As many of you, I did not understand during a long time the difference between the different types of brokers available on the foreign exchange market. The term broker is often used wrongly because it is not always the case. In fact they should be differentiated according to their business model. Currently, there are three main types of players on the eForex, the last two are more accessible to individuals:
- Pure brokers
- Market makers
ECNs (electronic communication network) are market place. All operations are performed directly on the interbank market. That is what we call the ‘no dealing desk’. Thus, as on the NASDAQ market place, the order book is displayed. Participants are therefore the counterpart of others participants, because as you know to buy we need a seller other side. ECNs are matching orders from their clients. You probably ask the same question I asked myself at the beginning, how do you do when no one is in front? It’s very simple, they rely on liquidity providers (LP).
These LP are banks that allow customers to have substantial liquidity and tight spreads obtain in the normal market condition. Prices are displayed in real time and therefore reflect the prices quoted by different banks. This allows full transparency of the market by providing access to information to all participants. Each liquidity provider continuously displays its prices and can hit in the displayed liquidity. The disadvantage is that the spread is not fixed especially when volatility increases during major economic announcements. The spread can sometimes reaches 15 pips on EUR / USD.
ECN have been for a long time reserved for institutionnals but some brokers today are offering this service to the particular. In this case, ECN are their own liquidity provider. So, the liquidity is tight compare to a liquidity provider as a bank.
The main advantage of such operation is that you remain anonymous and that ECN cannot know on which account the order is coming from. They cannot trade against you, I will come back to this point later. This is a great advantage especially for scalping … You can also decide to place an order between the bid and the ask.
ECNs get their commission from the volume processed by traders. Often this is around 10 to 20$ per million traded.
Pure brokers have roughly the same mechanism as the ECN with the difference that the liquidity offered to their customers is ensured in all cases by a liquidity provider. This provider is a bank which provides an important liquidity. Pure brokers are therefore simply intermediary between their clients and the bank. Prices are those posted by the bank on the interbank market but not in all cases.
Indeed, the pure broker can pay itself in two ways. The first is by the volume of transactions made by its customers (4 to $ 5 per million traded for example). This is often the one who is privileged and which allows the broker to reduce its spread. The second is the called markup (eg adding a pips to the best bid and subtract a pip at the best ask of its liquidity providers). The pure broker wins then a pip on each transaction.
Pure brokers do not take positions against you because they are automatically hedge by their liquidity provider. Although unlike ECN, your anonymity is not kept, the scalping is allowed because the broker is not at risk even if you keep your position a few seconds.
In addition to a larger liquidity, pure brokers offer advantages over ECN including customer relationship and services provided. You’ll often have a higher range of tools, advice, analysis, signals, subscription systems trading, managed accounts …
Broker Market makers
Finally, market makers are nothing other than a special broker. They often diplay fixed spreads but the main difference with pure brokers is the no transparency of prices. The market maker may decide to quote out of the market of its liquidity providers (LPs) at any time, this is often the case during announcements, some brokers literally freeze their prices, while banks are moving in the same time .. . but because of the guaranteed fixed spread this is a normal thing.
You should know that when your broker offers you 3 pips at the time of a Non farm Payroll, at the same time LP display spreads of 10 or 20 pips. The only way for him to adjust its risk while maintaining a fixed spread is to freeze its prices or to shift them abruptly to the other side of the spread.
Market Makers are probably the types of intermediaries that are most developed in recent years. Fixed spreads and fixed stops guaranteed are for many. These have found a formula that makes the Forex for private client easy, and also for the institutional which can trade on the FX market without being its main activity.
The market maker takes a position against you to be hedge. It will most likely be against you in his book because he is the intermediary between you and the liquidity provider. Risk management is ensured by the risk book that gives the position in each currency by volume. In fact, below a certain amount (around 50K), the market maker don’t transmit your order to the market, the process is internal. So if you are “too” profitable, you affected their “profitability” … All market makers are not doing this kind of operation but this happens.
Above it is the liquidity provider, so the bank which hedges operations in exchange of a commission, or the market maker itself.
To earn money, it can either be paid by a commission on the volume of transactions or increase by one pip the spread offered by the liquidity provider. The spread on EUR / USD is 2 pips. If a broker has a spread of 2 pips and does not charge any commission, the broker earn often money through losing trades of its customers.
Most market makers do not authorize scalping because they have no time to hedge. When accepted, the quotations are the prices offered by the bank and therefore the spread is variable. This is done in a special account.
Conclusion Types of Brokers
Advantages : transparency of prices ; book display ; possibility to place an order between the bid and the ask ; scalping authorized ; anonymity when you place an order ; competitive spreads ; dont trade against the customer
Disadvantages : Variable spreads ; less important liquidity ; fixed commissions, Risk of slippage
Pure brokers :
Advantages : High liquidity ; transparency of prices ; lot of services offered ; scalping authorized ; The broker is not against you , competitive spreads ;
Disadvatanges : Variable spreads ; commissions
Market makers :
Advantages : Fixed spreads ; No commission ; No slippage ; high liquidity
Disadvantages : Scalping forbidden; false quotations; if broker book only, win and you will not be welcome ; sometimes trade again the customer