When trading forex, where are you actually trading?

In the previous lesson, you learned that retail forex traders do NOT trade in the “real” FX market.

If that’s the case, then WHERE are you actually trading? When you click “Buy” or “Sell” on your forex broker’s trading platform, where do your orders go? 🤔

That’s what we’ll reveal in this lesson.

In order to understand where your trades go, we first need to understand where retail forex brokers and traders (like yourself) fit within the FX market ecosystem.

The FX market is fragmented and complex but we’ll try and provide a simplified and stylized overview.

Let’s pretend there is a giant body of water…a gigantic lake.

A lake that’s bigger than an ocean.

The gigantiest lake ever.

Let’s say this giant lake represents the “FX market”.

This giant lake is not empty.

It contains boats!

The boats come in different sizes.

These boats represent the market participants in the FX market.

Imagine there are thousands of these boats in the water.

These market participants tend to be banks, non-bank financial institutions (“NBFIs”), multinational corporations (“MNCs”), large institutional investors, algorithmic trading firms such high-frequency trading (“HFTs”) and electronic market makers,  hedge funds, and high-net-worth individuals (“HNWIs”).

Some are huge. Some are less huge.

The huge boats are the large commercial banks. Banks like Barclays, Citigroup, Deutsche Bank, HSBC, JP Morgan Chase, and UBS. Their boats are huge since they have a lot of capital.

The big boats sometimes trade directly with each other. This is known as a “bilateral trade”. So you can say that two boats can “trade bilaterally”.

When these big boats trade bilaterally, only the two market participants involved know what the quotes given were and the actual price that was agreed upon. Other market participants (boats) do not have access to this information at all.

Banks provide different quotes to different customers and agreed-upon prices and volumes are often never publicly disclosed. That makes it harder for any market participant to know if their trade was at a good (or bad) price.

But there aren’t only boats on this giant lake.

There are lots of islands!

These islands represent the different trading venues in the FX market.

The rise of electronic trading in FX resulted in an explosion of trading platforms and electronic execution venues. These platforms are known as interdealer (IDP), single-dealer (SDP), multi-dealer (MDP) platforms. However, with the rise of venues such as electronic communication networks (ECNs), application programming interfaces (APIs), and API aggregators, the distinction among these traditional segments has started to blur together and become less clear.

In general, trading venues are where different market participants can come together and trade with each other.

When trading on one of these islands (trading venues), market participants must abide by the island’s rules.

The island runs a marketplace that facilities trades between market participants. Some even provide anonymous trading where you can submit orders without revealing your identity to the other traders.

For example, if a buyer wants to buy 10 million units of USD/JPY at 110.00 and a seller wants to sell 10 million units of USD/JPY at 110.00, the orders are matched up. All without revealing the identity of either buyer or seller.

As you can see, there is not one single island where ALL trading takes place.

And prices that traders buy and sell are unique to each island.

For example, if a ship were to “island hop”, it might find on one island, the ask price for USDJPY is 110.00, while on another island, the ask price is 110.01.

The FX market is fragmented, meaning the USD/JPY market on one trading venue is separate from other trading venues. Each currency pair will have its own price, liquidity, and trading volume depending on the venue.

FX trading occurs in many different places all at once.

So there really isn’t a single “FX Market”. It’s a bunch of different markets that comprise the “FX Market”.

If you think about it, the “FX Market” is really a NETWORK of a bunch of different places to trade, rather than a single place.

Islands differ in size.

The size represents the amount of trading volume that occurs on an island.

Different boats trade on different islands.

While some boats are rich enough to be able to trade on any island, most aren’t.

Depending on the island, only certain boats are allowed.

For example, there are boats that are so rich, that they actually own their very own island!

If a boat owns an island, no other large boats (banks) are allowed. Only special, smaller boats (clients of the bank) are allowed.

These types of islands are known as “single-dealer platforms (SDPs)”. Examples of SDPs and its owners are Autobahn (Deutsche Bank), BARX (Barclays), Cortex (BNP Paribas), Neo (UBS), and Velocity (Citi).

Which is fine by most of the large boats, since they also own their very own exclusive island anyway.

Another example, the two big islands in the middle, only the biggest boats are allowed to trade there.

The people who trade on these big boats are called dealers.

So on these islands, dealers trade with each other in large quantities.

This is known as the “interdealer market”.

The prefix “inter” means “between” or “among”.

The interdealer market is also known as the “interbank market” since most dealers work for large multinational commercial banks that serve global clients.

These huge banks are also known as “bulge bracket” banks.

The “islands” in the interdealer market are known as “interdealer platforms” (IDPs). which are electronic trading platforms where non-disclosed (anonymous) trading occurs in the interdealer market. Examples of IDPs are EBS Market and Refinitiv Matching.

The interdealer segment of the FX market is where trades occur between FX dealers, as opposed to between dealers and their end customers, such as exporters and importers, asset managers, hedge funds, and even some retail forex brokers.

In the past, only the biggest of boats were allowed on these big islands. This is because large boats preferred to only trade with other large boats. They deemed smaller boats as too risky to trade with.

But nowadays, it’s possible for medium-sized boats to trade there as well by “attaching” themselves to one of the large boats.

We won’t get into the details right now to keep things simple but basically, the large boat (bank) allows the medium boat (hedge fund) to trade in its name. This is how the medium boats are able to access these big islands and trade with the other large boats.

In exchange for the privilege to trade in its name, the large boat typically charges the medium boat a fee based on the volume of trades done.

This arrangement is known as a “prime brokerage” arrangement, with the large boat in the role called a “prime broker” (or “PB”) and the medium boat in the role as the prime broker’s client.

Prime brokers make it possible for these smaller (but not too small) market participants, despite their limited credit history or higher risk profile, to use the prime broker’s higher credit rating, and trade almost anywhere and with anyone in the “lake”.

Basically, the clear distinction that separated the interdealer market and the rest of the market in the past has now become blurred.

The important thing to know about the interdealer market is that it is a global network (of trading venues) used by banks and large non-bank financial institutions (“NBFIs”) to trade currencies between themselves. Trades occur electronically or via voice.

This “market” operates in a highly decentralized fashion as a loose network where banks and NBFIs negotiate bilateral deals without central supervision. This supposed “market” is, in reality, a network.

So when you see the term “interdealer market” or “interbank market”, it simply refers to a network where currency transactions are negotiated between financial institutions and other large companies.

The rates that are traded in the interdealer market then spread (like gossip) to the other boats and smaller islands (the rest of the FX market) and are used as “reference” rates by other market participants.

These rates are what’s (hopefully) displayed to you by your retail forex broker. Usually with a markup.

Now that we’re discussing retail forex brokers, let’s see where they fit in the picture.

A retail forex broker is one of the tiny boats.

Of course, since some retail forex brokers are larger than others, their boats also come in different sizes.

There are large retail forex brokers. And there are smaller ones.

Retail forex brokers can’t trade directly with other boats.

In order to trade, a retail forex broker needs to “attach” themselves to a larger boat that will allow it to trade in its name. This special type of relationship is known as a prime broker (“PB”) relationship.

The large boat becomes the retail forex broker’s PB.

A PB is an entity that is willing to represent the retail forex broker in all its trading transactions that occur in the lake and settle the trades in its name.

But large boats are picky.

For the larger retail forex brokers, they’re able to enter into a prime broker (“PB”) relationship with a large boat.

For the smaller brokers, they’re considered too risky for the large boats. They do not meet the rigid standards and are not able to secure a prime broker relationship, which prevents them from being able to trade with others in the FX market.

Fortunately, there are special types of boats that have an existing prime broker relationship with a large boat and offer a service to these smaller brokers that allows them to “piggyback” off this relationship.

This special type of medium-sized boat is known as a “Prime of Prime” or “PoP”.

Prime of Prime (PoP) refers to a firm that has an account with a Prime Broker (PB) that offers its services to other market participants such as forex brokers. PoPs bridge the gap between the institutional and retail FX markets by enabling retail forex brokers to leverage the PoP’s credit relationships with its PBs.

The PoP allows the smaller retail broker to trade through it.

Another way for smaller retail forex brokers to be able to trade with the “big boys” is to “piggyback” off a larger retail forex broker who has an existing PB relationship.

So if a retail forex broker is one of the tiny boats (more like rowboats and kayaks), where do you, the retail forex trader, fit in this picture?

You don’t.

Huh?

“Aren’t I a boat?” you might ask.

Nope.

As you just saw, it’s already difficult enough for retail forex brokers themselves to get access to the FX market.

If other ships already deem them too risky to trade with them directly without some sort of chaperone (PB or PoP), why would they want to deal with individual retail forex traders?

“So if I’m not a boat, what am I?” you might then ask.

A retail forex trader is NOT a boat

Your retail forex broker is a boat. But…

YOU are in an aquarium on their boat.

Retail forex traders do not trade in the “market”.

Your broker creates its own market for you to trade in.

You trade with, and ONLY with, your forex broker.

When you enter an order, it is your broker who takes it.

An “order” is an instruction to buy or to sell as placed by you via your account on your broker’s trading platform.

As a retail forex trader, when you enter an order to buy or sell a currency pair, the forex broker IS the counterparty to this trade.

This is true for EVERY retail forex broker.

You can confirm this, reading the “Customer Agreement” document of any well-regulated broker.

Your forex broker may provide you a trading environment that may “look and feel” like you’re trading on the giant lake.

Think of it like a simulation. Your broker “imitates” the real FX market so that it looks like the real “market”.

For example, the prices it displays on your trading platform may be similar to what’s shown in the real “market”.

But in the end, you are not trading with other traders….your forex broker is your sole counterparty. It is taking the opposite side of ALL your trades.

Your broker is the sole “execution venue” for the execution of ALL your orders.

An execution venue is just a fancy word where orders are placed and executed.

Because you only trade with the broker, it’s a separate, but parallel, market.

When you are “trading”’ all you are doing is playing in your forex broker’s “internal market” or aquarium.

No money is leaving the broker.

It is only when it needs to hedge trades that real money is used by the broker. But these hedging trades made by the broker, not you. (This topic will be discussed more in a future lesson.)

Your trade never “goes out into the market”.

Nor do you trade with other traders. Not even with other traders who use the same forex broker as you.

For example, if you and another trader use the same broker, you both will NEVER trade with each other, both of you will always only trade with the broker.

You are not in the same aquarium with the other trader.

You both are in SEPARATE aquariums on the same boat.

Retail traders do not have access to the FX market. They only trade with their retail FX broker.

In order to actually trade with other FX traders, meaning you’d be trading against a counterparty who is NOT your broker, you need to be an institutional FX trader.

This is why we prefer to call the real FX market, the “institutional FX market”.

In the institutional market, retail forex brokers are referred to as retail aggregators.

They’re called this because retail forex brokers typically aggregate the net positions of their customers for hedging purposes. They then transact in the institutional FX market to manage their exposure to market risk. (This will be discussed in more detail later.)

You should be wary of any retail forex broker that claims that you’re able to directly trade in the “interbank market” or institutional FX market or that they will do so “on your behalf”.

While your broker can participate in the institutional FX market, you cannot.

You’re stuck on your broker’s boat. And can only trade whatever your broker offers you.

The electronic trading platform that your broker provides you is only connected to your forex broker.

You are NOT accessing the “FX market”, the trading platform is simply an electronic connection for accessing your broker.

You are accessing that trading platform only to transact with your broker. Again, you are not directly trading with any other customers of the broker.

Put simply: When you sell, the retail forex broker is the buyer. When you buy, the retail forex broker is the seller.

The purpose of retail forex brokers is to act as “market makers” for retail traders.

Because the wholesale (institutional) FX market is inaccessible to retail traders, the retail forex broker is literally “making a market” for you to speculate on currency exchange rates.

It does this by providing you an online trading platform that shows you quotes on different currency pairs that you can “buy” or “sell” on.

You are only able to open and close your positions with your broker.

When you open a position, you actually enter into a contract, which is a private agreement between two parties: you and your forex broker.

These contracts are called CFDs or rolling spot FX contracts.

Contracts you enter with your broker can only be closed by your broker.

This means that you will be NOT able to close a position with another party.

The quotes that your forex broker provides you may be informed by or even come directly from the institutional FX market (via price feeds), but it is your broker who you are still trading against. Nobody else.

Why is this important to know?

Since the broker is the one taking the opposite side of your trade, this creates a potential conflict of interest.

How?

If your trade makes money, your broker loses money. And if you lose money trading, your broker makes money on the trade (plus any other fees it may charge).

So from your broker’s perspective, it’s in their interest if your trades lose money (which conflicts with your interest since you want your trades to make money).

Notice how we mentioned a “potential” conflict of interest. “Potential” is used because there are ways to mitigate this conflict between you and the broker.

This will be discussed in more detail in a later lesson but what’s important to know for now is that the potential conflict of interest does exist.

Counterparty Risk in Forex Trading

Because your broker is your sole counterparty, this means that there is the risk that it might not meet its obligations to you.

This is known as counterparty risk.

A counterparty is the other party that participates in a transaction, and every transaction must have a counterparty in order for the transaction to go through.

The buyer and seller in a transaction are also known as counterparties.

• The buyer is the counterparty to the seller.
• The seller is the counterparty to the buyer.

A counterparty is the other party that participates in a transaction, and every transaction must have a counterparty in order for the transaction to occur.

With regard to trading, a counterparty is simply the other side of a trade. For example, a buyer is a counterparty to a seller.

You (the buyer) and the seller (the forex broker) are known as “principals”.

A principal is a party involved in a contract. So as the buyer, you are a principal. And as the seller, the forex broker is also a principal.

You trade as principal. And your broker trades as principal. When you trade with each other, it’s known as “principal-to-principal” trading.

This is why a forex broker is not really a forex “broker” but a forex “dealer“.

A broker is supposed to act as an agent on your behalf who simply ”brokers” a deal between you and another counterparty (principal). Or in other words, matching your order with a buyer/seller.

So by definition, a forex broker can NOT be a true broker because it IS your counterparty since it takes the other side of the transaction as principal.

Counterparty risk, also known as default risk or counterparty credit risk (CCR), is the risk that a counterparty will not pay as obligated on a contract.

For example, if two people agree to trade, and there is no one else to verify the trade, it is possible that one party could back out of the agreement, or be unable to produce the funds to hold up their end of the transaction.

If you open a position with your broker and then close it for a profit. What happens if the broker doesn’t have the money to pay out your winning trade?

What if other traders opened a similar position as you, where they all also ended up with a profit?

The aggregate profit from all these trades results in the broker having such a huge loss that it “goes bust” and doesn’t have the capital (money) to honor the winning trades.

Since the position was a transaction between you and the broker, and you can’t move or transfer the position with another broker, YOU ARE SCREWED.

Let’s repeat that again for emphasis.

When you win, your counterparty loses. If your counterparty, which is your broker, is unable or unwilling, to fulfill its obligations upon losing a trade, YOU ARE SCREWED.

Worried yet? Well, here’s one more example for ya…

What if another customer, using the same forex broker as you, opens a massively huge position, and price skyrockets in his favor, making him a ton of money. He bet right (and huge) and hit the jackpot! 🚀

He makes so much money though that the broker doesn’t have the money to pay him and “goes bust”. 💀

You have money deposited with the same broker, which you think is safe, but in reality, if all of the broker’s money is gone, then the money owed to this winning trader may come from your money!

Unlike in an exchange-traded market like stocks or futures, which has a “clearinghouse” that acts as an intermediary between a buyer and seller to make sure certain both parties honor their contract obligations, the FX market does NOT.

That’s because the FX market is an over-the-counter (“OTC”) market.

In an OTC market, there is no third party available to step in and make sure you receive the money owed to you.

Think of an OTC transaction like a face-to-face transaction. Such a transaction is arranged and prices are negotiated by two parties (buyer and seller).

Just like a face-to-face transaction, there is NO third-party or escrow service as an added layer of protection for both parties.

So if your broker goes out of business or can’t honor your winning trade, your money is gone.

At that point, your only course of action to try and recover any funds is to file a complaint with the regulatory agency that oversees the jurisdiction where your broker is legally licensed to operate.

Of course, this is assuming the forex broker actually holds a license with your local regulator and is authorized to provide retail forex trading services in the first place! This is why knowing where your broker is licensed and regulated is super important!

Now….just because it’s possible for a retail forex broker to “go bust” doesn’t mean it will.

Depending on how a forex broker executes its customers’ orders, there are ways to manage this risk.