At the end of each trade, the forex trader sees an update of his account balance, either increasing or decreasing. Although this seems normal, a novice trader may wonder where the money came from (in case of profit) or where it went (in case of loss). This article explains the path of money flow to and from a trader's account.
Financial inflows and outflows
In the OTC forex market, the broker either passes trading orders directly (STP-STP) to a liquidity provider (Credit Suisse, Goldman Sachs, Nomura, Citigroup, UBS, Bank of America, and many others) or takes the role of The counterparty to the transaction (the market maker).
Where does the money go when an individual forex trader works with an STP broker? Let's say the client places an order to buy 1 standard lot (100,000 units) on EUR/USD at 1.1120. The order is routed directly to one of the liquidity pools. In the event of the limit order being executed, the capital required to open the deal is held as margin in the client's account. If the client uses a leverage of 1:100, then the value of the retained margin will appear in his account at $1,120. The value of the stock remaining in the client's account is updated in real time in parallel with the price movement. STP brokers usually get leverage of 1:100 from their liquidity providers. Therefore, the liquidity provider will also withhold $1,120 from the forex broker's account.
If we assume that the client has closed his long position on EUR/USD at 1.1130. In this case, the sell order is directed to the liquidity provider to match it with a corresponding buy order. The liquidity provider will release $1,120 + $100 profit to the Forex broker, who will in turn release the retained margin, i.e. $1,120, with $100 profit added to the trader's account. The liquidity provider may or may not play the role of a counterparty in this transaction. In other words, he may open a new position in the hope of selling it later at a higher price to someone else, and may instead hedge the open sell position at a higher price. Thus the transaction cannot be classified as a loss incurred by the liquidity provider.
Assuming that the trader closed this position at 1.1110, in this case the liquidity provider will release only $1,020 ($1,120 - $100 loss) from the forex broker's account, which in turn will release only $1,020 of the retained margin in the trader's account upon opening Deal. In the end, the forex broker has recovered what he lost and will continue to operate as usual.
Let's now assume a similar case with a forex broker that acts as a market maker. When the client places a trade order, the broker holds the required capital (depending on the leverage used) and confirms the deal. Depending on the nature of the risk management strategy used by the forex broker, the orders of its clients may be collected and then sent to the liquidity provider. An internal matching is made between open buy and sell orders at the same levels on the same currency pair. When the client closes the order, a book change is made based on the net margin value. Again, depending on the mechanism used by the forex broker, his corresponding position may be closed at the same time with the liquidity provider.
Buying and selling currency pairs is similar to buying other physical assets as the actual cost of the product goes through multiple stages before it reaches the final consumer. Retail brokers and distributors take their share of the profits. Similarly, forex brokers charge their profits in the form of the spread which is added to the actual price and then passed on to the counterparty.