What a Forex Broker is, and Types of Brokerage Houses

A Forex broker is the intermediary between the trader and the Forex market. In plain English, without a Forex broker, a trader would have no access to the interbank market. For the services that it provides, the broker charges a small fee, which can be by way of a commission or in the spreads offered. Most of the time, both commissions and spreads form part of the income of the Forex broker.

The idea of a Forex brokerage house is to help the trader to be active on the market, regardless of whether the trades are winners or losers. It is in the broker’s interest to have active traders, as this is the only way in which commissions flow. If traders stop trading, or if traders lose their deposits fast, the broker will have lost business as well. It is therefore in the interest of both the Forex broker and the trader for retail traders to be profitable.

However, if all Forex traders were profitable, in the end, the broker would lose money because it must pay for the withdrawals that are made. This is not necessarily true, though, as it depends on the way the brokerage house is organised.

Types of Forex Brokers

Forex brokers are split into two main categories: market makers, and brokers that pass their trades to liquidity providers. Brokers that fit into the first category are dealing-desks types, and the other ones are non-dealing-desk types. A true Forex broker is one that falls into the second category, as that is the true meaning of a brokerage house: to give intermediate access to the interbank market. As for the market makers, there is a thin line between ethics and the way the business is conducted.

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Market Makers

Market makers effectively create a market for their own customers. In other words, they will only reflect the quotes from the real market, but without allowing their clients access to it. For such a business to be successful, the market maker takes the opposite side of the trades its clients make. That is, if a trader who has an account with a broker that fits in this category buys the EUR/USD, the broker will sell that pair with the exact same amount.

If the trader is successful, the broker loses money, and if the trader loses money, the broker wins. It’s as simple as that. Beating the market in this case effectively means beating your broker. You can see now that the brokers in this category pose an ethical problem with regard to retail traders, and are not popular at all. The thing is that brokers simply crunch the numbers, and it has been proven that 80% or more of retail traders lose their portfolio in the end.

By taking the other side of their clients’ trades, the brokerage house has an 80% chance of winning. Not a bad business plan, if you ask me! For this reason, being a market maker is more profitable than being a non-dealing-desk broker, as they make a profit from spreads, and from betting against their clients. So are brokers that fit into this category crooks? No, not all of them. As a matter of fact, there are many good brokers that are market makers, and even big names in the industry.

Trading with a market maker has advantages for the retail trader as well. Because the broker takes the other side of the trade, the settlement is done instantly, not in 2 days as is the case with other types of broker. By settlement, we’re referring to spot Forex trading, which is possible in this case. Moreover, if the broker is a solid business and a regulated one that offers funds segregation, etc., then why not trade with it if traders are beating the market with them?

As you can see, the only thing that stays in the way of trading with such a broker is their reputation, or the ethical dilemma of knowing that you’re trading against your broker and not in the real interbank market. For some people, this is a real issue.

Non-Dealing-Desk Brokers

The true meaning of brokerage is a non-dealing-desk environment. Brokers in this category pass their trades to liquidity providers, and make their profit only from commissions and fees. Or almost only! As in any business, there is a catch here, too. There are two main types of Forex brokers in this category: Straight Through Processing (STP) and Electronic Communication Network (ECN) brokers.

Straight Through Processing (STP) Brokers

STP BrokersAn STP broker passes or routes its traders’ trades to liquidity providers for execution. However, it can either do that for all the trades, or only some of them. Most STP brokers have their own trading department, and they split traders into two categories: traders who have a chance of surviving the Forex market, or being profitable; and traders who are most likely to lose their deposit.

The ones who are potential winners will have their orders routed to liquidity providers, and then the Forex broker takes the other side of the trade for the other traders. So how can a Forex broker know whether a person is going to be a winner or a loser in advance? Again, the broker is just crunching some numbers. There are, however, some things that can predict the chances of a trader being a winner or a loser. The size of the trading account gives one clue. If the trader’s initial deposit is a small one, chances are they are going to be a loser in the end, and so the broker trades against them.

This was just an example; the overall screening process is more complicated, based on numerous other things. As you can see, the STP broker is acting in a so-called grey area; but still, the business is better organised than a sole market-maker brokerage house.

Electronic Communication Network (ECN) Brokers

This is the true meaning of a brokerage house, and with such a broker traders can effectively see the interbank market. Other parties in the interbank market can take the opposite side of their trades, such parties being other Forex brokers, institutional investors, other liquidity providers, banks, etc. The drawback of trading with an ECN broker is that fills have a bigger slippage when compared with other types of brokers; and especially if a pending order is filled during an important economic release, the execution has some flaws.

For this reason, there are few brokers that are true ECN ones, and it is more likely that a broker is a mix of ECN and STP. Technological advances are making it possible for more brokers to be true ECN ones, though, so time will tell whether we’ll see improvements.

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