Many new Forex trading will be unaware that the majority operate using the Market Maker model. Market maker brokerages quote both a buy and sell price for a particular instrument, in the hopes that they can make a profit on the spread. The brokerage takes on the risk operating as a counterparty, it should be obvious that this presents a significant risk management problem for the brokerage. Market makers are to be contrasted with ECN and Direct Market access brokerages which place trades equivalent to those placed by their traders in the underlying markets making money from an increased spread and/or by charging commission. In this article we are going to examine how market maker brokerages manage to turn a profit, by managing their risk.
Market makers do not face much of risk management problem when sentiment regarding an instrument is neutral. Suppose that trader’s opinion about the EUR/USD is sharply divided, with around 50% of traders being bullish and the other 50% percent taking a bearish outlook. In situations such as these the brokerage faces little risk as any money made by one set of traders is likely to be cancelled out by the losses of others. This allows the brokerage to make money on the spread. As every pip made by those who made the right call is a pip lost by those who made the wrong call, meaning that the brokerage profits from the spread they set.
|EUR/USD||Spread||Price Movement||Brokerages (P&L)|
|Buy: 100 pips||4 pips||+10 pips||-$8,000|
|Sell: 100 pips||4 pips||+10 pips||+$12,000|
However the majority of the time sentiment regarding a particular instrument is less sharply divided. When for instance 90% of traders are long in the EUR/USD the brokerage is faced with a significant risk management problem with their being a number of ways in which the brokerage can try to alleviate risk. If the brokerage offers variable spreads it can attempt to widen the spread to both put off new traders opening a position in that particular instrument and as a way to minimise their risk. Such spread widening can help alleviate some risk but it is unlikely to fully solve the problem. While a market maker doesn’t place every trade in the underlying market they often engage in some market hedging. By mirroring the dominant sentiment while offering a wider spread the market maker again should be able to make a healthy profit. This involves traders at the brokerages going out and trading in the underlying market place often on the basis of a complicated risk management strategy.
It should be clear how brokerages which engage in such hedging can make healthy profits. However there is a type of market maker which never engages in any hedging of its positions. These brokerages are known as pure market makers and rely on only the spread to turn a profit. There are situations when this is possible as stated in the first paragraph; however brokerages operating as pure market makers often face severe risk management problems. Such market makers are often unregulated operating from offshore locations and take some shortcuts to ensure that they turn a profit. It hasn’t been unheard of for pure market makers to cancel customer’s profitable trades or ban profitable traders from trading with them. Many pure market makers rely heavily on the fact that the majority of retail Forex traders lose money, which means successful traders pose a significant problem for such brokerages.
I would strongly advise staying away from brokerages which operate as pure market makers, however many market makers offer a very high level of service. Oanda Europe would be a prime example of brokerage operating using the market maker model while offering its clients great execution and spreads.