Those new to Foreign exchange trading often become quickly confused when they come across people talking about the different types of Foreign exchange brokerages. Forex brokers can be divided up into two different categories; those who operate a Dealing Desk and those who do not. Brokers who operate a Dealing Desk are most commonly referred to as being Market Makers. The category of brokerages which do not operate dealing desks can be further subdivided, into STP and ECN brokers. STP stands for Straight Through Processing and ECN stands for Electronic communication network. Later on we well explain the key difference between STP and ECN brokerages.
Introducing Market Makers/Dealing Desk Brokers
Market makers or Dealing Desk brokers, make their money through spreads and trading against clients. These brokerages literally create a market, by offering both a buy and sell quote themselves. This means that Market makers are the counter-party to a clients trades, in other words they take on the risk of the clients position. Many people think this creates a conflict of interest, as it appears that it is in the best interest of the brokerage for their clients to lose. However, the majority of Market Makers engage in hedging and also limit their risk by offering a spread wider than on the inter-bank market. Meaning that the brokerage can turn a profit even if some of their traders make a considerable amount of money.
You will find Market Makers offering both fixed and variable spreads. Clients of Market Makers, do not see the underlying Inter-bank market prices and are rather quoted a rate by the brokerage. While this may seem alarming, the rabid competition between Foreign exchange brokerages means that the rates offered are the same or very close to the rates quoted on the Inter-bank market. Their are a number of Market makers who offer both an excellent level of service and competitive spreads.
Let’s say you Buy 10 lots of the EUR/USD with a dealing desk brokerage. The brokerage will first attempt to find a matching order on their client book. For instance if someone Sold 10 Lots of the EUR/USD, at the same time as your buy order the brokerage would be able to make a profit off the spread. When such brokerages can not match their orders internally, they will go to their liquidity provider(s) and hedge the position. If the spread offered by the liquidity provider is smaller than the spread offer by the brokerage, the broker can still make a profit though generally a smaller one. Just how brokerages manage their risk varies but the majority of reputable market makers will engage in some sort of hedging.
Introducing No Dealing Desk Brokers
As the name would suggest, No Dealing Desk brokers pass their clients trades through any sort of Dealing desk. This means that the broker doesn’t take the other side of a clients trade, i.e they do not act as the counter-party. But rather simply connect two individuals or organisations together.
No Dealing Desk Brokers act as intermediaries and help traders connect with one another. These brokerages can make their money in two different ways, firstly they can charge commission or alternatively they can increase the spread slightly profiting from the difference. No Dealing Desk Brokerages operate using either the ECN or STP model.
Introducing STP (Straight Through Processing) Brokers
Their are a number of STP brokerages that claim that they are in fact ECN’s, but the two types of brokerages differ in a number of ways. Those operating using the STP model simply rout their clients directly to one of their liquidity providers, who have access to the interbank market. The majority of STP brokerages will have a number of different liquidity providers, with each liquidity provider quoting it’s own bid and ask price.
|Bid (Sell)||Ask (Buy)|
|Liquidity Provider A||1.3000||1.3004|
|Liquidity Provider B||1.3001||1.3004|
|Liquidity Provider C||1.3002||1.3003|
The brokerages system will then sort the various quotes from their liquidity providers from best to worst. In the above example the best Bid (Sell) quote comes from Liquidity provider A, while the Ask (Buy) quote is offered by Liquidity provider C. So the spread offered by the STP in this instance will be 1.3000 – 1.3003.
The brokerage then profits by either charging the trader a commission or by increasing the spread offered to the trader by 1 or 2 pips. The fact that the prices offered by the various liquidity providers are always changing are the main reason why the vast majority of STP brokerages offer variable spreads. During news time or periods of high volatility, if the spreads of their liquidity providers widen then they are forced to pass these increased spreads onto their clients.
Introducing ECN brokers
True ECN brokers differ from STP in one crucial respect. An ECN brokerage allows their clients to directly interact with the other participants on the electronic communication network without acting as an intermediary.
The participants on the network can be very diverse and may include banks, other retail traders, hedge funds and even other brokerages. The traders on the network trade against one another by offering the best Bid and Ask prices. ECN’s also allow their traders to see the depth of the market, this means that ECN users can see the buy and sell orders of other market participants. This makes it difficult for ECN brokerages to slap on a fixed pip markup and the brokerages typically make their money by charging commission.