Commander in Pips: Now I might say that we are almost finished with our Forex Military School, although I do not know if this will make you glad or upset. We’ve passed through a long way, so all that we have left is just some talk about some practical moments that still seem quite important. Once you’ve finished the initial education run – you are preparing to open your first account. And in the current chapter I would like to discuss different types brokers and how to to choose one particularly based on what you want. Initially we will talk just about theoretical types of brokers (in the current lesson), but later we will touch on the topic of those, with whom we are struggling without a rest – scam brokers.
Commander in Pips: Where there is money - there always will be pitfalls and traps also. So, let’s start with brokers. Since we are small fish in the Forex Sea – our major preference and in fact only real possibility is retail brokers. We have too few assets to deal others when starting out. Just imagine, individuals with shallow assets like you and I had no access to forex markets not too many years ago. While online trading has not existed and internet technologies just have started to develop, the Forex market was only for special ones. Those special were banks, large financial companies, maybe couple of individuals – Gorge Soros is one of them. There were solid transaction costs; transactions themselves were not as fast as they now. At the same time, the currency market was under strict eye of governments and their regulators.
After some time the CFTC has released two root documents that have opened the door to Forex market for everybody. They were Commodity Futures Modernization Act and Commodity Exchange Act. By these documents, they actually have legitimized the appearance of retail forex brokers – this was in fact just a single link in the chain that was absent and does not allow developing retail forex trading a brokerage. Once there was fast and public internet, the appearence of retail forex brokers has let me and you think about trading as a business.
As a result retail brokers have started to appear as mushrooms after the rain, struggling and competing with each other for clients and giving by that competition an additional way of development of the forex trading industry. Now there are many brokers and to choose a good broker is not a simple task, especially when you will hear a bit more about scam in a later chapter.
Commander in Pips: Well, hence now we are discussing just the technical specific of brokers but not a morale one, then I might say that choice is up to you.
Pipruit: As usual… When something difficult comes – “the choice is up to me”.
Commander in Pips: Really? Ok, I will give you some additional clarification, so you will get a bit more understanding. In fact, choice of the broker will be simple if you can answer on the question what kind of trader you are. For instance, you may choose – would you like to pay some trading fee but get tighter bid/ask spread or do you better prefer a bit wider spreads but without any fees and commissions?
Commander in Pips: In fact, if you are a positional trader, make trades rarely and hold positions for a long time – spread will not be a significant issue for you. From another point of view – if you’re scalper and trade with huge position sizes you will prefer tighter spreads and some fixed fee per trade, that will not depend on trading volume.
Commander in Pips: Well, there really are some of this kind, but in reality they are just a small part of all brokers. Think for yourself – if customers will loose their accounts fast, how will the broker make their business and earn money? Their major income is bid/ask spread and fee. If client has lost their account fast –broker will not get more cash flow. So, in fact brokers want clients to stay in business. At the same time perfect client for broker is those that neither constantly wins nor loses. Broker will be very happy if you stay in business, trade on constant basis and generate good bid/ask cash flow for him and at the same time your account stands somewhere around breakeven. Brokers like these clients. Why? You will understand a bit later. But here we have to say that most brokers do not want most of their clients to devastate their accounts.
As an example, I give you a fast task. What is better to get – 80,000USD now or 5000 per year perpetually, if annual deposit rate in bank, say 5%?
Commander in Pips: And you will be wrong, since net present value of 5000 per year will be:
5000/0.05 = 100,000USD. So the same view applies to most forex brokers – what is better to get clients $3000 account now or regular spread for a long time?
Here you can see that this is not a simple question to answer.
Now, as an initial guide I will give you some information about types of brokers that exist in the current retail brokerage sphere. At the same time, you have to understand that we call as “brokers” those who in fact do not meet the definition of one. We just use this word to call them. In fact, a broker is a firm that acts on behalf of client and in their interests. Other words speaking – just execute clients’ trades. That is what happens on exchange markets. On the forex market there is a bit of a different story and there are a lot of retail companies that are call “brokers” but in fact they are dealers. A dealer is a company that acts on behalf of its own interest and places their own quotes. Clients, in fact have the right only to choose – make the trade or not. As a result this kind of “broker” in fact is a dealer which becomes the counterparty of your trades. But let’s proceed with the types - they are – Market makers, STP Brokers and ECN brokers:
1. Market makers (sometimes they called as Dealing Desk).
This is one of the most common types of brokers on the forex market. They are those who are not really brokers but are only “dealers” in fact. Since, as we already know, forex is an over-the-counter market, it is naive to think that you can get access to the overall quotes of big corporations and banks with your account having just 2000 USD or less. As a rule you will get access to just a small part of it that will be limited with some banks and retail brokers at best. More probable is that your view of the market will be limited to seeing the quotes of your market maker. Since there is no central exchange on forex that gathers all quotes, for many retail traders, a market maker (dealing desk) IS the market. You see only its quotes and take (or not) trades by its quotes. But do not be too scared – currently competition between DD brokers is so tough that their quotes tend to be fairly close to real interbank and market quotes. This market maker becomes the counterparty of your trades. In fact, your trades may never transfer on to a large market as they are.
1. Market makers (sometimes they are called as Dealing Desk) continued.
We will not discuss here the possible hedging tools that a market maker has to control overall direction and power of clients’ positions. We just say that market makers can partially transfer clients’ positions, say, “higher” – to a larger market maker or bank, if his own financial power and risk limit does not let him to be a counterparty of all trades. Even in this case, it transfers not every single position, but the pool of average position of all clients and only in a part that he can’t absorb by himself.
Since this kind of brokers control quotes and give you its own ones – it easily can get you a fixed spread.
So, when people tell that market maker trades against you – this is only partially true, because this “against you” trading appears just because it take counter position, that he has to do – that is just how this kitchen works, since he places quotes and you take it. Second, he gives both buy as sell quote so he is ready to take any of yours decisions – so there is no obvious conflict of interests. Many of his positions becomes flat since they equilibrated by counter positions of other clients. As a result, a market maker has some net long or short position and work with it. This “broker” maybe could have some interest that you lose your money, but it has to hold some balance to not skew quotes too much. Otherwise, it will lose many clients. The drawbacks this type of brokers become the advantages of other types.
As a result, we can say that this kind of “broker” (in fact dealer) will give you fix spreads, not quite natural quotes (precisely speaking he can skew them too much, will be the counterparty to your trades), orders execution could be on a discretionary basis.
2. Straight through processing Brokers (STP)
This is a really cunning fox. A pure STP broker has to be a “broker” as we’ve just described – work on behalf of clients and just be an intermediary between buyer and seller for some fee or part of the spread. In fact it should not be able to have any positions and even open them. This type of broker is not interested in anything beyond its fee. But our STP brokers are cakes of another sort, and often aren't “pure” STP. Sometimes, they can just transfer your trades to the market, but sometimes they can act as market makers and become counterparty of your trades. They have some special workers who track performance of different clients and trading automated systems. Successful traders/systems positions are just transferred to the market while for those who mostly lose or stay flat, the broker becomes the counterparty. While it does not work at 100%, this works with big numbers and statistics are their friend. Remember when we were talking about how casinos work.
Second profit source is spread part or fee part. The point is that STP broker get quotes from some bank or larger broker and those quotes are tighter than the ones it gives to customers.
Say, if the STP broker itself gets a 2 pip spread – you, as its client, will get 2-4 spread for instance. The same could be done with possible trading fees or commissions. This kind of quoting becomes the major reason of possible re-quoting or market orders rejections. If you place the order and the market runs fast – the quote could change while the STP broker was translate your order to a“higher” level – to larger broker or bank. This change could happen either in your favor as against you. Very probable if it will come in your favor, then the STP broker will deny your order and ask you to retry with different quotes. Very rarely an STP broker is ready to pay you from its own pockets - just to keep customers be happy with their broker. What might happen if the market runs against you – re-read the chapter where you discuss comparison of stocks and forex markets. Slippages of any size and delays are the most common effects of such procedures. In other words, since an STP broker provides you the quotes of some greater broker or liquidity provider, it can’t control them, so it has to change them and the spread as it changes by higher counterparty in the overall chain.
Here is simple example how an STP broker makes money. Usually there is not just single larger counterparty but some number of them, let’s say three – 1 bank, 1 larger broker and some hedge fund. They give the broker their quotes. These quotes are subject to change, but our STP broker always can create some combined quote with tight spread, because it can trade freely and with no limitations with these liquidity providers. Once the STP has determined quotes best for itself - in our example this is 1.40/1.4001, it adds some more pips (for example, 1 pip) to widen the spread and transfers quotes to you. No matter what you will do buy or sell – STP broker always will get 1 pip profit, since his spread is tighter on both Buy as on Sell side. If he will give you 1.3998/1.4002 – then it could get even 2 pips if you intend to sell at 1.3998. By the way, that’s why most STP brokers have variable spread, that could change, especially when the market is shaken by news or some other important event – because STP quotes depend on some other quotes provider and the STP broker can’t guarantee they will be constant.
As a result, we can say that this kind of broker will give you different spreads among different brokers, should be intermediary between counterparties, quotes come from larger brokers or banks, which will be the counterparty of your trades; orders execution should be automatic without much re-quoting.
Commander in Pips: Well, in reality you will hardly be able to distinguish this. Many brokers most of time apply some hybrid way. But here is one to help you. Most regulated UK and US brokers hardly will trade against you directly and obviously so that you will loose your money, skew quotes and so on - just because in this case they can get problems with their licenses. If you still like pure brokers, as they have to be – think about futures market – you will have no uncertainty what the broker is.
3. Electronic communications Network Brokers (ECN)
This is third type of broker and we already have talked about it. Compared to DD and STP – you can easily recognize an ECN. In fact, ECN is a real broker as he has to be. This is some kind of mini-exchange that shows part of the overall forex market. ECN gives you the ability to place your order onto the market, and to see it. Trading with an ECN has a great advantage – it allows you to see the orders queue both on the sell side and on the buy side and their volume, so that you can see market depth, trading volumes of this ECN and so on. Major income of ECN is just spread – if current spread on EUR/USD is 0.5 pip – ECN will show you, say, 1 pip. Or it could be charged as a commission, very much like exchange one.
As a result, we can say that this kind of broker will give the spread that could be different depending on member’s orders and ECN itself. Initial quotes could come from large broker or bank (s) who are major members of this ECN. Orders execution should be automatic without re-quoting, since you see all orders by yourself. You can see market depth.
Pipruit: Wow, I like this way. Probably I will try to become a client of some ECN, say Dukascopy.
Commander in Pips: : Hm, in this case you have to know, that since ECN is rather large substance, it usually is a member of real inter-bank market. Since ECN as a rule links to some large bank, you should have at least 50K-100K of assets to start trading at larger ECNs and your trading lots also should be pretty large.