Why Do Forex Brokers Pay or Take Overnight Interest?

With most Forex brokers when you leave a currency pair position open over the night, you will get a swap or an interest payment for it. It can be positive (you earn money) or negative (you lose money). That payment is usually very small, and the majority of the beginning traders just do not pay attention to it since their direct profit or loss from the trading is much greater than this rollover interest. But why do the brokers pay and charge this overnight interest payment or swap? And why do some brokers promote interest-free accounts?

The origin of the overnight interest is the fact that in the retail Forex market, the physical delivery of the currencies is absent. If you buy €100,000 with your leveraged $1,100 margin, the broker will not transfer those €100,000 to your bank account. But you have paid $110,000 for those euros, even if you borrowed them from your broker. So, if the Forex broker does not deliver the currency to you, it technically borrows it from you. In the above-mentioned example, you borrow $110,000 from the broker, and the broker borrows €100,000 from you. And where you have debt and loan, there you have interest rates. The interest rates for the overnight interbank lending (and that's what you are doing when trading Forex on leverage) are set by the central banks. For example, the rate that you pay for borrowing the dollars from your broker is controlled by the Federal Reserve System, while the interest rate that the broker pays to you for borrowing the euros from you is set by the European Central Bank. The difference between those two rates is the final overnight interest or swap rate.

Let's look at this rate calculation. You buy a standard lot (100,000 units) of EUR/USD with your account being in the US dollars with the leverage of 1:100. The current Fed rate is 0.75% and the current ECB rate is 0%:

1. You use $1,100 as the margin.
2. You borrow $110,000 from your Forex broker.
3. You buy €100,000 with the borrowed money.
4. You lend €100,000 to your broker (because it will not deliver the currency to you anyway).
5. You need to pay 0.75% yearly or 0.00208% daily on your borrowed $110,000.
6. Your Forex broker needs to pay 0% on its €100,000 borrowed from you.
7. In the end, the broker needs to charge the difference between €0 and $2.29 for each day that your position is open. This is your negative swap or overnight interest.

What would happen if you did not buy that standard lot of EUR/USD but went short on it instead? You would be paid that difference by your broker.

The problem is that in reality brokers do not pay or take the exact amounts for the overnight interest. They minimize the swap when they pay it out and maximize when you pay it. That way, they try to avoid the risks. But that is certainly not very fair.

Why do some of the brokers claim that they do not pay or take overnight interest? Because the interest is viewed inappropriate by one of the most popular religions in the world — Islam. Some Forex brokers offer interest-free accounts on request and charge a fixed commission per trade to compensate their interest-based losses. Some brokers provide only interest-free accounts and usually do not charge any commissions in that case.

How can you gain advantage from the overnight interest? First, you can use it for carry trade. When you feel that the currency pair with the big positive interest rate difference is going to remain stable or move in your favor for a long period of time, you can use the broker's leverage to receive some ridiculously high interest rate from the swaps only. Another way is to open an account with two brokers — one that offers no-interest policy and another — with a common Forex broker. This way you can hedge your positive interest rate difference position with the no-interest rate position at another broker. In this case, you will not be bothered by the market movement but at the same time you will gain advantage from the positive overnight interest. It is called swap arbitrage and is usually viewed as illegal by the brokers with no swaps, so I do not recommend using it.