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ECN/STP Brokers Explained

ecn_forexThere are three main types of brokers – Market Makers, ECN, and STP. Each of these types has its pros and cons, and often inexperienced traders have a hard time determining the best type of broker for their needs.

Market makers are very popular but they are also one of the worst types of brokers you can choose because they win if you lose money, and vice versa. If you want to work with reputable, trustworthy and friendly brokers, then you should focus on ECN or STP brokers.

In this article, you’ll learn about the differences between STP and ECN brokers and why they are better than market makers. Also featured is information about a new breed of hybrid brokers that combine these two models. We also cover the main benefits STP and ECN trading can offer to investors.

How No Dealing Desk Brokers Work

how no dealing desk works

There are two main categories of brokers on the Forex market and the first one comprises the so-called Dealing Desk (DD) brokers, also known as market makers. As the name implies, such brokerage companies “make the markets” by determining the bid/ask spreads via their dealing desks.
Customers’ orders are never quoted on the exact market prices because of the built-in spread that ensures a profit for the DD brokers. Another peculiarity of market makers is they sometimes issue requotes because customers’ orders are not routed directly to the interbank markets.

The market maker chooses to either accept or decline a client’s order depending on different circumstances such as volatility and news reports. It the best-case scenario, your positions are matched against those of other customers. However, if this proves impossible, a DD broker would either take a counter trade or pass the position to another liquidity provider.

A DD broker usually pays for winning trades straight from its account. Respectively, one such brokerage wins money when its customers close their positions at a loss, and vice versa.

This is not the case with No Dealing Desk (NDD) brokers which rely on straight-through processing (STP) or electronic communication network (ECN) technologies to route their client’s orders straight to other liquidity providers.

This provides traders with direct access to the interbank markets where their orders are filled faster and at better prices. An NDD broker basically plays the role of a bridge between its customers and the other liquidity providers.

There are no requotes on orders when one works with an NDD broker. The trader is exposed to multiple liquidity pools which enables them to get the best bid and ask prices. Another difference is that NDD brokers charge additional commissions for passing the spreads from liquidity providers to customers.

Electronic Communication Networks (ECN)

how ecn network works

ECN brokers rely on the so-called Electronic Communication Networks (ECN) for their operations. This is a digital system that matches up buy and sell orders for financial products automatically. Forex currency pairs and stocks are the two most common products traded via this computerized network.

The most well-known electronic communication networks to date include the prototype Instinet (launched in the late 1960s), NYSE Arca, and SelectNet. Some of these systems are intended for institutional investors while others were created specifically with retail investors in mind.

The ECN system links major brokers, individual traders, and liquidity providers, enabling them to execute trades directly between themselves without the need for using the services of any middlemen. This ensures high levels of anonymity for traders who use ECN brokers.

Another benefit of the ECN is that it enables investors to trade outside conventional trading hours. This is a great solution for people who cannot afford to actively participate in the markets during normal trading hours or are merely looking for broader availability and more flexibility.

The ECN model offers several other advantages from the perspective of retail traders, including lower spreads, faster execution of the orders, improved liquidity, and price transparency. The ECN also enables financial institutions to decrease their overall costs because it reduces manual effort.

Straight-Through Processing (STP)

how stp works

Many major financial institutions and large corporations utilize the straight-through processing (STP) method. STP systems allow for fully automated financial transactions where there is zero manual intervention, hence the name “straight-through processing”.

Such systems were first devised in the early 1990s and were intended for use on the equity trading markets. The biggest benefit of the STP is that obviously it saves time. The entire trading cycle, from the orders’ initiation to their final settlement, is handled automatically without human intervention.

The orders are processed in real-time. They are sent directly from the trader to different liquidity providers in the interbank markets without any intervention from the brokers. Traders’ orders are filled at better prices because they have direct access to the interbank market.

The orders do not pass through dealing desks in this case. Instead, the STP broker passes them “straight-through” to different liquidity providers like banks or larger brokerages. In turn, this prevents requotes and order execution delays. The STP system comes with several advantages including shorter processing times, decreased settlement risk, and lower operational costs.

STP Brokers Explained

stp brokers explained

STP brokers are less common but many traders still consider them the best choice and for a good reason. One interesting thing here is they combine the characteristics of ECN brokers and market makers. Their method of operation is a bit complicated so read carefully if you want to learn more about STP brokers and how they work.

When a Forex broker uses a straight-through processing system, they route the traders’ orders directly to different liquidity providers on the interbank market. These could be large banks, counter-party investors, major investment corporations or hedge funds. An STP broker silently connects traders straight with the interbank market.

No intermediaries are involved in the whole process because customers’ orders do not pass through a dealing desk. The absence of a middleman eliminates delays in filling the orders along with the need to issue requotes. Since customers have direct market access in this case, their orders are filled at the most competitive prices.

This leads us to the question of how do STP brokers earn money? The answer is by adding a nominal mark-up to the bid/ask spreads offered by their liquidity providers. STP brokers offer floating spreads depending on the bid/ask strength of the respective market. The mark-up, on the other hand, is usually fixed.

Also common for STP brokers is to allow their customers to execute trades during financial news releases, which is something that cannot be said about dealing-desk market makers. This, in combination with the lightening speed of order execution, renders STP brokers the perfect choice for scalpers and news traders.

There is more anonymity and zero conflict of interest here. STP brokers aggregate buy and sell prices from multiple liquidity providers, adding the nominal mark-up we talked about earlier. A trader then places their order and the brokerage transfers it to one of their numerous liquidity providers, retaining the profits from the tiny difference in the spread.

The STP system sorts out the buy/sell prices from the best to the worst and then applies the mark-up. Respectively, if the liquidity providers increase their spreads, the STP broker would respond by widening theirs with a larger markup.

Investors are, in essence, trading against fellow market participants rather than the brokerage, which has no benefit from the losses of its customers. In fact, it is the opposite. If the clients of an STP broker lose too much money, they would cease placing new orders and the broker would no longer earn money consistently from the market.

Why Forex Brokers Prefer the STP Model?

things to considerYou can probably guess already why an increasing number of traders prefer to use the services of STP brokers. This model’s advantages from a trader’s perspective are not difficult to spot. However, straight-through processing systems are beneficial to brokers as well for several reasons.
The first and most compelling reason has to do with the reduction in operational costs. Using an STP system is often less costly than operating a dealing desk because the broker saves from the payment of salaries.

Less work is involved when it comes to risk management since an STP broker merely passes its traders’ orders to its liquidity providers. Unexpected market movements thus do not affect the broker itself.

The STP model translates into fewer headaches for the brokers. They do not have to worry about crucial news releases and unexpected adverse movements in market prices. Much like traders, brokerage firms are also at the whim of market conditions. As a general rule, market makers who set their own buy/sell prices, have it easier when dealing with volatile market conditions compared to quieter periods.

Nevertheless, it is challenging for a DD broker to make accurate revenue predictions because they can never be absolutely certain when and by how much market prices will move. This is no issue from the perspective of an STP broker whose revenue normally remains consistent regardless of adverse price movements and poor market conditions.

Human errors with order execution are also impossible when a fully automated STP system is in place. Orders via an STP system are filled faster, which leads to a better experience for customers. The STP brokers themselves benefit from these higher levels of client satisfaction.

Such brokerages profit from the mark-ups on spreads rather than from their customers’ losses as is common for market makers. If customers are pleased with the overall service, they will continue to trade on the respective STP platform, generating consistent revenue for the broker with the help of the markups.

Benefits of the STP Model from the Traders’ Perspective

Brokers are not the only ones to benefit from straight-through processing systems. The STP model offers tons of advantages to traders as well. We outline the main positives of trading with an STP brokerage below.

  • There is no conflict of interest because of the way traders’ orders are executed. Unlike market makers, STP brokers do not have to resort to hedging, i.e. taking positions opposite to those of their clients. Instead of profiting from customers’ losses, brokers using this model generate revenue from the small commissions (the mark-up) they charge on each trade.
  • The STP system ensures higher levels of anonymity because it directly connects traders with the liquidity providers the broker works with. Respectively, this gives customers instant access to more liquidity and better interbank prices. This is especially beneficial from the perspective of scalpers who will not have to deal with issues like slippage and requotes.
    It also works to the advantage of news traders. The exposure of a market maker increases beyond certain predetermined levels after important news releases, which may cause them to reject the orders of some customers. A news trader is spared these hassles when trading with an STP broker.
  • STP brokers provide traders with deeper access to the markets. Companies that rely on this model aggregate market prices from multiple providers of liquidity. This translates into better trade execution, more transparency, and more competitive pricing for customers.
  • Orders are filled at a faster speed since they do not go through a dealing desk. Everything is processed automatically by the system which eliminates delay and the need for issuing requotes.

ECN Brokers Explained

ecn brokers explained

Similarly to STP trading platforms, ECN brokers give the trader direct access to the real interbank market. This means the broker’s profits and losses are not based on the success of traders. Instead, ECN brokers rely on commissions to make money.

The electronic communication network connects traders directly with the brokers’ liquidity providers. In terms of execution, it functions identically as the STP. Rather than trading against your broker, you trade against other market participants such as banking institutions, larger brokerages, hedge funds, private traders, and so on.

All of these entities are essentially trading against one another by offering their sharpest buy/sell prices to others. This provides ECN brokers’ customers with access to the depth of market, which renders the manipulation of market prices impossible. The depth of market contains all quoted prices for a given market along with the proposed trading volume for each bid/ask quote level.

Traders get the chance to compare their order execution prices with those of other market participants who have access to the same price feed. Another important thing to point out is that liquidity providers compete with each other for greater trading volumes, which motivates them to offer better quotes. ECN orders are sent at the most competitive prices. However, when liquidity is insufficient to fill them, the second-best prices are used.

One main difference between ECN and STP brokers results from the fact the former do not rely on bid/ask spreads or markups to generate revenue. Instead, they profit by charging customers a nominal fixed commission on each position they open. In most cases, this commission is $10/round lot, but it might be less or more depending on different factors.

The absence of markup leads to ultra-tight spreads, which gravitate toward zero pips in some cases. Much like their STP counterparts, ECN brokers quote only floating spreads. Fixed spreads are impossible in one such environment because prices are aggregated from many different sources of liquidity. This makes true ECN brokers easy to spot – you only need to look for variable spreads.

Keep in mind that ECN brokers have very high requirements in terms of minimum deposits and lot size. This renders them unsuitable for most retail customers and small-scale investors. It has become pretty much the norm for ECN brokers to impose a minimum trade size of one mini lot, which is 1/10 of one micro lot. Minimum deposits vary from $50,000 to $100,000 in some instances.

Benefits of ECN Brokers

Despite the higher minimum deposits and larger lot sizes ECN brokers require, they are becoming the preferred choice of many traders because they offer them multiple advantages, including the following:

  • The interests of customers and brokers are perfectly aligned because ECN brokers never trade against their clientèle. Your orders are matched with those of other participants in the markets. The ECN broker merely serves as an intermediary between the market participants. Whether your trades win or lose is irrelevant in this case because the broker profits from the commissions it charges. It is actually beneficial for an ECN broker if their clients win money. This enables them to grow their accounts and trade more sizable volumes, which works well for the broker.
  • The manipulation of market prices is impossible with ECN brokers, which ensures fair and fully transparent trading conditions for their customers. This is so because such brokerages display market prices from multiple liquidity providers instead of setting their own bid/ask prices as is the case with market makers. ECN clients also have direct access to the depth of market which further facilitates transparency.
  • Trades are executed immediately and at much sharper spreads than those offered by market makers. Many different liquidity providers are competing for trading orders. This motives them to offer the tightest possible prices in an attempt to win traders over and beat the competition.
  • The access to real-time interbank prices prevents the issuing of requotes. This is a common problem among those who use the services of market makers. Requoting has a negative influence on your long-term trading performance. It normally occurs when a broker declines to fill an order due to changes in the traded asset’s market price. The requotes offered by market makers rarely work to the advantage of traders.
  • Forex Brokers Combining the NDD and DD Models

    dd and ndd brokersSome Forex brokers rely on a combination of NDD and DD models as this enables them to cater to a broader spectrum of customer preferences. It is common for such firms to provide clients with a choice from both ECN and STP account types while at the same time still acting as market makers.

    Professionals and larger-volume traders get the opportunity to set up ECN accounts. Meanwhile, the trades of retail small-scale investors must still pass through a dealing desk because major liquidity providers are generally disinterested in handling their minuscule trading volumes.

    Hybrid brokerages can this way focus on other important areas, such as customer support, market analysis, and educational resources. The combination of ECN and STP also furthers the complete automation of order entries, trade execution, and spread pricing.

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