What is a Forex Broker 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, there would be no access to the interbank market. For the services that it provides, the broker charges a small fee, that can be found as a commission or in the spreads offered. Most of the times, both a commission and spreads are part of the incomes of the Forex broker.
The idea of a Forex brokerage house is to help the trader be active on the market, no matter if the trades are winners or losers. It is in the broker’s interest to have active traders as this is the only way commissions are flowing. If traders stop trading, or if traders lose their deposits fast, the broker will have lost business as well. Therefore, it is both in the Forex broker’s interest as well as in the trader’s interest for retail traders to be profitable.
However, if all Forex traders are profitable, in the end, the broker will lose money because it must pay for the withdrawals that are being made. This is not necessarily true, as it depends on the way the brokerage house is organized.
Types of Forex Brokers
Forex brokers are split into two main categories: market makers or brokers that pass their trades to liquidity providers. Brokers that fit in the first category are dealing desks, and the other ones are a non-dealing desk. A true Forex broker is one that fits in the second category as that is the true meaning of a brokerage house: to 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.
Market makers are effectively creating a market for their customers. In other words, they will only reflect the quotes from the real market, 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 that has an account with a broker that fits in this category buys the EURUSD, the broker will sell that pair with the exact amount.
If the trader is successful, the broker loses money, if the trader loses money, the brokers wins. As simple as that. Beating the market in this case effectively means to beat your broker. You can see now that the brokers in this category are having an ethical problem with retail traders as they are not popular at all. The thing is that brokers are simply crunching numbers. It is proved that eighty percent or more of retail traders are losing their portfolio in the end.
By taking the other side of their client’s trades, the brokerage house has 80% chances 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. These brokers are making a profit from spreads and from betting against their clients. 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, big names in the industry.
Trading with a market maker has advantages for the retail trader as well. Because the broker is taking the other side of the trade, the settlement is done instantly, not in two days like in other broker’s cases. By settlement, we’re referring to the 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., why not trading with it if traders are beating the market?
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 trade against your broker and not in the real interbank market. For some people, this is a real issue.
The true meaning of brokerage is a non-dealing desk environment. Brokers in this category pass their trades to liquidity providers and are making a profit only from commissions and fees. Or almost! Like in any business, there is a catch here, too. There are two main types of Forex brokers in this category: STP (Straight Through Processing) and ECN (Electronic Communication Network) brokers.
STP (Straight Through Processing) Brokers
An STP broker is passing or routing its trader’s trades to liquidity providers for execution. However, it can do that for ALL the trades or only some of the trades. Most STP brokers have their own trading department and they are splitting traders into two categories. Traders that have a chance to survive the Forex market, or to be profitable, and traders that are most likely to lose their deposit.
The ones that are probably winners will have their orders routed to liquidity providers, and the forex broker is taking the other side of the trade for the other traders. How can a Forex broker know if a person is going to be a winner or a loser in advance? Again, the broker is crunching some numbers. There are things that can tell in advance what are the chances for a trader to be 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 it is going to be a loser in the end, and the broker is trading against him/her.
This was just an example, but 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 gray area, but still, the business is better organized that a sole market maker brokerage house.
ECN (Electronic Communication Network) 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, and such parties are other Forex brokers, institutional investors, other liquidity providers, banks, etc. The drawdown of trading with an ECN broker is that fills are having a bigger slippage when compared with other types of brokers. Especially if a pending order is filled during an important economic release, the execution has some flows.
For this reasons, there are few brokers that are true ECN ones, so it is more likely that a broker is a mélange between ECN and STP. Technological advances are making possible for more brokers to be true ECN ones, so time will tell if we’ll see improvements.
Recommended Further Readings
- Financial Products to Trade
- Forex Trading Sessions and Their Importance
- Forex Brokers Types – ECN or STP?
- What Makes a Good Forex Broker?
- Why Trading with a Regulated Forex Broker?
Other Educational Materials
- “The Forex market in practice: a computing approach for automated trading strategies.”Gallo, Crescenzio. International Journal of Economics and Management Sciences 3, no. 169 (2014): 1-9.
- “Hidden Markov Model Application to Transfer The Trader Online Forex Brokers.”Suharleni, Farida, and Agus Widodo. CAUCHY 2, no. 2 (2012): 66-73.