Spot Forex differs from many other financial instruments as it is possible for the brokerage to take the other side of customer trades. This is where the distinction between the A and B book comes in, with many hybrid brokerages operating both an A and B book.
When a customers trade is passed through to a liquidity provider or Multilateral Trading facility, this is known as A booking. When this happens brokerages turn a profit by marking up the Spread or charging their customers commission. When this happens there is no conflict of interest as the brokerage will make the same profit regardless of whether the trader is profitable or not.
Genuine STP/ECN brokerages only operate an A-book, as they make the commitment to place all of their customers trades with a liquidity provider or alternatively match-up traders looking to take up opposing positions. The fact that there is no conflict of interest means that many traders will only trade with brokerages that do not operate a B-book.
FXTM (Pure ECN)
XM.com (99% as A-book although a market marker)
Avatrade (Majority are passed)
If the brokerage instead decides to keep the customer’s trade on their own book, this known as B booking. The brokerage takes the other side of a customers trade which means when B-booking, a brokerages total profit can often be equal to the total losses of the trades placed on their B-book. Brokerages are able to manage risk associated with keeping a B-book by using certain risk management tactics, such as internal hedging, spread variation etc. The fact that the majority of retail Forex traders lose money, means that operating a B-book can be very profitable.
It is obvious that running a B-book can bring a brokerage into conflict with their customers, as profitable traders can see the brokerage losing money. Traders are often worried that brokerages will use underhand tactics to ensure they remain profitable. This is why many brokerages operate both an A and B book, selecting which trades are placed with a liquidity provider and which ones are kept on their own book. This hybrid model can be extremely profitable, and is used by a significant number of brokerages.
The Hybrid Model
The popularity of the hybrid model is understandable as it allows brokerages to increase their overall profitability. It also allows brokerages to make money from traders who themselves are profitable by simply passing these trades onto various liquidity sources.
A key tool in a hybrid brokerages risk management is client classification, with brokerages placing certain traders on their A-book while others are placed onto the B-book. The majority of industry risk management software has the ability to determine how to classify traders, helping brokerages maximise their profits.
Certain types of clients are much more likely to be B-booked:
- Those using significant amounts of leverage.
- Those who are risking a large percentage of their total capital on each trade.
- Traders who do not place stop losses.
- Traders who are trading small accounts (statistically, smaller accounts are much less likely to be profitable)
The hybrid model isn’t necessarily a bad thing for traders, with many hybrid brokerages being able to remain very competitive in regards to spreads. As the profits made from traders placed on the B-book can lead to the brokerage charging those on the A-book a smaller mark-up on the spreads they receive from liquidity providers. The issue arises when hybrid brokerages, poorly manage their risk seeing them make significant losses from those trading on the firm’s B-book.
Many brokerages place their clients trades onto different books depending on client and trade classification. The A-book customer’s trades are passed onto the brokerage’s liquidity providers, while others are kept on the brokerages B-book. The brokerage is essentially betting against those kept on their B-book, and brokerages which only operate a B-book should probably avoided. Many brokerages operate a hybrid model, and there is nothing inherently bad in such a model. But many traders feel uncomfortable and prefer to trade only with brokerages who pass all trades onto liquidity providers, which explains the recent growth in the number of STP/ECN brokerages.