2.5 The Dealing Desk Brokers or Market Makers

 

How a market maker makes the market in Forex.

 

To understand what a Market Maker or Dealing Desk broker is, consider a situation that you have bid and ask rates quoted by a broker as follows:

 

  • EUR/USD Ask rate (buying price): 1.1409

 

  • EUR/USD Bid rate (selling price): 1.1407

 

No sellers in market for thr right price.Let's assume that you wish to place an order to buy EUR/USD at the quoted price of 1.1409. Now when you are buying a certain volume at certain price, someone else has to be in the market willing to sell that much volume at the matching price, right? What would happen if there are no sellers to sell the currency pair at the quoted bid rate? Your broker can not ignore your order as he has assured you of a buying price, right? So someone has to take the risk to sell EUR/USD at 1.1407. It is a "risk" for the seller because the price may go up after he sells.

 

This seller can be the broker with whom you are directly trading or some other liquidity provider to whom he is passing the risk. This seller is nothing but the dealing desk broker or the market maker. If, as a Forex trader, you are trading directly with this entity then he is your dealing desk or market maker broker.

 

Dealing Desk brokers (DD) have a dealing desk through which all orders are routed. This brokers quote both bid and ask prices with a thin fixed spread and, in this way, they "make the market" for traders. A Dealing Desk Forex broker is, therefore, also called a Market Maker. 

 

They are always ready to act as the ‘counterparty’ to the trading client’s orders – i.e. when traders want to buy, their Dealing Desk is ready to sell to them, and when traders want to sell, the Desk is ready to buy from them. In both these cases there are no intermediary parties between the trading client (FX trader) and them. This means they are always willing to be at the opposite side of the trade. A dealing desk broker mainly makes money via fixed spreads and, at times, also by profiting on positions taken opposite its clients. Let's not get scared by the later statement as we will come to it later when we talk about the risks and mitigation.

 

How a Market Maker Makes Money?

 

Simply speaking, the market maker quotes both selling and buying prices i.e. ask and bid rates with a spread and the spread i.e. the difference in these rates is their profit. Market Makers or Dealing Desk brokers can afford the risk of having fixed spreads without worrying about the volatility. This is because while the current exchange rates are quoted by them, any changes in the rates will also be quoted by them. They are making the market i.e. the market rates, right?

 

How a Market Maker Mitigates the Risk?

 

The risk is mitigated by "Matching" and "Delta Hedging".

 

A market maker or dealing desk broker has its own liquidity as well as access to the liquidity of other liquidity providers.Risk mitigation by Market Makers to earn money. 

 

Let's say that you are taking a long position for a currency pair at the quoted bid rate. If at the same time there is a seller for the quoted ask rate then your position gets squared off by the seller's position and there is no risk for the market maker. The other trader sells what you buy and the broker earns the profit through the spread. This offsetting can be with another Forex trader's counter position or any other liquidity provider's liquidity if the bid and ask prices are as per the quoted rates. This is called "Matching".

 

In case there is no counter "sell" position to fulfill your "buy" position then the market maker becomes a counterparty and takes a counter position. He sells what you want to buy. In such a scenario while you are carrying the risk that the price may go against you, he is also carrying the risk that the price movement may go in your favor. 

 

Wait here!!! If your losses are his profits then he would like to make you lose money on every single trade, right? And remember that this broker is making the prices. You agree? Well, better disagree. If you keep on losing then he will lose you as a client, right?

 

If you make a profit, he loses. And if you keep on losing then he loses a client altogether! How he covers the risks of not losing money? How he ensures that you can make money if you trade nicely after graduating from FxTides's school and he also keeps on earning profits? He covers this risk with various hedging techniques. These techniques vary from broker to broker their discretion and according to their business policies.

 

Delta Hedging for Risk Coverage

 

Delta hedging by market makers to mitigate the risk. 

Let’s say that the market maker’s clients have an aggregate long positions for EUR/USD worth 314 standard lots and an aggregate short positions of 156 standard lots. The buying side outweighs the selling side by 158 lots. This difference is called delta. There is a great risk for the market maker if the price of EUR/USD goes up because in that case the buyers will make profit and being a counterparty, i.e. a net seller, the market maker will run into losses. 

 

In order to hedge against this risk the market maker may open its own separate long positions to buy the risky delta positions i.e. 314-156=158 lots. The market maker buys these lots from other market makers or pool of banks. Now if the price goes against the broker and EUR/USD goes up then he loses on the initial 158 lots but earns on the hedged long positions of 158 lots. This is called delta hedging. The market Maker covers its risks  by matching and hedging according to the guidelines of regulatory bodies and their own policies.

 

Is it risky to trade with Dealing Desk of Market Maker Broker?

 

Your are safe in trading with a dealing desk broker as long as you trade wisely.It may seem that your losses are the gains for the market maker as he is trading against you. Well, let's scratch the world "AGAINST" and just say that though he is counterparty in the trading but still your losses and hence dissatisfaction will be his loss. He may lose you as a client. 

 

Remember that at any given point of time the Market Maker is offering both buy and sell quotes and it is your decision to buy or sell. The market maker is not concerned about any individual position. He only focuses on total or aggregate positions. He will protect his exposure to risks by matching and hedging on the aggregate positions and not by going against you. The goal is to match and hedge in such a way that the aggregate risk exposure is zero and the profits come from the bid-ask spread and not through your losses.

 
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