How Forex Brokers Work
So without further ado, let’s get in to the details of how forex brokers function. Removed from the top-tier interbank market, retail forex brokers are there to provide a service that would otherwise not be accessible, that’s, giving an investor with a $10,000 bankroll, chance to speculate in the up-until-recently exclusive forex market.
There’s generally thought about to be 2 types of brokers providing access at the retail level:
Electronic Communications Networks (ECNs) and Market Makers. ECNs are generally more exclusive, requiring larger deposits to start, but are seen as providing more direct access to the interbank market. As they will see, there are definitely advantages to this, but some disadvantages as well.
Market makers, on the other hand are as a rule, the counter party to their clients’ trades, generating of a conflict of interest, whereas ECNs profit from commission fees charged directly to the clients, irrespective of the result of any trade, they’re seen as being neutral – an ECN has no incentive for a client to lose money. In fact, one could argue that an ECN stands to profit more if a client is thriving; meaning that she/he will stay around longer and they’re going to be able to collect more commission fees from them.
A market maker, on the other hand, being the counter-party to a client’s trade, makes money if the client loses money, providing an incentive for some shady practices, in an unregulated market. The extent to which this happens varies among individual brokers.
There are also some benefits to trading with a market maker. Some brokers also provide a service that doesn’t fit in to either section – they route different orders differently, depending on complex algorithms, or on a dealing desk, that analyze each order and try to fill it in the way that will be most beneficial to the broker’s bottom line.
They can offset some client orders against one another, effectively generating an in-house market, they can select to be the counter-party to a client’s trade (trade “against” the client), or they can offset their position with a hedge through a higher-tier counter-party. Note that the market maker is chiefly concerned with managing its net exposure, and NOT with any single individual’s trades. They NOT gunning for your cease losses specifically, but may be gunning for clusters of stops.
Like any other business in the history of business, your broker’s raison d’etre, is to make as large a profit as feasible. There are about as plenty of ways to go about this as there’s brokers. For those who are in it for the long haul, however, it is usually best to adopt a set of practices which are deemed fair by their clients: sure boundaries are set, and operating beyond them can cost a brokerage its reputation, and along with it its clients. Straying outside these boundaries, therefore, isn’t regarded as being in line with the long term goals of the business.
How strictly these boundaries are enforced, especially when there is small chance of clients ever even becoming aware of any transgression, again varies from business to business? For the sake of simplicity, in this article they assume that everybody in the business is squeaky neat, as if every client could peek in to the broker’s back office at any time and dissect every trade. This is obviously not the case, and plenty of brokers do take advantage of this opaqueness, but the details of that are best left for another discussion.
In case you have already read the first article in the series, Structure of the Forex Market, you will recall that market mechanics are responsible for the variation in bid/ask spreads, and also for slippage. So it seems the six largest novice traders’ pet peeves are not a lot a function of who their broker is, but their lack of understanding of the way the forex market operates.
A broker that offers a fixed spread tends not to fill orders in the coursework of periods of low liquidity because this would expose them to undue risk, and as much as their job is to cater to their clients, keep in mind they’re in business primarily to make money for themselves. Some brokers also offer guaranteed order fills, such as “guaranteed cease losses”.
Again, if there is no counter party to take the trade, they have to expose themselves to risk in order to fulfill this guarantee, so don’t be surprised in case you see such a broker quoting different/delayed prices around important trend lines or support/resistance levels. Be especially aware of brokers who offer both guaranteed fills and fixed spreads. When a broker offers something that seems lovely to be true, you would be wise to query how exactly their business model can support such a dicey practice.
As a general rule, a broker will help you only when your interests are aligned with theirs. On the other hand, brokers provide a valuable service, without which you wouldn’t have the chance to profit from the forex market, so think about the way it all comes together before blaming your broker for everything.
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