Forex Brokers and Where They Fit in the Market
This lesson will cover the following
- How the forex market works
- What is a forex broker and what can they offer investors
- What is a liquidity provider
As youve already read in the previous chapters, the foreign exchange market is the biggest and most liquid market there is, with a daily turnover of $5.3 trillion dollars as of April 2013. And it keeps growing with each single day passed as the limitless possibilities for profit, use of leverage and low margins of relative profit compared to other markets attract more and more investors.
There are many people however, most often individual traders who just recently entered the market, that picture themselves a particular brokerage firm when they are asked what is Forex and how the system works. But there is much more to it than you thought, and of significant importance. In order to choose a reliable and suitable broker and avoid disadvantages such as latency risk, negative slippage instead of a both-ways one and many others, a trader must first learn how the Forex market actually works and how an order is executed.
Brokers and their use
Brokers make the market easily accessible for any trader as their platforms, some proprietary and custom made, while others white-labeled or directly bought and used, provide a user-friendly interface, which allows everyone, more or less experienced, to execute orders within a fraction of a second. This is where they derive their value from.
Forex brokers allow their customers to use a great variety of strategies when trading by providing them with a certain set of trading instruments and various indicators. Some companies of course excel above others by giving their users many more interface customization options, instruments and indicators, a wider variety of deposit and withdrawal methods, and of course like in any other business, better customer support.
But where exactly in the market chain do the brokers find themselves. If you look at the Forex market from a different, over-the-top perspective, you will notice that it, like any other ordinary market, consists of buyers and sellers, with the product being the service of providing the ability to trade currencies. Traders (the clients) pay sellers (the brokers) a fee (the bid/ask spread of the traded asset or a fixed commission) to gain access to the Forex market. But in this chain, brokers are merely the retailers who provide the service. Have you ever wondered where does the actual money (liquidity) come from? The next few lines will answer that question.
The institutions responsible for providing the Forex market with enough money are the so-called liquidity providers, also known as market makers. A liquidity provider connects many traders and brokers together, creating a joint market whose increased liquidity benefits all of the participants as it drives spreads down, thus reducing the cost of trading. Market makers sell and buy from their clients in exchange for profiting from the bid-offer spread, thus facilitating the trade and reducing transaction costs.
Liquidity providers are most often large banks and other financial institutions. In Forex, some of the biggest and well known liquidity providers are HSBC, Bank of America, Citibank, UBS, Credit Suisse, Goldman Sachs, JPMorgan Chase, Detsche Bank and others, with the latter ranking first.
So, how do traders connect with market makers ?
Before a Forex broker begins to operate, it needs to have invested a certain amount of money in order to acquire three elements of utmost importance – a trading platform, a sophisticated back office and a bridge interface through which it can establish a connection with the interbank currency market.
The trading platform, as we already noted before, is what the user sees and experiences during his everyday trading sessions. The constantly updating information he sees on his screen – prices, quotes, charts, news etc., comes from the back office systems where you can find the price engine, trade and account servers , news servers etc. The whole flow of information streamed from the back office is integrated in the trading platform, which as we already said, gives the broker a competitive edge, if it is user-friendly, lag-free and grants access to an extended set of tools.
Some brokers have the capital to be able to afford making their own, proprietary, trading platforms, while some use white-labeled products which they customize and others just buy a license for using a platform as it is, like MetaTrader by MetaQuotes Software Corp.
This gets us to the third fundamental element which a broker needs in order to operate – getting Forex price quotes from market makers. In order to receive quotes from the liquidity provider, a broker needs to set up a connection with the interbank market through a so-called bridge interface. A broker will use the Application Protocol Interface (API) instructions that the liquidity provider, a major participant in the interbank market, will provide it with in order to set up a link and receive real-time streamed quotes.
Typically, larger brokers establish a network with more than one market maker, most often up to four, allowing them to be flexible when executing orders since the different banks prices vary to some extent. Meanwhile, small Forex brokers usually have only one liquidity provider, leaving them dependable on whatever prices the sole market maker announces. It is useful to remember that no matter which broker you choose to trade with, you will only be interacting with a fraction of the Forex interbank market as brokers only operate with a small number of market makers.
Lets picture the whole process with an example. A trader decides to place a a long order on EUR/USD and sees on his screen a current price of 1.3000 – 1.3003. The user submits a request to buy at the 1.3003 ask price, which is then forwarded to the brokers back-end bridge. At this point the broker receives streamed quotes from its liquidity provider/s.
Lets imagine our broker operates with two market makers. One of them has set prices at 1.3001-1.3003, while the other quotes at 1.3000 – 1.3002. The broker will now confirm the trade and profit through his bid/ask spread. Brokers will of course always choose the better asking price and in our case buy at 1.3002 (1 pip below the price its client buys at), offsetting the trade risk and leaving the broker indifferent to whether the trader wins or loses money.
Now, lets move to the closing point of the position. Let us imagine the euro gained versus the US dollar and the broker showed his clients the EUR/USD cross rose to 1.3100 – 1.3103 after seeing that the first liquidity provider has set a 1.3099 – 1.3101, while the other quoted at 1.3100 – 1.3103. As soon as the trader closes his position at 1.3100 (the rate the broker offered), the broker itself closes again at the best price provided by the market makers, in our case 1.3099, earning it one extra pip. This way the broker remains indifferent of whether the user makes or loses money.
Types of brokers
There are two major types of brokers – Dealing and No Dealing Desk brokers, with the latter being able to be a Straight Through Processing broker or a Straight Through Processing broker + Electronic Communications Network broker.
Dealing Desk brokers
Dealing Desk brokers are market makers and act as a counter-party to their clients orders. A Dealing Desk broker will set a bid and an ask price at which it is willing to buy and sell and may decide to quote above or below actual market levels. When a user enters a trade, the broker will always open an opposite position, removing the case of an order not getting executed.
Dealing Desk brokers profit by buying at lower prices and selling at a higher, or the bid/offer spread, allowing them to earn money when prices move both ways. Orders placed with the DD broker rarely exit his own liquidity pool and reach the interbank market, making them very self-sustainable.
Some may think that by having determined prices and always entering the opposite position such brokers may be in a conflict of interests, but the trader always has the right to reject the terms. Dealing Desk brokers usually offer fixed spreads.
No Dealing Desk brokers
No Dealing Desk brokers are the opposite of Dealing Desk brokers and provide traders with a direct access to the interbank market. Since they do not set their own prices like the Dealing Desk brokers, they profit by adding a markup to the bid/offer prices which the liquidity provider quotes. An NDD broker will not enter an opposite position when a client places an order with it, rather match it with a counter-party. In this case the broker only serves as an intermediary.
They can be an STP (Straight Through Processing) or STP + ECN (Electronic Communications Network) broker. There is no requoting of prices, which makes it available to trade during economic announcements without restrictions, but the spreads are not fixed and may spike during increased volatility.
– Straight Through Processing broker – an STP broker is a type of an online NDD broker who is connected with a single or multiple liquidity providers. In this mode, clients orders are fully computerized and immediately forwarded without any broker intervention to the interbank market, where they are processed.
– Electronic Communications Network – an ECN broker uses an electronic communications network to put its clients directly in touch with other traders. They provide real-time order book information, featuring processed orders and offered prices by banks on the interbank market, which helps improve market transparency by sharing information with all participants. This enables ECN brokers to offer their customers more competitive spreads and since the spreads are narrow, they profit by charging a fixed commission per transaction.