All new Forex traders keep asking the same question: Where does the money go after a trader makes a deposit; is there any guarantee that that trader’s money will be returned to him and how is the profit generated? In this article, we will try to give you the answers to all this and familiarize you with the concept of “segregated accounts”, “liquidity providers”, “ECN-accounts”, execution of “Immediate Market” orders, and more.
How to Trade Forex
To get started, a trader needs to register with a broker and make a deposit. The deposit amount is shown in the personal area; however, the money will go to the segregated account. It is an account in a reliable bank with a good record where the money of all traders is saved. The segregated account is not directly connected to the broker’s account, therefore the broker cannot use the customer’s money for its operating expenses. Compliance with this requirement is strictly monitored by a regulator. With the help of some analytical programs, the bank maintains control over the individual sum of each trader; this is bank-specific, which is not a trader’s interest circle.
Now let’s review the procedure for opening a position. On the platform screen, you will see the exact time to buy, say, CAD, and give a purchase order to your broker. The order is processed with the help of the broker’s software and placed on the market by a liquidity provider.
If the intention is to be precise we have to say that a broker has software, allowing to consolidate liquidity from external suppliers. Upon receipt of the trader’s order, the software automatically sends the data to the suppliers; it receives their answers by informing about the demand and supply and then executes the trader’s order at the price we observe is the most attractive on the market offered by their suppliers.
Liquidity providers are the largest intermediaries that connect all participants in the exchange market world, including major investment banks such as Barclays, Morgan Stanley, Citibank, Deutsche Bank, Bank of America, and others.
A trader’s order execution procedure can be summarized as follows:
-A trader places a purchase order for a certain instrument at a fixed price;
-The other trader places a sales order for the same instrument. A barometer is formed based on orders from traders and liquidity providers make their price offers;
-If the supply and demand prices are the same, the purchase and sale overlap;
-If the order of both does not match, the offer is held until the liquidity provider makes the best price offer and the trader is told if it agrees with the new price;
-If the liquidity provider fails to execute the order, its order will pass to other liquidity providers.
Therefore, a broker transfers each order to a liquidity provider, which in turn ensures that an order is executed at the best current price. If one trader makes an unsuccessful trade, the other will make a profit. The broker earns exclusively on the spread (a transaction fee), a broker shares its profit with a liquidity provider.
A delicate moment of execution of the order is slipping. It takes time to process the trader’s order. At the same time that a trader sends an order for a transaction at a specific price, market prices may change and the order will be executed at a slightly different price. A professional trader knows the importance of quick order execution (up to 0.5ms), which allows avoiding this slippage, which is helped by the ECN-accounts.
ECN- is an electronic communication network where customer orders go directly to liquidity providers and therefore avoid conflicts of interest.
Conflict of interest is when a broker uses internal information to prevent the execution of orders. In ECN systems the broker acts as an intermediary, which ensures transparency of transactions and high data transfer speed. The absence of slippage is also a great advantage of ECN.
Note that even in classic broker communication schemes they often do not have direct contact with a provider. For some brokers this information is confidential. Sometimes, ECN liquidity systems can be providers themselves. They are called STP-brokers.
Types of Order Execution
Instant Execution is an immediate order execution at the current price. If a broker cannot execute the trader’s order, it will make its own offer with the guarantee of an execution order at the specified price (recotization). A trader may or may not agree to a new offer;
Market execution is an execution at the best price. Although the probability of execution of the order is almost 100%, slippage (slippage) is still possible.
The Market Execution is considered to be a sign of the broker’s security since the order is shown in the interbank, where the price is dictated by the market. In the case of an Instant Execution, a broker has an opportunity to manipulate and reject a favorable price and offer its own price.
Working Principles of A-Book and B-Book
The principle of relations between broker and liquidity provider and international market is called A-Book. This system is specified above.
However, there is another system, called B-Book. In this system, all customer transactions are closed through opposite transactions. That is, an order is not transferred to the liquidity provider (external market), but is executed by the broker. A broker or one of your traders will execute an order to compensate.
Important! Brokers using this B-Book system are often called “kitchens”. It is not a completely correct term, because it is considered that a broker “kitchen” tries to take the customer’s deposit in possession, while B-Book brokers are interested in attracting new customers, as they earn money with the spread.
Features of a broker using the B-Book system are as follows: they do not report on liquidity providers, a small amount of deposit (for example $10), restrictions on trading. Many brokers use both systems. If a trader has no trading experience, has a small deposit, and uses a risky strategy, it will not be introduced to the market as it is economically unprofitable. Transactions of such a trader will be closed to offset with reverse positions of traders from the same broker and there will be no conflict of interest between a trader and a broker.
When a trader gains experience allowing him to take risks with a large deposit (in which case he will need to use wider trading options, such as instant order execution, etc.) a broker will offer the trader an A-Book system, which introduces him to the foreign market.
A broker may use an internal clearing system, or transfer transactions to the interbank market. A trader’s transaction can be transferred to the interbank market even through a brokerage house or by ECN-systems directly to liquidity providers.
Features of a Trusted Broker
A trusted broker is interested in increasing the volume of transactions as they earn money exclusively on spreads. Liquidity providers do not trade small transactions; moreover, the availability of ECN accounts is proof that the broker works with large investment banks, which shows that you are dealing with a solvent broker;
A trader is not restricted to choosing strategies. A broker is interested in customer success trading and does not limit their freedom of action.