Forex trading
Forex (FX), also known as foreign exchange, is a decentralised global market. The forex market is the most liquid and largest financial market in the world, with a daily trading volume exceeding 6 trillion US dollars.
Forex trading is the conversion of one currency into another in the forex market.
Starting off as a novice trader in forex trading can be a daunting challenge to most people. Keeping in mind that over 70% of forex traders are eventually unsuccessful to master forex trading. The forex market is extremely competitive, and a trader needs assistance and guidance.
Furthermore, the forex market does not function in the same way as other financial markets. In order to have access to the foreign exchange market, a trader will have to make use of the services of one of the numerous forex brokers.
Deciding which forex broker to choose, is a major factor in the process of becoming a successful forex trader. Additionally, it not only a choice about competence, commissions, and a good reputation, but foremost about the right type of broker.
Not all forex brokers are the same. Based on the trading model used by a broker, there are two different types of forex brokers, namely dealing desk brokers and non-dealing desk brokers.
Two different types of forex brokers
Dealing desk broker
A dealing desk broker is effectively creating a market for clients, helping to ensure there is enough liquidity so trades can be done smoothly.
Dealing desk brokers are called “market makers”, because they give rise to potential markets for forex traders.
Non-dealing desk brokers
Non-dealing desk brokers do not deal with the trades of forex traders. Alternatively, they pass the trades to the interbank market where many liquidity providers, like banks and other financial institutions, are willing to buy and sell currency pairs.
There are two categories of non-dealing desk brokers: ECN brokers and STP (Straight Through Processing) brokers.
The focus of this article will further be on the following two business models: Market Makers and ECN brokers.
Market Makers
As already mentioned, dealing desk brokers create markets for forex traders, therefore they are called “market makers.”
One of their main functions is to help to maintain enough liquidity in the market, in order that trades can be done continuously. Put differently, market makers keep the forex market functioning in that they buy and sell currencies, as long as traders are willing to pay a specific price.
There are two types of market makers:
- Institutional – Typically large banks and financial institutions.
- Retail – Usually brokerages dedicated to offering retail forex trading services to individual forex traders.
Market makers execute transactions on both sides of the market, establishing quotes for the bid (buy) and ask (sell) prices. They are compelled to buy and sell at the prize and lot size they have quoted.
As a counterparty to each forex transaction with a trader, a market maker must take the opposite of your trade. That is to say, whenever you buy, they must sell to you, and vice versa. Thus, market makers basically bet against you as trader and they want to beat you. For example, if you want to sell a currency, you will get a bid price that will be slightly lower than the actual market price. If you want to buy a currency, you will have to pay the ask price, which is set somewhat higher than the market price.
The fact that a market maker can trade against you, can constitute a conflict of interest, implying the market maker may be more motivated not to offer you the best price available.
The way market makers generate profits is via the spreads charged to their clients. A spread is the difference between the bid and ask price. The spreads are usually kept at a reasonable level because the competition between numerous market makers is strong.
Advantages of market makers
- Some market makes have more user-friendly trading platorms, that usually come with free charting software.
- Price movements of currencies can be less volatile than currency price quotes on ECNs. However, this can be unfavourable for forex traders who utilize scalping as a trading strategy.
Disadvantages of market makers
- The possibility of a conflict of interest in the trading process because they may trade against you.
- Many market makers disapprove of scalping practices, thus making it difficult for scalpers to get their orders executed at the prices they prefer.
- You may get worse quotes for bid/ask prices than what you could get from another market maker or ECN broker.
- The quote displays and order placing systems of market makers may come to a standstill during times of high volatility in the market.
ECN brokers
ECNs (Electronic Communication Networks) are networks that match buyers and sellers of foreign currencies.
A true ECN broker is one that sends your order to the interbank market, the primary exchange market, and enables you to see the actual prices of the liquidity providers that are taking the other side of your trade. This allows for great transparency in the trading process. Liquidity providers include banks and big financial institutions.
The liquidity providers send their quotes to the ECN venue and the ECN broker takes the best price available.
Trading with ECN brokers can be costly. ECN brokers incur big expenses due to large volumes required and even the best ECN brokers are unable to offer micro-lots to their clients.
ECN brokers earn their money from fees and commissions, On ECN accounts, forex traders are charged a fixed commission for opening and closing trades, while spreads depend on the prices of the liquidity providers.
Advantages of ECN brokers
- Great transparency in trading processes.
- No conflict of interest because ECN brokers do not trade against their clients.
- Direct access to the forex market combined with the benefit of higher liquidity.
- No spread mark-up and better spreads available from different sources.
- The confirmation of the completion of trades will be available immediately.
- Trades remain unidentified on ECN platforms, helping traders to execute transactions that reflect real market conditions.
Cons of ECN brokers
- High commissions on transactions.
- A big deposit is required to open a trading account and to start trading.
- Difficult to calculate stop-loss levels due to variable spreads.
- Trading platform is not user-friendly.
- Executions of orders are not guaranteed, especially when they are still pending before key economic announcements.
Concluding remark
The choice of a broker, especially the type of broker, should be carefully considered. It is essential to do proper research regarding important factors like trust, reputation, compliance, and the business model (i. e. market maker or ECN) in order to find a broker that can enhance your performance as a forex trader.
Frequently Asked Questions
How can I determine if a broker is an ECN broker?
It is not always easy to identify a broker, but the best way to find out if you are dealing with an ECN broker would be to open a live trading account with a small amount and then compare the spread difference from a broker who is a market maker.
Is it good to use an ECN broker?
Better trading conditions and executions presented by ECN brokers affords traders the opportunity to trade more efficiently and profitably. Add to that increased transparency and no conflict of interest which makes trading with an ECN broker a sound choice.
Do Market Makers manipulate prices and how?
It can be viewed that market makers manipulate prices. They make their money from buying shares at lower prices than the prices at which they sell those shares. (bid/offer spread). The more actively those shares are traded, the more money market makers make off it.
Do Market Makers trade against you?
It is fair to say that market makers present a conflict of interest when it comes to order execution because they may trade against you. Traders should be aware that there are Market makers who may display worse bid/ask prices than those that you would get from another Market maker or ECN broker.
Is a Market maker a trader?
Market makers are very high-volume traders who “create a market” for securities. They do this by always standing ready to buy/sell which lead to them earning profits on the bid/ask spread. Market makers thus benefit the market by adding liquidity.
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