Are market-making brokers taking advantage of high leverage? Answers to painful questions

• There is a difference between broker types and their regulation levels.
• Conflicts of interest may arise in one-sided markets. 
• Leverage is used all the time, and the key is not to use it excessively. 
• It is the trader's responsibility to either avoid risky brokers and high leverage. 

Why do market-makers provide high leverage? Given that a high percentage of forex traders lose money, do these brokers take advantage of traders' risk? Or do brokers pass the orders to the interbank network and make money off of spreads? Here are a few answers.

* This post originally appeared as a response to a Premium user's question in Trading Studio. Sign up to get access to FXStreet's top analysts. 

Types of brokers

There are different types of brokers, and the short advice is to use regulated brokers. There is a lower chance of the broker working against the trader – and at least someone to complain to in such a case. 

The longer answer – albeit not a full description of all brokers – is that some transfer orders to the interbank network and some do not. Those that pass all orders to the network are intermediaries, making money off of spreads and sometimes fees they charge from users. 

Market makers may match orders from different traders. For example, if there is one user going short on EUR/USD and another going long, using the same size, these orders balance each other. In this case, there is no need to pass the order to the interbank market.

When the balance breaks

The problem arises when the balance significantly breaks, and everybody goes in one direction and the broker does not pass the orders to the interbank network. In that case, the broker is basically positioned against its clients, which is a problematic conflict of interest. 

In the infamous case of the "SNBomb" from January 2015, brokers relied on the Swiss National Bank's promise to maintain the 1.20 floor under 1.20. When the SNB suddenly let go of the peg, EUR/CHF collapsed. That caused some brokers to go bankrupt. 

Conflicts of interest

But even in normal conditions, that conflict of interest mentioned earlier is problematic enough. First, if all the traders make the right bet and the broker doesn't cover, there is a risk for the broker and risk for traders – being unable to withdraw funds. 

Secondly, it means that these brokers assume that most traders will not only lose money but also fully liquidate their accounts. In such cases, the brokers' income comes not from spreads but from the traders' deposits – almost everybody would liquidate their accounts. 

Leverage, the good, the bad and the ugly

Regarding leverage, it is a tool used by all types of traders, investors, and banks to make money. There is nothing inherently wrong with leverage, as that is what allows markets to function at a faster rate. Even at the strictest jurisdiction, the most prudent banks use leverage when holding only a small amount of deposits as a guarantee against bigger loans.

When people take out mortgages, they leverage a small downpayment in order to buy a house, and most of them pay their debts.

The problem begins when leverage becomes excessive, turning a small trade into a big gamble. Leverage levels of triple digits are undoubtedly excessive, and some brokers take advantage of the temptation to use only $1,000 to make a trade worth $100,000. That can have devastating consequences as the opportunity to make significant gains also means a high probability of demolishing the account.

When the account vanishes quickly, not only the money is gone, but also the lesson.

The trader's responsibility is not to use excessive leverage, even if it is offered by the broker. More reasonable levels should be used, resulting in smaller profits – but a higher chance of learning from losing trades before liquidating the account. 

Final thoughts

Some brokers try to temp traders to use high leverage. It is the trader's responsibility to use lower leverage or to switch to another broker, if they think their practices are risky. Circling back to the beginning, the best practices are: trading with a regulated broker, and using low leverage, especially in times of high liquidity.