Types of Forex Brokers – ECN or STP?

There are so many Forex brokers in this world that a trader doesn’t know who to pick when trading the currency market. As part of the process of choosing the right Forex broker, it is important to know how to differentiate between them. People normally look at things like spreads, commissions, and whether the broker has a good reputation, but the starting point should be how the brokerage business is organised. Is the broker a market maker or not?

If not, how is the execution of client’s orders made? One can tell much about the Forex broker just by looking at the types of trading accounts it is possible to open with it. As mentioned in one of the previous articles here on the Trading Academy, brokers are categorised into dealing-desk and non-dealing-desk brokers. This means that either the broker will create a market for its clients, mirroring the quotes from the interbank market and taking the opposite side of the market, or will route the trades to a liquidity provider for execution.

The second type of brokers, the non-dealing-desk ones, are further split into two types. They are of equal importance, but even here there are some things to consider.

Non-Dealing-Desk Brokers

Non-dealing-desk brokers transfer their clients’ trades, or parts of them, to a liquidity provider for execution. If the broker routes all the trades to a third party, it only gains from commissions and spreads. If it keeps some of the trades in the house, it will make a market for those trades, and the profits generated contribute to the overall business profitability. Because of that, even if brokers claim they are non-dealing-desks, if they keep a part of their clients’ trades in-house, it means that the claim is not true.

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Brokers will advertise themselves as being non-dealing-desks because this attracts customers. There is an ethical problem that retail traders perceive when trading with a brokerage house that takes the other side on their trades. So how do you tell whether a broker is telling the truth? How can you know whether the business is truly a non-dealing one, or just a combination of the two?

The following should help in identifying the correct type of brokerage business, and shed a bit of light into this grey area. Forex brokers run profitable businesses, and therefore the Forex industry is characterised by intense competition among brokers.

Advantages and Disadvantages of an STP Broker

STP stands for Straight Through Processing, which means that the broker will pass all or some of the client’s trade to liquidity providers for execution. While this is a better form of organising the business than a true market maker brokerage house, it is not perfect. A true broker will need to give access to the interbank market structure, liquidity, and componence. In such an environment, the broker will “show” the market.

This is not possible in the case of an STP broker. Moreover, an STP broker may keep some trades “in-house”. In doing that, they are creating a market for these trades. It is known that only around 20% or even less of traders make a living from trading the currency markets, and brokers bet on this rate. The other 80% of traders are a juicy segment that is far more profitable than only relying on commissions and spreads as fees.

To gain those profits, some STP brokers have special trading departments committed to executing the trades, and making sure everything is done the right way. These departments sometimes take trades on their own, and for that trading, knowledge is required. Organising such a trading department requires technological, human and financial resources that the broker must spend, and this will take a big chunk of the overall expenses. However, the potential profits are big enough to cover all this trouble, so this disadvantage is easy to overcome.

A big problem facing these “hybrid” brokers is knowing what kind of a trader one is, and in what category they will fit: a winner or a loser? The size of the trading account is a good indication of the potential of a trader. As a rule of thumb, the bigger the account, the most likely the trader will be dealt with by true STP, while smaller accounts will be diverted to the money market business. Furthermore, all those questions that the broker asks you before opening a trading account have the purpose of identifying your experience, knowledge, etc., in order to assess your potential category.

All in all, there are few brokers that are true STP, so the likelihood is that you’ll find brokers that claim they are STP, but are a hybrid between STP and a market maker. This doesn’t make the broker a bad one, but the business has some ethical issues if one cares about such things.

Advantages and Disadvantages of an ECN Broker

ECN BrokerECN stands for Electronic Communication Network, and a true ECN broker is one that offers a clear view of who is taking the other side of your trade. Other parties interested in your trade might be other commercial banks, other brokers, money managers, institutional traders, funds, etc. This transparency comes at some cost, though. An ECN broker has big expenses, and only lately has the technology allowed retail traders to join the “party”. The reason is that large volumes are required, and a true ECN broker is not able to offer micro-lots to their clients.

To have an idea what this means, imagine that one trading lot means that if the market moves 1 pip in the right direction (a pip is the minimum distance a currency pair can move, and represents the loss or profit of a trade), a $10 profit is realised in a US dollar-denominated account. However, to be able to trade full lots requires a lot of margin to be mobilised in the trading account, and this is not something that the day-to-day retail traders, the ones who represent the bulk of the market, can do.

Therefore, if you see a broker that claims to be a true ECN broker and is offering micro-lots, you should know that the statement is not true. It may be a combination of ECN and STP, but is not a true ECN broker. For true ECN accounts, the broker offers special conditions, and the minimum amount to start is much bigger than that needed for other accounts. This is just a simple trick to help you to know what kind of a brokerage house you’re dealing with.

There is a thin line between STP and ECN, and the conclusion of this article should be that true ECN brokers are hard to find. Until further technologies are available, traders will have to settle with brokers that use a combination between the ECN and STP, which is far better than trading with a true market-maker broker.

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