It’s a good idea to understand what a forex broker does if you’re interested in getting involved in trading forex, or even if you simply want to gain a general understanding of how currency markets work. After all, your forex broker is the embodiment of your access to the forex market, the sine qua non of your trading activities, and the one entity without whom your forex trading activities would, by definition, come to a complete halt. Viewed from this perspective and considering the extraordinary control that your forex broker thus wields over your trading activities, understanding what your broker does, how he does it and what motivates him to do it are very important matters indeed. Certainly, your grasp of the differences between forex brokers and the services they offer should play a role in your choice of the type and nature of forex brokerage with whom you will choose to work.
Retail foreign exchange trading as we’ve come to know it today would not exist—indeed, it could not— without the internet, and forex brokers are a uniquely online business. Unlike stockbrokers, who have the ability to engage in so-called “paper trades” if they so desired, or stock trading itself, in which paper share certificates can be provided to investors as physical proof of their ownership, forex traders by definition have no physical “proof” of their trading and investment activities, because they are not actually buying anything; rather, the retail forex trader is risking his money on his ability to predict the movement of two currencies’ prices in relation to each other. His only method of doing so is to provide his forex broker with his prediction in the form of an order, which the broker fills; the trader himself has neither access to either the actual currencies on which he is betting, nor to any meaningful price transparency to independently confirm how close his prediction came to coming true. In a business where the difference of one pip can be the distinction between profit and loss, the role of the broker is of paramount importance to the retail forex trader’s bottom line: not only does the broker provide the trader’s sole access to the market, but he also controls the prices and spreads that are passed along to his retail forex trading client.
Forex brokers can be divided into two categories: those that are known as “ECN” (electronic clearing network) brokers, and those that are known as market makers. While both provide retail investors with the opportunity to engage in the currency markets, the distinction between the two can be greatly significant to forex traders.
ECN brokers are considered to be the more “elite” of the two types of brokers, because they provide more direct access to the interbank market, where institutional foreign exchange trading takes place. In return, they typically require a larger initial deposit to qualify their clients to trade. They keep their spreads thinner to remain competitive and avoid alienating their clients and as such, typically make their profits not off of their spreads but rather, off of the fixed commissions per trade that they charge their clients; in addition, an ECN broker may impose service fees or per-trade fees (regardless of the size of the client’s order), which the retail forex trader must take into consideration when comparing brokers to each other in order to determine the best fit for their risk profile, capital profile and trading style. Because most ECN brokers assume that their clients have attained a certain level of experience and sophistication, they tend to offer fewer services of the type that typically appeal to beginning traders, such as charting software, electronic assistants, and the like, they cater to their clients with fewer products aimed at novices (such as demo accounts, mini or micro accounts, and similar products) and their user interface may tend to be more matter-of-fact, with fewer “bells and whistles”. At the end of the day, however, most ECN brokers are motivated by the desire to see their clients profit from their forex trading activities, because the longer the client’s account displays a positive balance, the longer the client will keep trading—and the more commissions the broker will earn. If you’ve got some experience under your belt and don’t need much technical assistance, utilizing an ECN broker may be the best choice for you.
Unlike ECN’s, market makers are decidedly less transparent in their pricing, and in general, their spreads will tend to be wider than those offered by an ECN and thus more favorable to themselves. Market makers make their profits off of the differences between the buying and selling prices of currency pairs, not off of commissions charged on the orders placed by their clients, and, more tellingly, set these spreads themselves without revealing to the retail client what the actual currency costs charged to them by ECN’s or banks may be. This mark-up can be of concern, because it implies an inherent conflict of interest: although market maker brokers owe a certain fiduciary responsibility to their clients, they are dependent on their clients’ losses as the source of their own profits. As a matter of fact, when placing their orders through a market maker most retail forex traders are unaware that the broker is hedging their risk by placing a corresponding order against their own client. Indeed, most market makers are counting on the fact that the overwhelming majority of their clients will lose the money in their accounts, causing market maker brokers to constantly seek out new clients from whom profits can be made, and it is because of this troubling relationship that so many brokers—market makers all—visibly promote and advertise their services, offering demo accounts, mini accounts, charting software, analytical support, high levels of leverage, and all the bells and whistles necessary to continue to attract new clients to their firms.
Market makers brokers can nevertheless be a satisfactory initial destination for the beginning trader who would benefit from access to the very features promoted to lure him in. The experience to be gained from practicing in a demo account, or in multiple such demo accounts, can be invaluable, as can the support and assistance offered by many market maker brokers. So long as the novice forex trader is prudent in staying within his capital limitations and resists the siren call of the generous leverage offered by such brokers, there’s no doubt that taking advantage of the full range of services offered by a market maker can provide the beginning retail forex trader with the education he needs to be successful in his forex activities.
In the final analysis, it’s not the responsibility of the forex broker to police their retail clients and make sure that the clients do not trade what they cannot afford to lose any more than it is their responsibility to manage their clients’ greed, expectations, or competencies. Online forex brokerages provide a valuable service, provide access to markets which would otherwise be unavailable, and provide their clients with the opportunity to realize significant profits from their trading activities. The relationship between the retail trader and the broker can be both meaningful and symbiotic, or it can become insignificant and adversarial: which way it winds up manifesting itself depends entirely on how the forex trader manages his expectations.