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Generally, if an FX broker decides to hedge a customers' position, it automatically hedges the customer's trade to Liquidity Providers when the trade occurs in the spot market. Let's say, the customer buys EUR/USD, the broker also buys EUR/USD in the LP as quickly as possible. When the customer closes the position, the broker sells EUR/USD in the LP. By doing that, the broker becomes safe in terms of the price movements.

But there's a problem here. When a gap occurs, the customer gets stopped out with a negative balance and the same is true for the broker's position in the Liquidity Provider, the broker also loses money in the Liquidity Provider more than it should loose because of the price gap. The regulations do not allow the broker to request the customer to neutralize the negative balance.
Let's say the customer lost all his money 100k and his balance is -5k because of the price gap but the broker can not request the -5k, so the income is 100k. Similarly, the broker lost $105k in the LP, the outcome is 105k, which causes 100k - 105k = -5k loss totally. So, the hedging operation caused a loss in this scenario.

Are there alternative ways to do this kind of hedging using some derivative instruments or different strategies?

Do you think there can be a solution by using FX options since it gives a right, not the obligation?

Thanks

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Yes, there are new ways to mitigate this since the CHF blowout a few years ago. Some people realized back then that there was a way to game retail FX brokers by having opposite leveraged positions and not paying negative balance.

For instance, some brokers set up a fixed liquidation execution price that is less favorable than the liquidation trigger price.

For instance let's say you buy EUR/USD at 1.13 with 50x leverage and that your account would be wiped out (0 margin value) at 1.11, the broker might then guarantee you a liquidation at 1.11 but trigger it once the spot reaches 1.1120 (broker hits the LP at 1.1120 but fills you at 1.1100). The broker will pocket the difference most of the time when people get liquidated in normal market conditions, and this should offset the cases where market gaps (opens directly below 1.1100).

Obviously this is not easy to calibrate for the broker, you don't want people to get liquidations at awful prices in normal times or they won't come back (or might sue you), and you don't want to wipe yourself out of existence either if there's a blowout.

Another way is to liquidate you at 0 against a short guy in the opposite direction, I've seen that on a bitcoin futures platform recently. I would not take it very well if I was the short guy but it is efficient.

There's an article about the crypto exchanges liquidations on March 13th, 2020 https://www.theblockcrypto.com/linked/58703/derivatives-market-liquidations-push-bitmexs-insurance-fund-to-all-time-high-cut-deribits-by-almost-half I'm no crypto evangelist, but they are far more transparent than retail leveraged fx/stocks platforms, Robinhood and IBKR surely have thousands of negative balance accounts now and we won't know about it before they get bailed out....

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  • $\begingroup$ Lliane, as I understand correctly you suggest the broker to add stop-loss at 1.1120 to the hedge position and when the market gap occurs around 1.1100, LP will close the position at 1.1120. But what if the price goes to 1.1120 and turns back to up? The broker's hedge position will be closed and the price will go up... Or the customer may deposit money after the broker set the stop-loss, so the customer will not be wiped out at 1.11. $\endgroup$
    – xyzt
    Mar 13, 2020 at 11:19
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    $\begingroup$ No, the broker closes your position when the market is at 1.1120, but the client gets liquidated at 1.1100. You can see it as the broker taking an extra fee on liquidation orders and punishing people who get liquidated. $\endgroup$
    – Lliane
    Mar 13, 2020 at 12:39

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