In the previous article, we have discussed an overview of the financial industry. Now we know that the entire Forex market is about buying and selling of currencies. The majority of these foreign exchange transactions are done by major financial institutions and global organizations. But where do the retail traders like you and I undertake Forex trading? We do it through independent companies called brokers. In this article, let’s understand what a Forex broker is and the different types of Forex brokers existing in the market.
What is a Forex broker?
In the Forex market, buyers and sellers can be thousands of miles apart. So there needs to be a mechanism that matches their interest. This is where a Forex broker comes into the picture. A Forex broker is a platform where the buyers and sellers get to buy and sell currencies. It acts as a middleman between a trader and the market. In simple words, to find a buyer or seller for a particular currency, the broker matches your order with the respective buyer or seller. These brokers are also known as ‘liquidity providers.’
Types of Forex brokers
Even though all brokers in the Forex industry provide the same basic service, there is a difference in their functionality and mechanism. The first thing to look for with every Forex broker is whether they have a ‘dealing desk’ or not. In brokerage firms, the dealing desk refers to a team of traders who manage the broker’s inventory and hedging operations. Nowadays, most of the dealing desks consist of hundreds of traders and analysts.
Brokers that work on dealing desk operate in a closed environment wherein they set their own price rates. They fill their client orders by matching the buy and sell orders of their clients. When a broker uses a dealing desk, they are called as Market Makers.
Brokers that don’t use a dealing desk get rates from the interbank market and process their client orders by linking them directly to institutions, hedge funds, mutual funds, and other brokers. When a broker does not use a dealing desk, they are either known as ECN (Electronic Communication broker) or an STP (Straight Through Processing) broker.
Market Makers (MM) are called ‘dealers’ in the interbank market. They charge a variable spread instead of commission, which is why most of the time, they are accused of manipulating the spread and prices of the currency pairs. Theoretically, the spread should widen or narrow during high liquidity conditions, but MM brokers offer a fixed spread and compete based on the spread.
Electronic Communications Network (ECN) Broker
ECN brokers make their profits from spreads they charge on buy and sell rates or from fixed trade commission. The transactions here are mostly interbank. Because the spreads in the interbank markets are dynamic, ECN brokers prefer charging commissions rather than fixed spreads. This is one of the easiest ways to trade, but this requires a much higher investment capital as clients in the interbank markets only trade large lots. Therefore, trading with ECN brokers requires a minimum account balance of $1000. In addition, there is no guarantee that you will find a buyer or seller in the interbank market at your quoted price. ECN brokers sometimes won’t be able to execute orders at that price, so they issue a re-quote or simply reject the order. These are some of the limitations of ECN brokers.
Straight Through Processing (STP) brokers
Like ECN brokers, STP brokers, too, don’t have a dealing desk. But they use some of the practices of Market Maker brokers to provide flexibility to their clients. They display rates similar to the interbank market rates, and their first priority is to process trades directly in the interbank market, like an ECN broker. If the counterparty is not found, they start acting like a Market maker and match the order with their own client. The initial capital required to trade with this type of broker is relatively lesser compared to ECN brokers.
These are the different types of brokers in the market. So when you are choosing a broker, make sure to select the one that suits your trading style and capital available to trade.
The ‘Market Makers’ provide trading platforms like Act Trader and MetaTrader since their orders are executed at the dealing desk. However, non-dealing desk type of brokers uses direct access trading platforms. They display prices directly from different liquidity providers. The platforms which are best suited for this requirement include Currenex Viking software and Level II software. The trading platform should be chosen in such a way that it suits your trading objectives. We hope this article helped you in deciding that. Let us know if you have any questions in the comments below. Cheers!