Like any other business in the history of business, your broker’s
raison d’etre, is to make as big a profit as possible. There are about
as many ways to go about this as there are brokers. For those who are
in it for the long haul, however, it is generally best to adopt a set
of practices which are deemed fair by their clients: certain boundaries
are set, and operating beyond them can cost a brokerage its reputation,
and along with it its clients. Straying outside these boundaries,
therefore, is not considered as being in line with the long term goals
of the business. How strictly these boundaries are enforced, especially
when there is little chance of clients ever even becoming aware of any
transgression, again varies from business to business. For the sake of
simplicity, in this article we assume that everyone in the business is
squeaky clean, as if every client could peek into the broker’s back
office at any time and dissect every trade. This is obviously not the
case, and many brokers do take advantage of this opaqueness, but the
details of that are best left for another discussion.
So without further ado, let’s get into the details of how forex
brokers function. Somewhat removed from the top-tier interbank market,
retail forex brokers are there to provide a service that would
otherwise not be available, that is, giving an investor with a $10,000
bankroll the chance to speculate in the up-until-recently very
exclusive forex market. There are generally considered to be 2 types of
brokers providing access at the retail level: Electronic Communications
Networks (ECNs) and Market Makers. ECNs are generally somewhat more
exclusive, requiring larger deposits to get started, but are seen as
providing more direct access to the interbank market. As we will see,
there are certainly advantages to this, but some disadvantages as well.
Market makers, on the other hand are more often than not, the counter
party to their clients’ trades, creating somewhat of a conflict of
interest, whereas ECNs profit from commission fees charged directly to
the clients, regardless of the result of any trade, they are seen as
being completely impartial – an ECN has no incentive for a client to
lose money. In fact, one could argue that an ECN stands to profit more
if a client is successful, meaning that s/he will stay around longer
and they will be able to collect more commission fees from them. A
market maker, on the other hand, being the counterparty to a client’s
trade, makes money if the client loses money, providing an incentive
for some shady practices, particularly in an unregulated market. The
extent to which this happens varies among individual brokers.
There are also some benefits to trading with a market maker (see our
ECNs vs. Market Makers article) Some brokers also provide a service
that doesn’t quite fit into either category – they route different
orders differently, depending on complex algorithms, or on a dealing
desk, that analyze each order and attempt to fill it in the way that
will be most beneficial to the broker’s bottom line. They can offset
some client orders against one another, effectively creating an
in-house market, they can choose to be the counterparty to a client’s
trade (trade “against” the client), or they can offset their position
with a hedge through a higher-tier counterparty. Note that the market
maker is mainly concerned with managing its net exposure, and NOT with
any single individual’s trades. They are NOT gunning for your stop losses specifically, but may be gunning for clusters of stops.
If you have already read the first article in the series, Structure of the Forex Market,
you will recall that market mechanics are responsible for the variation
in bid/ask spreads, and also for slippage. So it seems the two biggest
novice traders’ pet peeves are not so much a function of who their
broker is, but rather their lack of understanding of the way the forex
market operates. A broker that offers a fixed spread tends not to fill
orders during periods of low liquidity because this would expose them
to undue risk, and as much as their job is to cater to their clients,
remember they are in business primarily to make money for themselves.
Some brokers also offer guaranteed order fills, such as “guaranteed
stop losses”. Again, if there is no counter party to take the trade,
they have to expose themselves to risk in order to fulfill this
guarantee, so don’t be surprised if you see such a broker quoting
different/delayed prices around important trend lines or
support/resistance levels. Be especially aware of brokers who offer
both guaranteed fills AND fixed spreads. When a broker offers something
that seems too good to be true, you would be wise to question how
exactly their business model is able to support such a risky practice.
As a general rule, a broker will help you only when your interests are
aligned with theirs. On the other hand, brokers provide a very valuable
service, without which you wouldn’t have the opportunity to profit from
the forex market, so please think about how it all comes together
before blaming your broker for everything.
http://www.forextradingzone.org/articles-How_Forex_Brokers_Work
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