overhedges your trade to its liquidity provider, it takes advantage of your informed trading decision and wants to ride along with your gains.
Technically, overhedging means that the broker hedges more than 100% of your trading position to juice its profit from its liquidity provider.
Assume you open a long 100,000 EUR/USD. What your broker does is hedge 110% of your trade with its liquidity provider. It will go long 110,000 EUR/USD, hoping your trade wins.
Since it hedges what it is supposed to hedge, many traders also call this execution as A-Book+
How did your broker know? That simply means that the broker profiled you and your past performance.
Take a look at Ester's trading situation and see how her broker overhedge her trade.
Overhedging Scenario
Ester is an expert forex trader, and her broker knows it.
One day, she opened a buying position for 100,000 EUR/USD. Her broker found this the perfect opportunity to ride along with her winning streak, so the broker C-Booked her trade by overhedging it. Her broker entered a buy position for 110,000 EUR/USD with its liquidity provider.
After a few moments, the EUR/USD appreciated, and Ester gained a profit of $1,000 from her broker, which also resulted in a $1,000 loss for the broker.
However, the broker overhedged Ester's position by 10%. Overhedging Ester's trade generated a $1,100 profit for the broker. The broker bagged a $100 profit from its transaction between Ester and its liquidity provider.
Reverse Hedging
For those traders who've consistently performed badly, C-Book brokers take advantage of their position by doing a reverse hedge.
A reverse hedge is basically when the broker inversely mirrors your trade. Technically, it aims to make more money by adding more to the B-Booked position.
In other words, the broker opts to accept more risks because it's confident your position will run at a loss. Sounds like B-Booking, right? That is why we also call it B-Book+
Here’s the trading situation of John to describe the reverse hedging concept vividly.
Reverse Hedging Scenario
John believes that the EUR/USD will appreciate in the coming hours. So, he entered a buying position for 100,000 in 1.2000.
However, the broker knows that John tends to make unprofitable trading decisions; hence, it reversely hedges his position to accept more market risk. Essentially, his broker opened a short position of 100,000 EUR/USD with its liquidity provider to take more market risks.
After holding the position for a few hours, John noticed the market crashed against him. The downward movement resulted in 200 pips lost on John's end, which amounted to $2,000.
On the other hand, John's broker profited $2,000 from John's loss. And since it used a reverse hedging strategy, John's broker also generated a profit of $2,000 against its liquidity provider.
But remember, these C-Book techniques can also be harmful if the broker makes an incorrect prediction. C-Booking a trade opens more risks to the brokers.
In the next lesson, you'll be able to internalize how brokers aggregate and hedge market risks in their favor.
