- The two kinds of brokers
- STP brokers
- ECN broker
- Market makers/Dealing desk
- Which kind is better? It depends
In order to trade forex – in fact, in order to trade anything – you’ll need a broker. A broker is the one who connects buyers and sellers and enables you to get your hands on whatever you want to buy, or to find someone willing to buy what you want to sell.
The two kinds of brokers
Basically, brokers fall into one of two types: those that simply pass your order onto the general market, called an straight-through processing or STP broker, and those that take the other side of the trade, called a market-maker.
A straight-through processing (STP) broker takes your order and passes it straight through to one of the major banks that participate in the wholesale FX market. They make their money by taking a small commission or by adding a small spread onto the price that they get from the wholesale market. This is the same way any retail business operates: buy wholesale, add your mark-up, and sell it retail.
So for example let’s say that Deutsche Bank or some other major bank is quoting EUR/USD at 1.1000-1.1001. Your STP broker might sell it to you at that price and add on a commission of 0.2% of the total amount of the trade. Or it might quote EUR/USD to you at 1.0999-1.1002 and then buy from (or sell to) Deutsche Bank at their price, picking up one pip on the trade.
An Electronic Communications Network (ECN) broker is similar to an STP broker. They post on their web site the actual prices and pending orders that are visible in the wholesale market and allow you to access the market through them. They make money by adding a small mark-up to the price. For example, if the spread in the interbank market is 0.2 pip, they might display a spread of 0.5 pip and so make 0.3 pip on each trade. However, the minimum lot is usually a fairly large $50,000 to $100,000 and you’re not guaranteed to have your order filled.
Market makers/Dealing desk
Then the other kind of broker is called a market maker, also known as a dealing desk. They’re different from a straight-through processing broker in that they take the other side of your trade rather than passing it onto the market. If you buy EUR/USD, they sell EUR/USD to you and take on the position themselves.
Of course this means their position depends on what their clients want to do. If their clients all want to sell EUR/USD, they’re going to have to buy a lot of EUR/USD. They might not want to do that. Maybe they agree with their clients – maybe they also think EUR/USD is going to fall. In that case, they can and do offset their risk in the wholesale market by selling EUR/USD . Or they might adjust their rates to discourage their client from selling and encourage them to buy instead.
Pros and cons with the two types of brokers
There are advantages and disadvantages to both types.
The advantage of an STP broker is that their interests are aligned with their clients. They make money each time their clients trade, so it’s in their interest that their clients make money too. Moreover, the prices they offer may be better as they reflect the best prices available at that time from various competing market-makers.
On the other hand, an STP broker may take longer to execute your trade than with a market-maker. A market-maker is typically quicker than an STP broker because they control what prices they offer.
However, there’s a major conflict of interest between you and a dealing desk broker in that every dollar you make is a dollar the broker loses. This means they may not offer the best prices if they don’t want to take on any more risk.
In both cases, there’s one thing you should look out for: the salesforce may urge you to keep trading rather than withdraw your money. For example, in some firms, the sales force is paid a commission on the net amount of money that they bring in any month. That means any withdrawals reduce the amount that they make. The temptation is for them to urge you to keep your money on deposit and keep trading until you lose it all.
Which kind is better? It depends on you
Which kind of broker is better for you? It depends on you and your trading style whether you’d rather have wider spreads and no commissions, or tighter spreads but pay a commission.
People who take longer-term positions and try to ride a trend aren’t so concerned about how wide their spreads are. They may be better off with a market-maker. But day traders and people who are just trading in-and-out of the market for a few pips here and there prefer to have tighter spreads, as the market has to move less for them to recover their transaction costs. These investors may prefer STP brokers.
The two main types of brokers are A) straight-through processing, or STP, brokers, which pass your trade on to the interbank market and take a small mark-up, and B) market-makers or dealing desks, which take the trade on their books. Both have their good and bad points. With both though you have to be sure that you are getting as near as possible to the actual market rate, because unscrupulous brokers are quite capable of cheating you out of a pip or two every time you trade. That adds up over the longer term.