Broker reliability + behind the scenes

How do I know that the broker will not use my money to do other things? Which Act outlines how the broker must handle our money? How often does the CFTC check brokers to make sure that they are conducting their business according to regulation. What happens it the broker goes bankrupt?

Also, how does forex actually work behind the scenes. Say I go long on AUD/USD, for 100K, does this mean that for my deposit of $1K, the broker will lend me enough USD to buy 100K AUD? Am I correct in my understanding that I pay back the broker what I borrowed in USD when I close my position? I borrow from the broker, but where does the broker get the money from? Also, theoretically, I can keep my position open for an eternity. Does this mean that the loan from the broker is essentially an interest only loan that you can theoretically never pay back? Also, why does the large banks not offer retail forex?

Also, what about CFD brokers who also do FX? When you trade with them, is it different from the other FX brokers in the sense you do not actually trade currency but rather contracts which bet on the movement of the currency. Who are the CFD providers? Is this always the broker? If so, why would a broker be willing to allow you to go long on say EUR/USD, when the market sentiment is clearly bearish for the USD and downward movement of the USD would cause them a loss that would probably exceed what they charged from you in the spread + commission?

You don't know if your broker will use your money for other things. Infact odds are, they will. Banks do the same thing, but at the end of the day they're still liable for the amount of the deposit or contract... so are brokers unless they go bankrupt. No act defines how a forex broker must operate, assume it's caveat emptor... even the NFA can't oversee everything.

If you have 100:1 leverage then yes, a 1k deposit can control $100k in trading capital. Of course that's dangerous, a relatively small drop in the market could wipe out your account. Because brokers use automated margin call software they can do this safely, and pull the plug if you lose too much without taking any long-term client default risks.

If you don't get a margin call yes you can keep your trade open forever, but remember you will pay swap rates. You aren't getting the money for free, you are getting it at whatever the short term interest rate is. If you're long on an XXX/USD pair that offers better interest rates than the USD, then you get a net positive swap (the differential between the 2), on the other hand if your trade doesn't generate enough swap interest to pay the short term interest rate then you have to pay it from the trade. Long term swap-based trades are called "carry trades" and carry a risk all their own.

Does that mean you never have to repay the principle? Well in theory if you wanted to go for years and years... sure, but that isn't really a loan at that point, it's a long term investment. And your swap fees are the ROI. That's why brokers are able to raise capital liquidity... a half-decent operation can seriously mitigate risks while providing a solid rate of return on investment. In essence you become part of a money market fund's bottom line.

Example: They get this liquidity from large banks, if you look at the interbankfx thread you'll see where they've gotten their liquidity from.

Brokers let you take different positions because they hedge their risks against you. Oftentimes trades are paired, so only the net aggregate trades are placed on the market. This passes your risk of loss on to the market and lets them stay out bulk losing trades. Remember you're still responsible for your trade, so they take any losses out of your balance.

If they're not placing market orders to balance that risk then they are what's called a "bucket shop." A bucket shop puts orders "in the bucket" and basically pairs them against each other. This is illegal in a lot of areas, but forex is still fairly unregulated. In that case they'll take positions against their clients, often times manipulating spreads at times where things are statistically against them. They'll slow down trades, increase slippage and generally manipulate the system to turn the odds back in their favor. Obviously that's not a broker you'd want to trade with.

Great Reply!
I believe this is one of the biggest problems we have to deal with.
We can't know if the brokers are good brokers or brokers who want to take our money.
Have had a few brokers some of them where great others wanted to take my money...

Thanks Rabid - you really cleared things up