Hedging Client Positions
Market makers face serious risks every day because it is impossible to know how the prices of financial instruments will fluctuate and how demand for those instruments will change as a result. There is always the possibility that, by incurring significant losses, a market maker could find itself unable to fulfill its obligations to clients.
Here’s a simple example.
A trader buys 100,000 EUR from a market maker for 125,000 USD. In other words, he opens a single lot position to buy EUR/USD at an exchange rate of 1.25000. Due to economic and political factors, two days later the EUR/USD exchange rate is 1.30000. If he sells his 100,000 EUR to the market maker at the new exchange rate, the trader will get 130,000 USD for a profit of 5,000 USD. The market maker has no choice but to buy back the Euros at the new exchange rate.
What if dozens, hundreds or even thousands of traders make the same or similar transactions? The market maker has to have sufficient capital to meet these demands and pay out profit to its clients. However, market makers frequently hedge their clients’ positions to protect themselves.
Let’s see how the hedging process works at EXNESS. All client positions are sorted by instrument, volume and direction (buy/sell). Offsetting positions of equal volume for the same instrument cancel each other out from the Company’s perspective and don’t require hedging.
For example, a trader buys 1 lot of GBP/USD, while another trader sells 1 lot of GBP/USD. No matter which way the exchange rate moves, one trader’s loss will cover the other trader’s profit.
This type of hedging, where a market maker uses one group of positions to cancel out another group, is called matching.
If, for some reason, the buy or sell volume for an instrument is significantly greater than the offsetting volume, the market maker opens a position with a larger market participant. This position will be in the same direction as the larger set of positions on its books, but equal to the difference between this set of positions and the offsetting positions. Since the larger market participant has more capital, it is able to bear the risks associated with fluctuating exchange rates. By redirecting the aggregate position to the interbank market, the market maker ensures that it will be able to pay its clients their profit.
The following example will help you understand what a market maker does when it needs to hedge its clients’ positions.
Let’s say that the market maker’s clients have an aggregate open position to buy USD equal to 234 lots and an aggregate sell position of 112 lots. The buy side outweighs the sell side by 122 lots, so the market maker opens its own position to buy 122 lots of USD to cover the risk of a sudden large movement in the exchange rate for this instrument. Now, if the USD exchange rate rises strongly, the market maker’s clients are guaranteed to receive their profit from the return the market maker gets on its own position.
Single large-volume trades are hedged in a similar fashion. Market makers can use hedging to selectively insure the individual positions of particular traders if necessary.
In today’s dynamic, unpredictable market, our Company uses the interbank market to hedge both aggregate and individual positions. EXNESS analyzes its total buy and sell positions for all instruments at least three times each hour. Based on real-time data, our system automatically hedges positions whenever necessary.
This diagram shows how EXNESS uses hedging.
Automatic withdrawal is another way that EXNESS protects its clients’ interests. This unique service is popular with our traders – at present, over 95% of all withdrawal requests are processed automatically without the involvement of the finance department. The benefits are double: traders have round-the-clock access to their funds, and they know that they are being treated fairly and honestly. With automatic withdrawal, you have fast access to the profits you earn.