Internalization: How Forex Brokers Aggregate Hedging Redundancy Orders and Risks

With A-Book (or STP) execution, the broker manages the risk of each individual trade.

But what if one trader opens a long position in GBP/USD and another trader opens a short position in GBP/USD at or at the same time？

Instead of the A-Book broker having to hedge each trade separately with LP, why risk two irrevocable trades？

Well, they can.

Instead of managing the risk for each individual trade, a broker can aggregate trades from clients with the same currency pair.

This process of aggregating transactions is called internalization.

For example, some customers may buy GBP/USD, while others may sell GBP/USD. Different traders have different opinions, so there may be cases where opposing trades can be “matched” or “deleted” together.

When a broker matches one client's trades with another client's, it removes market risk in a similar way to hedging trades with an external liquidity provider (LP).

Since the broker does not send trades to the LP, it saves money by NOT having to deal with the LP and pay the difference of the LP.

A broker can aggregate all long and short positions in GBP/USD and offset them against each other.

This is why forex brokers want a large client base. This allows them to more easily “internalize” the risk. The larger their customer base, the more transactions, which means the more likely the deals can match.

As the cost of dealing with liquidity providers (due to spreads) saves the broker money.

For example, the broker can see from his book that he has a total of 10 million units of GBP/USD long positions and 8 million units of GBP/USD short positions. 10M long 8M short = 2M long net

10M long - 8M short = net 2M long

The difference would leave the broker with a net long position of 2 million GBP/USD.

This “spread” is also known as the “residual” because it is what is left after all transactions are cleared.

What remains exposes the broker to market risk, which is why it is also known as “residual risk”.

The broker must now decide how to manage this residual risk.

He has two choices:

· Take the Risk (“Do Nothing”)

· Risk Transfer (“hedge”)

Example: Ledger execution vs internalization (full compensation)

Elsa buys and Ariel sells the same amount of the same currency pair (GBP/USD) at the same time.

In this case, the broker wants to transfer his market risk to his LP. LP price up 0.0011 or 1 pip:

Let's take a look at the difference between running on Books and internalizing.

A-Book

Internalization

If the broker executed A-Book execution, he “paid the difference” in the broker's LP and P&L against. LP will be equivalent to:

(1.2007 − 1.2010) x 1,000,000 = -300 USD

If the broker takes advantage of the fact that the trades happen at the same time and does not hedge with LP, then he will not have to pay this cost.

The main risk for a broker using the internalization model occurs when positions are not cleared completely, exposing the broker to price movements that can lead to losses. If a broker has client orders that can partially offset each other, the broker will have a much smaller net position that exposes them to market risk.

Again, this is called “residual risk”.

It can manage this residual risk in two ways:

· The broker can transfer this risk externally to the liquidity provider by performing hedging trades.

· The broker can accept this risk and manage it internally.

Example: Running A-Book vs. Internalization + Hedge Orders

Let's see the difference between A-Book execution and internalization then hedging:

A-Book

Internalization + Hedge Orders

If the broker executes A-Book execution, the P&L that the broker realizes relative to the LP will be equal to:

(1.2008 − 1.2009) x 1,000,000 = -100 USD

But the broker doesn't necessarily need A-book Elsa's transaction, as Eric's transaction may have been deleted.

So if the broker had 'internalized' or aggregated all GBP/USD positions, they would not need to protect Elsa's trade and would save money by not paying the LP spread.

Even after internalizing, this still leaves the broker with a net short position of 2,000,000 GBP/USD.

As you can see, the broker has hedged this residual risk with LP.

If there are enough trades of similar size to clear each other, internalization can be very profitable for a broker.

That said, if there are any positions that cannot be cleared, this residual risk exposes the broker to the same market risk as B-Book trading.

A common practice when brokers internalize trades is:

· Start by offsetting client positions, then...

· Aggregate residual exposure and external hedging with LP on a “volume weighted average price” or “VWAP” basis.

From the above example, we can see that Elsa's transaction was internally settled by Ariel's transaction.

Elsa buys 100,000 GBP/USD buy, while Ariel sells short 100,000 GBP/USD, so the broker's risk is 0.

But then three other traders, Eric, Jasmine and Louis bought GBP/USD at different prices.

Since no other clients are overdrawn, the broker wants to cover this risk.

Instead of hedging each trade, the broker aggregates three separate trades and creates a single hedging trade with a VWAP-based LP of 1.2511.

This is how VWAP is calculated:

VWAP = Total Notional Value / Total VolumeVWAP = 1,251,060 /

1,000,000VWAP = 1.2511

Grouping multiple client trades is common practice for brokers, as trading with most LPs requires a minimum trade size, usually at least 1 standard lot or 100,000 increments.

Therefore, if a broker's clients open positions of less than 100,000 units, the broker has to wait for other clients to trade and then “pool” the risks of the different trades.

Another reason brokers can aggregate orders is that they reduce the time it takes to hedge everything with LPs.

For example, if the broker is using STP execution, the execution of many small buy orders in turn can “signal” the LP that the pattern can continue. If it detects more orders interested in buying than selling, it can “black” the price and raise the ask (buy) price higher than usual.

This can lead to worse client fill of the broker than if the broker only sent one order to the LP.

This is especially important in illiquid or rapidly changing markets.

Here is a summary of the advantages of a forex broker depending on the