ECN/STP brokerages are preferred by many traders, because it tends to mean faster execution, more accurate pricing and more liquidity. However, this is not always what traders receive when they open an ‘ECN’ or ‘STP’ account with their chosen broker. In this article, we take a look at how ‘liquidity’ is actually provided, and what is the real story behind pricing, volume, price, cost and ultimately, better trading conditions.
The Theorethic ECN Model
Why is ECN / STP considered “better”?
ECN/STP brokerages are preferred by many traders, as this execution model allows a brokerage to make a profit regardless of whether a trader is profitable or not. This is due to the fact that the brokerage never takes the other side of a client’s trade and simply passes the risk onto a liquidity provider or trading using the firm’s Electronic-Communication-Network (ECN) – this is known as ‘A-booking’ a client’s trade.
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Before Talking Execution: ‘Liquidity’ matters in the FX Market
The Foreign Exchange (FX) market is by far the largest compared to any other asset class and arguably attracts a wider diversity of market participants given that currency exposure is something that applies to everyone whereas other asset classes are more specialised and tend to apply to select market participants.
The FX markets’ DNA is geared towards direct decentralised trading amongst multiple venues simultaneously. This poses both challenges as well as opportunities for both the buy and sell sides of the FX trading arena.
The FX market is efficient in terms of bringing buyers and sellers together although how efficiently — remains a matter for debate.
In the meantime, the FX market continues to change and evolve in order to suit the needs of its users. Technological innovation has enabled brokers, banks and liquidity providers (LP’s) to offer powerful solutions that improve their clients’ trading experience but in parallel, technological progress has raised expectations amongst end users (traders) of what is possible and what can be realistically expected from trading venues.
In the FX market today, the spectrum of participants has grown immensely since trading services started moving online in the late 1990’s. More traders and deeper liquidity have flattened trading costs and helped to make the industry more competitive as a whole. Both individual and institutional traders have benefitted albeit in completely different ways.
Type of market participant
The broad trader categories in financial markets are hedge funds, high-frequency traders, proprietary trading firms, asset managers, banks and last but not least, individuals. All of these users have different motives and expectations, but most importantly, they all have different incentives.
Large institutions crave price security and maximal depth of market. They want certainty that all of their exposure is risk managed appropriately which means market orders must be filled in their entirety at the most advantageous price possible. Large trade sizes also mean spreads tend to be decided upon trade entry as opposed to the retail market where the spread is of prime importance and often decides trade entry for retail traders.
Individual traders, often referred to as ‘retail clients’ are invariably interested in the ‘top of book’ price i.e. the best possible bid-offer spread being offered at any one time. Individual traders tend to be small in terms of capitalisation and their trading motive tends to be profit rather than hedging, risk management or an actual interest in the underlying commodity.
Retail clients want speed of execution and razor thin pricing — available 7 days a week if possible. Individual traders are often motivated by the substantial profit-potential leveraged trading typically provides. Institutional and individual traders have a completely different mentality which means a different service must be offered in order to satisfy different expectations.
All-in-One or Separate?
In current market conditions, the most successful approach to offering ‘optimised’ trading services that cater for all types of trader has been to separate the existing business into separate units that each focus on a specific customer requirement rather than trying to perfect an existing service to suit all clients simultaneously.
This ‘boutique’ approach helps trading venues to be more efficient and in turn, helps to insulate their revenues from various external shocks including changes in external conditions that cannot be affected or controlled. Liquidity aggregators are now able to create different ‘flavours’ of liquidity whereby the whole order, quote, trade, execution process is customised to suit a particular client type with specific motives and expectations.
eToro , FXTM, and XM Trader are just three examples of how a broker can facilitate trading services to both institutional and retail clients under one brand name. Only by separating all business activities including liquidity sources, platform, staff and IT infrastructure can a broker hope to offer trading services to all market participants without compromising key features such as pricing, liquidity, latency or execution.
What is an ECN/STP Brokerage?
ECN/STP brokerages, are also known as No-Dealing Desk brokerages. These brokerages simply act as agents for their clients either passing trades straight through to their liquidity providers (known as Straight-Through-Processing) or are matched up with other traders using the brokerages ECN (Electronic Communication Network.ECN/STP brokerages are preferred by many traders, as this execution model allows a brokerage to make a profit regardless of whether a trader is profitable or not. This is due to the fact that the brokerage never takes the other side of a client’s trade and simply passes the risk onto a liquidity provider or trading using the firm’s Electronic-Communication-Network (ECN) – this is known as ‘A-booking’ a client’s trade.
Market Makers or Dealing Desk brokerages in contrast do not pass all trades onto liquidity providers or other traders, but on occasion take the other side of trader’s position (this is known as ‘B-booking’ a client). This can often mean that the brokerage’s profits are equal to the trader’s losses. This is thought to introduce an unpalatable conflict of interest, which many traders believe could lead to brokerages using manipulative tactics to remain profitable. There is no such conflict of interest with genuine STP/ECN brokerages, with the brokerage making profit by marking up the spread or charging commission. In fact, ECN/STP brokerages want traders to profit, with traders continued business allowing the brokerage to continue to profit from the spread mark-up/commission charged.
ECN/STP brokerages are also favoured by traders, as these firms often able to offer more competitive spreads. Market Makers typically offer wider spreads as this is one way in which they can manage risk, though this is not true of all Market Makers. ECN/STP brokers pass many trades onto liquidity providers who are able to offer very tight spreads due to the huge volumes they are dealing in, meaning under standard market conditions spreads tend to be much tighter.
Brokerages that operate an ECN can often go a step further and allow traders to benefit from Spreads starting at 0 pips, with the brokerage matching up traders who want to take opposite positions in a particular instrument. These brokerages then profit by charging the traders involved commission for taking advantage of the brokerages Electronic-Communication-Network (ECN).
Does ECN = STP?
You will often find the terms ECN/STP used together or in the same sentence, which has led to many people asking what the difference between an ECN and STP actually is. The reason why STP and ECN brokers are often talked about as if they are the same thing is due to the fact that both brokerage models operate without a Dealing Desk. This means the brokerage doesn’t interfere with a trader’s order but simply place the trade with a counter party. Many traders favour brokerages using a no dealing desk model as the interests of the brokerage and the customer are fully aligned.
The Differences between the STP and ECN Model
STP stands for straight-through-processing, which means when a trader places an order with the brokerage they will simply pass this trade onto one of their liquidity providers. These liquidity providers will vary broker to broker and may include other brokers, banks, and other specialist liquidity providers. It is these liquidity providers who are the ultimate counter party, not the brokerage that the individual is trading with.
This means that the more the trader trades the more money the brokerage can make, which means it’s in the brokerages interest for clients to make money. It is for this reason why STP brokerages are seen to avoid the conflict of interest inherent in the traditional dealing desk model.
ECN stands for Electronic-Communication-Network, just like an STP brokerage an ECN broker will send some of its trades to the various liquidity providers used by the brokerage.
However the difference between the two models is hinted to in the name, as an ECN will also internally match orders placed by users of the network. For instance, if one trader using the ECN wants to go long, the brokerage can often match the order with another trader who wants to go short. This means that users of Electronic-Communication-Network Brokers can often take advantage of 0 pip spreads when the brokerage successfully matches user’s orders. ECN brokers make money by charging its users commission on top of any spread. The reason why many traders prefer ECN brokerages is that ECN’s can often provide traders with tighter spreads though it is important to work in the costs of any extra commission.
Advantages to using an ECN Broker
An ECN brokerage gathers quotes from several different sources, this means spreads with ECN brokerages are often considerably tighter. Typically, Foreign exchange brokerages make their money off the spread with all costs being included within the spread, ECN brokerages however make their money by charging commission to their clients. While the commission does an extra cost, such brokerages still tend to offer better value for money overall.
ECN brokerages only match traders with various liquidity providers, meaning that the interest of the customer and the brokerage are aligned. As the brokerage makes money regardless of whether the trader is successful or not, there is no reason for the brokerage to engage in any unscrupulous activity in order to maximize profits.
Again, due to the fact that ECN’s make money off commission, they rarely place limitations on the kind of trading activity that clients can undertake allowing both hedging, trailing stops, and unlimited scalping. This means that many traders feel much happier trading with an ECN brokerage.
Disadvantages to using an ECN Broker
ECN brokerages do have some disadvantages, for instance many ECN brokerages have much higher minimum deposit requirements. Which means some traders may not be able to open an ECN account at the brokerage of their choice. However, there are a number of ECN brokerages that cater to clients who have limited capital at their disposal.
Another minor gripe some traders have with ECN brokerages is that it can be more difficult to work out stop-losses and break even points in advance due to the variable spreads on offer; however most market markets now offer variable spreads as standard.
ECN vs. STP: Which is better?
ECN brokerages are generally considered to be superior to STP brokerages, with many ECN’s being better value even when commission isn’t taken into account. It is important to be aware that not all brokerages advertising themselves as ECN’s do in fact operate as such, and are glorified STP brokerages. Genuinely true ECN brokers will provide traders with Depth of Market information which will allow users to see the liquidity available on the Electronic Communication network at different prices.
With this being said there is nothing inherently wrong in using a brokerage which operates as a STP, with their being many brokerages which provide their clients a great level of service. Just as there are ECN brokerages that do not truly operate as such, there are a number of STP brokerages which do not straight-through-process all trades which is why it is important to check out a brokerages execution policy before depositing (and to monitor on-going trade execution to ensure high standards are being kept).
Difference between STP and ECN In Execution
As already mentioned, there is one fundamental difference between STP and ECN brokerage. STP brokerages simply pass client orders onto liquidity providers at the currently available best price, often aggregating quotes from a number of different sources including Tier 1 Liquidity Providers, Prime Brokerages and often other FX brokerages.
ECN brokerages also attempt to match up traders using the brokerage. For instance, imagine there are two traders who are currently trading with an ECN brokerage. One of these traders wants to go long in the EUR/USD, while the other trader wants to go short. If they both place orders at the same time or at the same price the brokerages ECN network will match these two traders together. This often means that ECN brokerages can match up trades with no spread between the Bid-Ask, though traders are likely to be charged commission.
When trading with an ECN brokerage you will likely find that the majority of your trades are passed onto external liquidity providers rather than matched up with other traders. This will be particularly true when the market is trending in one direction, and there is no-one to take the other-side of a trade.
Broader Industry Challenges
Low volatility and low trading volumes, combined with lower spreads, means margins are tighter and narrowing. Operating an organisation with hundreds of staff is much more difficult than a boutique brokerage with a few dozen employees.
Liquidity providers vary in scope and size although at least 70% of all FX liquidity originates at the inter-bank level using platforms such as EBS and Thomson to conduct trading activity.
ECN’s and hedge funds provide approximately 15-20% of all FX liquidity while the remaining participants such as corporates, brokers and individuals make up around 10%.
However, despite this seemingly skewed liquidity picture, access to liquidity has never been so diverse. ECN’s such as Currenex have entered the market and have not only bridged the gap between the inter-bank and retail markets but have inter-connected all users including the banks themselves.
The linear model of direct trading relationships has been gradually replaced by a dynamic, inter-connected model that allows for multiple liquidity pools with various characteristics to be offered simultaneously.
Rough sketch of online FX market in its inception in the 1990’s working under linear trader-broker relationships. Trading activity tended to occur via a handful of counterparties with little inter-connectivity.
Rough sketch of today’s online FX working dynamically under PB’s, liquidity pools and greater diversity of market participants. Trading activity can occur with multiple counterparties simultaneously, even within the same order. Liquidity pools can be ‘flavoured’ to suit particular niches with specific technical requirements that may not suit other market participants. The desired product type, order size, order type and speed of execution will decide the most suitable liquidity pool for each specific trader.
When using an ECN or aggregator, clients are potentially seeing quotes from other banks or other individual users but due to complete anonymity and all financial obligations being settled via a prime broker, it’s impossible to say who traded with who and for what amount. Differences in the type of liquidity available are not extensive.
Last Look – a Key Aspect
One key aspect of streamed pricing that is often balked at by traders is the ‘Last Look’ mechanism.
Most liquidity providers incorporate a ‘last look’ feature on every trade which allows the provider a final confirmation of the trade terms before making the decision to accept or reject the order.
If a liquidity provider or broker is streaming a tight price, they usually want the ability to have a last look before they accept the order regardless of volume. It’s not a question of slippage – the order is not requoted but simply accepted or rejected. Both retail and institutional brokers have risk management responsibilities so when deciding to accept a trade, they do not want to do so at any given price. The offered quote must be a balance of appropriate pricing, reasonable speed and manageable size that fits into the broader goals of the executing broker.
Executing all trades at market would quickly lead to a large, unstable exposure for the company irrespective of whether those trades are well risk managed or not. Even if the broker wants to hedge exposure with an alternative LP and prevent exposure from growing, there may not be enough time do so if all available liquidity providers are quoting unsuitable prices and rejecting trades via the Last Look feature. Whereas in the past brokers would often go out into the market to adjust their exposure through other liquidity providers, today they often use existing client order flow to assist in this risk management process.
High Frequency Trading (HFT) and the FX Market
A fairly new phenomenon making headlines in the trading community is High Frequency Trading (HFT). HF traders’ core expectation is low latency with the motive to conduct hundreds of small trades in a short period of time. The goal is to make a small profit on each trade which adds up to sizeable profits over time. HF traders can only operate on an order-book styled order system because streamed pricing is completely unsuitable. Consequently, equity markets are where HFT has been utilised most.
In terms of HFT, the FX market is slightly different to Equity markets. In the FX market latency is measured in milliseconds while in Equities it’s microseconds. Equity market trading venues are based on order-books while on stock exchanges there is no concept of Last Look and orders are processed a lot faster compared to FX. There is a percentage of the FX market that competes on the basis of ‘who is faster’ but overall this is still a relatively small market niche for the time being.
The rationale for having such a discrepancy in latency between Equities and FX is based on the fundamental fact that the seller in any transaction is assumed to be holding the stock. The supply of a particular stock is limited whereas supply of a particular currency isn’t. More importantly, with multiple liquidity pools and providers available, the supply isn’t sourced from one or a handful of counterparties. Anyone can obtain market access, quote a price and supply has just been created.
Essentially, the FX market is a lot more speculative and ‘fiat’ whereas equity markets are more of a zero sum game with the added caveat that actual company ownership is being exchanged.
Bottom Line: The FX Trading world can be simple or complex — and it’s all to do with the trading style
Given the high level of competition in the FX market combined with staggering growth in sophistication across the board, it is now undoubtedly a buyer’s market. Both large institutions and individual traders must be proactive in how they select their avenue to access FX market prices and execution. Traders can obtain tight spreads, deep market prices, low latency and pretty much anything else they require but the only caveat is that it is impossible to have it all, at once. All traders need a venue to trade and all venues need traders – it’s all just a question of terms.
Relationship management and regular communication is a good way for traders to improve their trading terms and for brokers to accurately ascertain their risk profiles and trading strategy to better manage their own risk exposure.
With margins much lower today compared to 5 years ago brokers have to do more business or cut costs in order to maintain the same level of earnings performance. The only other alternative is to take bigger risks in how they price, execute and offset exposure. In today’s market any broker or liquidity provider must strike a balance between being generous via over-competitive pricing (to attract more clients and flow) and being greedy by pushing the boundaries of risk management (to maintain revenue and earnings growth). Too much of one or the other is unsustainable.
Technology (Fintech) is playing a huge part in this balancing act and with new types of market participants such as HFT’s and ECN’s adding to the diversity of the FX market as a whole, market participants can only benefit.
Institutional brokers do not service retail clients and retail brokers tend to skip offering true institutional services. It’s difficult to offer the best possible offering to all market participants, all of the time. At some stage prioritisation has to occur with the broker focusing on a core client type rather than hope to offer a one-fits-all solution.
With spreads now at their lowest level in history for both retail and institutional clients, the immediate challenge is on brokers to maintain high standards and operational efficiency despite lower margins and revenues. As market volatility picks up and trading activity rises it’s hoped that brokers will not be tempted to make up for the tough times by gorging in the good. Choosing a honest and decent broker should be your main concern more so than finding particular ECN or STP forex providers with specific execution style.