Forex Leverage: How is it provided? What is the mechanism?

[Good1]

Quote from rmorse:

The liquidity providers are typically banks. But after the trade, your broker must cover all counter party risk on your behalf. If a bank fails to meet their obligation when you unwind the pair, your broker is responsible. When you enter into these swaps, you don't actually swap the currency. You are agreeing to cover the change in price when you unwind the pair. The trade is called a non-deliverable swap.

Thank you. This seems to explain it. If this is the case, a broker does not ever want an account going in the negative due to a trade. Sounds like it will be the one holding the bag, unless a margin call is answered. Would a forex broker terminate a trade that looks like it's going too far south? The change-in-price concept sounds to me alot like the CFD (contract for difference) approach. It also sounds a little like there's a disconnect between me and other small retail traders in the market. Like there would not be a person on the other side of my tiny little trade.

So let's see if i've got this. A broker is mainly interested in keeping your account in the black, and leverage is just a number? Just trying to get this through my head. In the old days of the stock market, if someone wanted leverage, they'd borrow money from a broker if the broker thought they were worth the risk. Trying to understand the modern mechanism analogous to that. Is there a loan or a credit of some sort in this process?

Another way of looking at it, if i start with $10K and make a net profit of $20K, where does this 20K come from? Is it new money or existing money?

Sorry i'm so slow. But some experience with computer programming has taught me not to think that i understand something until it's crystal clear.

 

[rmorse]

I'm sorry, but I'm not really following your question. If you open an account with a broker with $10k, and trade, they are not concerned with where you make your money. Your broker is faciliting trading for you. They make their money on part of the spread you see. They make money from activity. You're make or lose money from being right or wrong in your decisions. FX platforms are quite automated. If you lose a certain amount of money, they will auto liquidate you, protecting the broker from loss.

These are highly leveraged products because currencies are not as volatile as other securities and the system is large and liquid. In my opinion, using 50:1 leverage in one trading strategy, if it's a high percentage of your trading assets is very dangerous. A 2% draw down puts you out of business.

 

[Good1]

Quote from rmorse:

I'm sorry, but I'm not really following your question. If you open an account with a broker with $10k, and trade, they are not concerned with where you make your money. Your broker is faciliting trading for you. They make their money on part of the spread you see. They make money from activity. You're make or lose money from being right or wrong in your decisions. FX platforms are quite automated. If you lose a certain amount of money, they will auto liquidate you, protecting the broker from loss.

These are highly leveraged products because currencies are not as volatile as other securities and the system is large and liquid. In my opinion, using 50:1 leverage in one trading strategy, if it's a high percentage of your trading assets is very dangerous. A 2% draw down puts you out of business.

Thanks Robert,

One way to rephrase the question might sound like this:

If i make $5K using 10:1 leverage, where does the money come from?
If i make $10K using 20:1 leverage, where does the money come from?
If i make $20K using 50:1 leverage, where does the money come from?

I willing to presume that my immediate broker is disinterested. That broker will make his/her money on a fixed spread, or on a fixed fee.

But if there's a disconnect between me and the other little guy trading micro-lots...where does the money come from? Who are my trading partners?

This is in an effort to understand just how the leverage is made available. In 1906, for example, if you wanted leverage, you'd go talk to J.P. Morgan, and, if you looked like an upstanding character, he loan you money with which to increase the number of shares you would normally trade. If he wanted his money back, you'd have to sell shares to pay him back. These days, i understand the mechanism is different. I was just wondering what that was.

Thanks for your responses.

 

[rmorse]

Quote from Good1:

Thanks Robert,

One way to rephrase the question might sound like this:

If i make $5K using 10:1 leverage, where does the money come from?
If i make $10K using 20:1 leverage, where does the money come from?
If i make $20K using 50:1 leverage, where does the money come from?

Thanks for your responses.

It's not like stocks, where if you buy $100K of equities with $50K in your account, that you have to borrow money for settlement on the trade. FX trading is the trading of Non-Deliverable currency swaps. You don't deliver anything, so your broker does not have to finance anything. Your making a bet on the change of the swap value.

You're putting up a minimum deposit to make sure if you lose money, the counter party can get paid. If you make money on that trade, you make it from the counter party of the trade.

I hope I answered the question now. If not, give me a call Monday.

Bob

 

[Good1]

Quote from rmorse:

It's not like stocks, where if you buy $100K of equities with $50K in your account, that you have to borrow money for settlement on the trade. FX trading is the trading of Non-Deliverable currency swaps. You don't deliver anything, so your broker does not have to finance anything. Your making a bet on the change of the swap value.

You're putting up a minimum deposit to make sure if you lose money, the counter party can get paid. If you make money on that trade, you make it from the counter party of the trade.

I hope I answered the question now. If not, give me a call Monday.

Bob

Thanks Bob,

Let me propose a model that is intended to reflect what is actually happening, based on what i've been able to gather so far.

There is a market where "currency swaps" are, well, swapped! Companies, banks and nations would be the typical players in this market. That activity generates the up and down movement of pairs of currencies according to supply and demand. This creates a data-feed that we can watch and make bets on. Theoretically, it's a valid data-feed in that no one knows for sure what it will do next. It's "live".

So lets say a 1000 people make bets through 10 brokers who get liquidity through one liquidity provider. Since each broker is theoretically disinterested, this makes the liquidity provider the counter-party. But the only "bet" the liquidity provider is betting on is that 75% of the 1000 people making bets will bet wrong. The other 25% will bet right. This means that the liquidity provider will gain, in theory, about 25% on all the money that was bet by the 1000 people.

Because of these statistics, the liquidity provider will take any size bet from any broker. It's the brokers responsibility to make sure that no individual account is allowed to go negative, so as to avoid being hooked for it. That's why they will liquidate a trade that brings an account too close to zero. This gives the liquidity provider some assurance that it can handle ANY bet of any size for any duration. Theoretically, it knows it will get paid regardless, because each account has some basic collateral to cover losses.

The liquidity provider is like a *pool* where all wins are paid out, and all losses are paid out dynamically; if not in real time, at least daily. If current statistics hold up, the liquidity provider can't lose. This would explain why so much liquid is made available, which would explain why so much leverage is available.

So the way i see this, there really isn't a counter-party, neither my immediate broker, nor the liquidity provider. And the bets of the 1000 people really have no effect on the price movements of the pairs of currency (any more than betting on baseball affects what the players will do). In other words, those of us with small retail accounts are more like spectators who don't really influence the market, and who don't really transact directly with each other.

Possibly, the liquidity provider is an actual player in international currency swaps (but doesn't have to be in order to make money). Possibly, it responds to the mood of all those who are making bets, as measured by the balances/statistics in it's pool of bets. Only in this sense would the 1000 people making bets actually have an influence on the market. But their influence is more like casting votes, while the liquidity provider listens and casts it's own vote for it's own reasons.

How close do you think i am to actually comprehending what going on?

Thanks for your replies!

 

[Good1]

Ok so i looked around a little more, wondering just who are these mysterious *liquidity providers*. I found this over at pipinvestment.com:

Liquidity Providers List

Here are the top ten and percentages as of the date of the list (unknown):

1. Deutsche Bank 18.06
2. UBS 11.30
3. Barclays Capital 11.08
4. Citi 7.69
5. RBS 6.50
6. JP Morgan 6.35
7. HSBC 4.55
8. Credit Suisse 4.44
9. Goldman Sachs 4.28
10. Morgan Stanley 2.91

A broker may communicate with one or more of these kinds of liquidity providers using software like this:

FX Inside Professional

 

[rmorse]

There is a lot here, and some gets into details I might not be up on. One thing I do assume to be true, is that the liquidity provider is not concerned with you being right or wrong. They want to buy on the bid and sell on the offer ALL day. They want to take advantage of platforms trading at different prices and arb them. They want to be as balanced as possible, like a bookie. When he is out of balance, he will not only change his market in the pair, but also go out and swap currencies in the interbank market.

At the same time, those same players are adding liquidity on many different platforms and making a vig in the real swap market. If you go on vacation from US to Europe, spend money on your credit card, your bank or credit card must swap that currency for you. When companies are buying and selling goods over seas, they need to move money back and forth often. Banks charge a fee or a spread for this. All this trading give them a position in real currencies and FX and futures on FX and options on FX. They make their money on all or any part of this they trade.

Just as they are not concerned with you making money on your trade over the next few days, they will always be concerned with counter party risk. They make all these bets with all these parties all over the globe. If they don't get paid on the bets they make money on, because a broker goes under, the cards can all fall. That's why we require deposits. That's why your broker needs to make pips on your trades to make money. The NFA requires certain standards of and assets from your broker. Also, banks will only do business with brokers they feel comfortable with. They are not concerned with your trading, just that you trade with them at their price.

Bob

 

[Good1]

Thanks Bob, that was a very good reply.

At least it fits, and explains a little better, the general picture i've gotten about how it all works. So heres what i'm understanding as far as where the leverage comes from:

Leverage is just a number that the broker will allow you to *amplify* your basic unit of play by before it sends the order on through to the liquidity provider. The liquidity provider does not see a leveraged number. It only sees what the broker is sending through, trusting that there are assets backing it up. People are allowed to amplify their basic units of play like turning up the volume on an amp. Whether they understand or not the risks involved in this, the broker is going to make sure, as best they can, that the player doesn't break any thresholds, such as a zero balance account.

The liquidity provider is simply a player that has the *liquidity* (lots of available liquid cash) sufficient to take on almost anything a collection of brokers can throw it's way. If it can't take it on, it let's the broker know by simply not taking the order. Another way the liquidity provider can handle the situation is to actually get into the currency swaps market (what you've called the interbank market) and do a deal there if it feels it needs to do so.

Indeed the interbank currency swaps market may be an integral part of a bank's business, while taking orders from brokers may be just an additional income stream to them. That may explain why Deutch Bank decided to get out of that aspect of it's business because they felt they were not making enough money (according to an article i read).

So it seems to me that so long as about 75% of small retail traders continue to bet consistently wrong, then 25% of small retail traders will have the ways and means to access large liquidity providers with whatever leverage they feel comfortable with (whatever works). If these ratios did not hold, possibly as a result of a better educated small retail trading community, there might be fewer liquidity providers catering to that market, and the opportunity would come to an end.

On the other hand, you seem to suggest that the liquidity provider is profiting on the difference between the bid and the ask on the orders coming from the brokers. If that's the case, they may not be relying so much on a 75/25 ratio between consistently losing traders and consistent winning traders. But i'm feeling certain that that ratio plays a factor in it's income stream.

So at the end of the day, i feel i should not think of myself as trading the forex market anymore than i play on a major league baseball team. I feel the best paradigm going forward is that i am quite literally betting on the changes in price on a data-feed that derives from an actual market where there are currencies being swapped back and forth, that may or may not relate directly to what i am doing as a speculator.

Does that sound about right?

Thanks for your replies!

 

[rmorse]

Close enough. In my opinion, it's nice to understand the market, but making money from the opportunities in FX come not from what we are dicussing, but from coming up with a strategy that produces consistant profits.

Some make money from arb, some from technical analysis, some from fundamental analysis. Some use FX as a hedge against another asset class. You can use anything that works for you. Then, do it over and over until it does not work anymore.

Strive to make money every month. Don't gamble. Control your risk, have fun,

Bob

 

[Good1]

Quote from rmorse:

You can use anything that works for you. Then, do it over and over until it does not work anymore.

Strive to make money every month. Don't gamble. Control your risk, have fun,

Bob

Thanks Bob, nice replies! Talk at you later!