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 them. People normally look at things like spreads, commissions, if the broker has a good reputation, but the starting point should be how is the brokerage business organized. Is the broker a market maker or not?
If not, how is the execution of client’s orders being made? One can tell much about the Forex broker only by looking at the trading accounts that are possible to open with it. As mentioned in one of the previous articles here on the Trading Academy, brokers are dealing desks and non-dealing desks. 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 ones, are further split into two parts. They are of equal importance, but even here there are some things to consider.
Non-Dealing Desk Brokers
Non-dealing desk brokers are transferring their client’s trades, or parts of their client’s trades to a liquidity provider for execution. If the broker is routing 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 are contributing to the overall business profitability. Because of that, even if brokers claim they are non-dealing desks, if they keep a part of their client’s trades in-house, it means that 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 retail traders are perceiving when trading with a brokerage house that takes the other side of their trades. How to tell if a broker is telling the true? How can one know if the business is truly a non-dealing one or just a combination between the two?
The following help identifying the correct type of the brokerage business and give a light in this gray area. Forex brokers are running profitable businesses and therefore the Forex industry is characterized by intense competition among brokers.
Advantages and Disadvantages of an STP Broker
STP comes from Straight Through Processing and this 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 or organizing 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 twenty percent or even less of the traders are making a living from trading the currency markets, and brokers bet on this rate. The other eighty percent of traders are a juicy part that is far more profitable than only relying on commissions and spreads as fees.
To gain those profits, some STP brokers are having 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. Organizing such a trading department requires technological, human and financial resources that the broker is spending and will make a big chunk of the overall expenses. However, the potential profits are big enough to cover for 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 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 true STP, while smaller accounts will be diverted to the money market business. Furthermore, all those questions that the broker ask you before opening a trading account have the purpose of identifying your experience, knowledge, etc., to know 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 they 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 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 with some costs, though. An ECN broker has big expenses and only lately 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 is moving one pip in the right direction (a pip is the minimum distance a currency pair is moving and represents the loss or profit of a trade), a $10 profit is realized in a U.S. dollar-denominated account. However, to be able to trade full lots requires a lot of margins to be mobilized in the trading account. And this is not something that the day to day retail traders, the ones that represent the bulk of the market, can do.
Therefore, if you see a broker that claims to be a true ECN broker and it is offering micro-lots, you should know that the statement is not true. It is a combination between ECN and STP, but not a true ECN broker.
For the true ECN accounts, the broker is offering special conditions and the minimum amount to start is way bigger than the one needed for other accounts. This is just a simple trick 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 need 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.
Recommended Further Readings
- What Makes a Good Forex Broker?
- Why Trading Forex?
– Advantages and disadvantages of trading the currency market, what are trader’s expectations and what is a realistic approach to follow - What is a Forex Broker and Types of Brokerage houses
– Explaining what a Forex broker is and does, how the business should be organized, and how many types of Forex brokers exist. - Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc. - Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc. - Benefits of Mobile Forex Trading
Other Educational Materials
- “Opening an Account.” – How to Select a Forex Broker, and Set Up and Fund a Trading AccountKritzer, Adam. In Forex for Beginners, pp. 195-212. Apress, 2012.
- Investing as a BusinessMcCormick, G. (2012). (Doctoral dissertation, WORCESTER POLYTECHNIC INSTITUTE).
