Business Models of Forex Brokers

Guest Post By Alex Eliades

I have recently been exposed to the various business models that Forex brokers use to profit from offering trading services and it is definitely an area that should be more transparent. To define them we are looking at market making, STP (straight through processing) and ECN (electronic communication network) along with various cocktails of the three.

As many of you will know a broker that works as a market maker matches buyers and sellers together on their own network but makes money by charging a difference in the spread. However, a large percentage of Forex brokers are not able to physically match up the buying and selling of trades as there is very rarely enough orders to do so. If they were to try, then a client would place a trade and often have a long wait until it was matched up with another trade and get processed.

Therefore, a Forex company that offers the market making model uses an external price feed, fulfills orders by becoming the buyer or seller of currency itself. Therefore, in a way a broker offering a market maker model is trading directly with its clients. This means that for a market maker broker the total client trade must overall be negative in order for the broker to profit. At first it may appear like a bad idea to trade with a market maker because a trader could believe that if they consistently make money then it is not in the broker’s interest to have them as a client. Well, if a broker is operating as a 100% market maker then that would be true but most brokers identify traders that profit and large trade volumes of risk and they cover those positions with prime brokers or liquidity providers at a spread lower than they are giving to those clients. This way brokers that operate market maker models can still accommodate and profit from traders that profit. The negative side of this is that while small trades are processed instantly anything over a certain threshold would go to a dealer, who would either accept an order for the broker or pass the risk on to a prime broker. If an order is requested at a price that is unobtainable in the market or is seen too risky then the dealer can reject the order and issue an alternative re-quote, which the client can accept or decline. The whole market maker model does work well for brokers but as many have noted does have a conflict of interest between the client and the broker. It is in the interest of the broker for a novice trader to deposit a lot of money, trade badly and lose everything. If a trader is consistently profitable then a broker operating as a market maker is at risk and will take measures to protect themselves, which in some cases can work against the trader.

Looking at the agency business models otherwise known as STP and ECN there are some distinct differences and advantages when compared to the market maker model. The first thing to understand is that with the agency model the broker acts as a middle man passing trades between a prime broker and its client. The broker covers their operating cost by either adding a mark-up in the spread or by charging a commission on each trade. This way it is in the interest of the broker for the clients to make a lot of trades, profit and continue trading. It is not in the interests of the broker for a client to make a huge deposit and lose everything in a single trade as the broker does not profit from losses. Therefore, the agency model aligns the interests of the trader and the broker and gives the broker a great incentive to provide the best trading environment to its clients so that they can become profitable and trade more. This also makes brokers that follow the agency model ideal for traders that use scalping and hedging strategies or EAs. It is also worth noting that the agency models make re-quotes a thing of the past as orders do not go through a dealing desk. However, it is important to understand that as orders are passed through directly to the market there are some cases when orders cannot be executed at the price ordered in the traders platform. Instead, they get executed at the closest possible price instantly with what is known as ‘slippage’, which is a difference in the order and execution price. This can happen due to latency between the traders PC, the server placing the order and the actual market liquidity itself. Slippage can be both positive and negative and good brokers will always pass on positive slippage to their clients as well as negative slippage. A trader of a direct market access broker will usually experience a 50-50 split between positive and negative slippage when it occurs at all. Under a market maker model the equivalent re-quote will never be positive.

Let’s take a look at the STP and ECN agency models in more depth to understand how they work and differ from one another.

First up, the STP model stands for Straight Through Processing and does as its name suggests. Using an STP model a broker takes the pricing offered from an institutional broker and offers it to the trader with either a spread mark-up or a commission fee per trade.

Second, the ECN model stands for electronic communication network and this works by taking pricing from a pool of liquidity providers and relaying all prices as well as market depth to the trader so that the trader can get the best pricing from many sources. Just like the STP model, a broker offering an ECN to their clients will cover their operating costs through a mark-up in the spread or on commission per trade.

By default, the most popular trading platform MT4 is not capable of passing through ECN pricing from multiple sources with the market depth without the aid of a plugin. For this reason only brokers that offer platforms such as MT5, Saxo Trader and Currenex can offer a true ECN environment to their traders. Despite this many MT4 brokers claim to offer ECN accounts. They either do this with an unofficial MT4 plugin or they are actually offering STP/ECN accounts, which is a cocktail of the two models. Under the STP/ECN model a broker would offer MT4 (that doesn’t support multiple price feeds) and using a bridge have it connected to an ECN so that the best pricing is displayed from multiple liquidity providers in one price feed. This results in the lowest spread forex brokers that offer the MT4 platform.

With the fierce competition between brokers and the push towards transparency in the Forex market it seems that the people will be in search of the best ECN Forex broker for the foreseeable future. Market makers will still continue to operate but the fight between the various broker models will continue to be thrashed out for quite some time and I am sure dominance will boil down to which one can offer the most advantageous trading environment.

Guest Post by Alex Eliades