How Forex Brokers Manage Their Risk (C-Book)

You may come across the word “C-Book” in addition to forex brokers who “A-Book” or “B-Book.”

The term “C-Book” is used to represent “risk management procedures” used by forex brokers and CFD providers that are allegedly different from A-Book and B-Book.

“C-Book,” in our perspective, is just marketing gibberish. It's more of a catch-all word for adjustments or tweaks to A-Book and B-Book implementation rather than a dissimilar strategy used by brokers to minimize risk.

As you can see, the broker uses “C-Book implementation” to try to make more money for itself rather than to control risk.

These methods of implementation are contentious, and whether forex brokers should use them or not is debatable. We'll let you make the final decision.

We'll go through three different types of “C-Booking”:

· Hedging in partial

· “Overhedging” and

· “reverse hedging” are terms that are used interchangeably.

Partial Hedging

Partial hedging of a customer's order is the most prevalent type of “C-Book implementation”

Only a quota of market risk can be hedged by a broker. This will mitigate, but not eliminate, adverse price swings in the hedged position.

The unhedged risk/residual risk, provides the broker with the possibility to benefit IF the price swings in his favor.

Consider it a “partial A-Book” and “partial B-Book” risk management method.

In other words, the broker has A-Booked a percentage of its risk and B-Booked the rest.

Consider a scenario in which a broker hedges 50% of a customer's position.

At 1.2001, Elsa begins a long EUR/USD trade.

The size of her position is 1,000,000 units, or ten normal lots. This means that a one-pip move is worth $100.

By creating a long 500,000 EUR/USD position with an LP at 1.2000, the broker hedges 50 percent of the risk.

(This would be called A-Book if it had gone long the entire 1,000,000 units, as 100% of the position is hedged.)

The price of EUR/USD is rising.

Elsa decides to take a profit and end her trade at 1.2101, earning a profit of 100 pips ($100 x 100 pips).

This results in a $10,000 loss for the broker.

The broker would have had to eat the entire loss if it had just B-Booked Elsa's trade.

But, thankfully, it covered a quota of Elsa's trade.

While the hedging trade gained 102 pips, the profit was $5,100 because the position size was 500,000 (half of the 1,000,000).

The profit from the LP offset some of the losses from Elsa's trade, resulting in a net loss of $4,900 (rather than the whole $10,000).

In the event that the EUR/USD plummeted, the broker's earnings against Elsa would be reduced due to hedging losses.

Elsa opens a long EUR/USD position at 1.2001 in this scenario.

By creating a long 500,000 EUR/USD position with an LP at 1.2000, the broker hedges 50 percent of the risk.

The price of the EUR/USD is falling.

Elsa's stop-loss is hit, and she exits her trade at 1.1951, resulting in a 50-pip ($5,000) loss.

This results in a $5,000 profit for the broker.

The broker would have kept all of this profit if it had only B-Booked Elsa's trade.

But it didn't; instead, it acted as a hedge for Elsa's trade.

The hedged trade resulted in a 48-pip loss. The loss was $2,400 because the position size was 500,000 (half of 1,000,000).

The LP's loss helped to offset some of Elsa's profit, resulting in a net profit of $2,600 (less than the whole $5,000).

So far, you've seen how A-Book allows a broker to fully hedge (=100%) against a customer's position. You've also noticed C-Book allows a broker to partially hedge (>100%) against a customer's position.

“overhedge”

Partial hedging is not the only variant of C-Booking

Another disparity C-Booking is when a broker can “overhedge,” which means it can hedge more than 100% of a customer's position.

Instead of a hedging trade that covers 100% of the risk, it can choose to hedge 110 percent of the risk.

A more accurate term than “C-Book” would most probably be “A-Book+.”

Why would a broker do such a thing？

If the broker believes the customer's trade will benefit, it can “ride along” with the customer and also profit.

At 1.2001, Elsa opens a long 1,000,000 EUR/USD trade, implying that the broker is now short 1,000,000 EUR/USD.

The broker has the option to:

· Not at all (B-Book)

· Hedging is done in part (C-Book)

· 100% hedging (A-Book)

· >100% hedging (C-Book)

Elsa is a well-informed trader, so the broker chooses option #4.

It takes care of 110 percent of the risk.

With an LP at 1.2000, it goes long 1,100,000 EUR/USD.

It would have gone long 1,000,000 if it had A-Booked the trade.

Instead, it went long 1,000,000 plus 100,000 more units, or 110 percent of Elsa's position size.

Elsa is right, and the EUR/USD climbs.

She end her trade with a profit of 100 pips ($10,000).

Apparently, this results in a $10,000 loss for the broker.

However, take note of the P&L with the LP.

The broker's profit from the LP outweighed its loss from Elsa because the broker “overhedged” and had a larger position size against the LP.

Profits were able to be “juiced” by the broker.

This “overhedging” method, still, has risks associated with it.

Let's have a look at what occurs if the customer loses.

In this case, the EUR/USD decreases, and Elsa loses $10,000 on her trade.

Apparently, this results in a $10,000 profit for the broker.

However, take note of the P&L with the LP.

The broker's loss from the LP outweighed its profit from Elsa because the broker “overhedged” and had a larger position size against the LP.

If the broker's hedge surpasses 100 percent, this is the tradeoff.

It puts itself at a higher risk of losing money if the consumer is wrong.

“Hedge in the Reverse”

Another type of C-Booking is when a broker partially or completely “reverse hedges” a customer's trade.

This strategy is predicated on the notion that a customer trades so poorly that it's possible to profit not only by B-Booking the position, but also by ADDING ON to the B-Booked position!

A more accurate name would probably be “B-Book+,” rather than another form of “C-Book.”

In other words, the broker not only does not attempt to hedge or transfer market risk, but actively seeks to increase market risk!

When a broker decides to entirely “reverse hedge” a customer's trade, it is effectively raising its B-Book risk.

At 1.2001, Elsa goes long 1,000,000 EUR/USD.

The broker is now short 1,000,000 EUR/USD because it is Elsa's counterparty.

If the EUR/USD rises, the broker is now exposed to market risk.

This is B-Book execution if we stop here.

Is it possible for the broker to A-Book the trade and completely hedge it？

Nope.

It has identified Elsa as a losing trader, so instead of fully or partially hedging with an LP, it decides to “reverse hedge” 50% of the deal.

So, instead of going long EUR/USD to cover its market exposure, it uses an LP to go short 500,000 units!

Remember that it already owes its consumer 1,000,000 units. With the extra 500,000 units against the LP, however, it ADDED EVEN MORE RISK EXPOSURE.

In this scenario, the broker was proven to be correct.

The EUR/USD exchange rate has dropped.

Elsa's trade ended in a loss for her, but the broker made a profit.

However, its exchange with the LP resulted in a profit.

This technique can be quite profitable if the broker chooses the right trades to “reverse hedge.”

However, if it makes the wrong decision, the risk it faces is considerably higher than if it had B-Booked the trades, resulting in even larger losses.

Here's an illustration of how things don't work out for the broker.

At 1.2001, Elsa goes long 1,000,000 EUR/USD.

The broker is now short 1,000,000 EUR/USD because it is Elsa's counterparty.

Instead of going long EUR/USD, which would have covered its market exposure, it uses an LP to go short 500,000 units.

Remember that it already owes its consumer 1,000,000 units. With the extra 500,000 units against the LP, still, it ADDED MORE RISK EXPOSURE.

The exchange rate of EUR/USD is rising.

Elsa made a profit on her trade, resulting in a loss for the broker.

If the broker had A-Booked and opened a hedging trade with an LP, the LP's profit would have covered Elsa's loss.

Instead, it lost money on its trade with the LP.