What is Credit Checking in Forex Trading?

Credit checking, with regards to forex, looks into the financial health of counterparties in a currency transaction. This credit check ensures that both parties have the means necessary to cover their side of the transaction in a trade.

Credit checking can also refer to checking the credit of anyone, including one's self. Loans often require a credit check. 401k loans may not necessitate a credit check.

Key Takeaways

  • Credit checking in the forex market refers to looking into the financial position of a counterparty.
  • Brokers may do credit checks on trading clients, while institutions may run credit checks on other institutions they engage in financial transactions with.
  • Credit checking may be required when first doing OTC transactions with another party.
  • Brokers typically credit check clients when they open an account, not prior to each transaction the client makes.

Understanding Credit Checking

A credit check in the foreign exchange (forex) market is much like the credit check a landlord makes on a potential tenant. The landlord is doing a background check to see if the prospective tenant can afford to make the regular rental payments on time. 

Without the process of credit checking, one party in a forex transaction would have no assurances as to the creditworthiness of the other party involved. By engaging in credit checking before transactions take place, confidence is maintained that each party has enough credit to carry out and honor the deal.

Since the 2008 financial crisis, regulation across all markets has become more strict making credit checks a more arduous and lengthy task. In addition to checks, most firms have increased capital requirements for customers, which has acted as a form of a credit check, or safety net against trader's and firms that can't make good their side of the transaction.

In January 2015, when the Swiss National Bank (SNB) pulled the price floor between the euro and the Swiss franc, the value of the franc rose by as much as 25 percent in a matter of minutes, which wiped out margin traders, and the losses were borne by the brokers. While credit checks could not have aided these losses, the increase in capital requirements has potentially reduced the magnitude of the losses should an event like this occur again. 

When Credit Checking Occurs

Retail traders may undergo credit checking when opening a forex account, or any type of trading account. The broker is verifying the financial viability of the trader, should that trader get into a position where the money in their account can't cover their outstanding losses, essentially creating a negative balance in the trader's account.

If the client is unable or unwilling to cover the loss, the broker may have to bear those losses and then decide if they wish to legally pursue the trader for funds to cover the losses. Credit checking helps determine if the client is likely able and willing to cover losses or negative balances.

Credit checking on retail clients, opening retail trading accounts, is typically done when the client opens the account, and not for each transaction.

Over the counter (OTC) transactions, typically between businesses or financial institutions, may do credit checking on a counterparty on an as-needed basis. For example, if two parties are about to engage in a large currency transaction, they may wish to verify each other's financial position via a credit check prior to engaging with each other.

Once parties are aware of each other's financial position they may not require credit checks each time they do a transaction, especially if it is under a certain dollar amount. If the transactions increase in size, or one party believes there has been a material change in the financial position of the other, credit checking may be required again.

Example of Credit Checking Between Institutions

Assume that two private companies want to engage in a currency swap. They are private, so their financial information may not be publicly disclosed and therefore a counterparty may not know how that company is doing.

Assume Company A needs to swap £10 million for $12.5 million from Company B. This implies a GBP/USD exchange rate of 1.25. The parties then agree on what interest rate is tied to each amount. They could both pay a fixed rate, both pay a floating rate, or one party could pay a variable interest rate while the other pays a fixed rate.

The specifics of the deal don't matter too much in terms of the credit check. What does matter is that each party feels the other side can cover their side of the transaction. Swaps are sometimes entered based on the expectation of future revenues or cash flows. Yet those revenues or cash flows may not always materialize. Therefore, Company A will want reasonable assurance that Company B can exchange the funds back and/or pay any differences in interest rates and exchange rates that may develop between when the swap is initiated and when it expires. Company B will want to see the same from Company A.

A strong commercial credit score, as well as other financial information provided by each company, such as their cash position and possibly revenues and expenses, will help each party feel more comfortable with the transaction.