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More About Forex Brokers

There are mainly two types of brokers. One type is an ECN (Electronic Communication Network) and another a Market-Maker.
 

How Market Makers Work


Market makers "make" or set both the bid and the ask prices on their systems and display them publicly on their quote screens. They stand prepared to make transactions at these prices with their customers, who range from banks to retail forex traders. In doing this, market makers provide some liquidity to the market. As counterparties to each forex transaction in terms of pricing, market makers must take the opposite side of your trade. In other words, whenever you sell, they must buy from you, and vice versa.

The exchange rates that market makers set are based on their own best interests. On paper, the way they generate profits for the company through their market-making activities is with the spread that is charged to their customers. Spread the difference between the bid and the ask price, and is often fixed by each market maker. Usually, spreads are kept fairly reasonable as a result of the stiff competition between numerous market makers. As counterparties, many of them will then try to hedge, or cover, your order by passing it on to someone else. But there are also times in which market makers may decide to hold your order and trade against you.

There are two main types of market makers: retail and institutional. Institutional market makers can be banks or other large corporations who usually offer a bid/ask quote to other banks, institutions, ECNs, or even retail market makers. Retail market makers are usually companies dedicated to offering retail forex trading services to individual traders.

Pros:
  • The trading platform usually comes with free charting software and news feeds. (For related reading, see Demo Before You Dive In.)
  • Some of them have more user-friendly trading platforms.
  • Currency price movements can be less volatile compared to currency prices quoted on ECNs, although this can be a disadvantage to scalpers.
Cons:
  • Because they may trade against you, market makers can present a clear conflict of interest in order execution.
  • They may display worse bid/ask prices than what you could get from another market maker or ECN.
  • It is possible for market makers to manipulate currency prices to run their customer's stops or not let customer's trades reach profit objectives. Market makers may also move their currency quotes 10-15 pips away from other market rates.
  • A huge amount of slippage can occur when news is released. Market makers quote display and order placing systems may also "freeze" during times of high market volatility.
  • Many market makers frown on scalping practices and have a tendency to put scalpers on "manual execution", which means their orders may not get filled at the prices they want.


 

Here's a website link at FXStreet that further explains the differences between Dealing Desks and ECNs:

http://www.fxstreet.com/brokers/criteria/#versus

Market Makers are an important and integral part of the financial markets. Without them, there would be severe liquidity problems.

market maker is a person or a firm who quotes both a buy and a sell price in a financial instrument or commodity, hoping to make a profit on the turn or the bid/offer spread. In foreign exchange trading, where most deals are conducted OTC, and are therefore completely virtual, the market maker sells to and buys from its clients. Hence, the client's loss is the company's profit and vice versa. Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets.
From a former dealing desk clerk:

I used to work at a Large Australian Investment Bank here in Sydney - I'll give you a hint, the bank recently tried to take over the London Stock exchange. I worked on the FX cash dealing desk in 2003 and 2004 - which most of the guys who know dealing desks well....it is the lowest ranked dealer you can be. But I was only 18 years old at the time, and I was on a cadetship program with the bank, through university.

I was working along side some of the best salesmen and traders in the country. These guys are literally on millions or in some instances tens of millions of dollars a year in bonuses and salaries. Anyways, my dream was always to be on the other side of the phones as a private trader, hence me being one now - cause working at banks is quite stressful and i enjoy a laid back lifestyle, but i also have a massive passion for finance.

Anyways, enough lifestories - Basically we were the interbank market. The bank I worked for is among the top 15 investment banks in the world. So we were the end of the line so to speak, we only dealt with other major banks. (Rule of thumb was to deal with Citigroup as little as possible...lol)

However, believe it or not - We also were a market maker with our clients. In fact most major Investment Banks are. Contrary, to people's beliefs that banks are straight through processing, which they are - but also dealt clients prices and matched them with other clients.

We would take positions against our clients, quite frequently - as our division was not only a broker to our clients, but a trading house too. You don't understand the amount of losing volume that came from clients every day.....millions! Through our dealing desk we had a volume on average of over US60 billion dollars. (sometimes it racked over 100-150 billion) - This was in 2003, 2004 by the way, I would imagine today the volume would be much, much larger. So, the trader's who liase with the executing dealers on the desks everyday would try to scalp off your position - so that they can take a commission, plus a greater spread.

For example - If you were long 100,000 euro's at 1.20. Our bank would take a position for 30,000 short euro's at 1.20 against you. Would wait till the market hit 1.1990 and then scalp 10 pips, with a prescribed stop loss. They would not do this all the time, but they would do this when the traders felt the time was right. Sure enough, the amount of losing trades from clients outweigh the winners, and the bank would be in profit.

We would also play clients positions against each other. Not in a bad way....but it was to offer the clients a better level of service - I'll explain why.

Part of the reason why the bank was so heavily focused on being a market maker - was not only to make profits. But to ensure better service for their clients. The real truth is, that we wanted our clients to do well - but the reality was that most didn't, no matter how much advise or consultancy we gave them. Some of biggest losing clients were actually large corporate accounts.

How we would ensure better service for our clients, was by trying to fill most orders (we couldn't do all of them, cause the volume through from some clients was to the tune of tens of billions - including leverage that is.) - and we could only fill orders sometimes, by playing clients up against each other.  However we didn't guarantee fills.

The dealing desk also provided 24 hour support to clients, including advisory from a trader you dealt with especially. (Most of our trades were executed over the phone by the way, we did have a web based platform - but we wanted to encourage traders to ring us up - so we can give them a better level of service through supporting them with their trading - including giving advice, and market information - so a trader could ring us up anytime and ask us for market depth or major buyers of certain pairs. etc)

We would often favor clients who held their positions - we liked day trading accounts for their volume.

Although we were a large investment bank, we hated scalpers and often tried to deter them from using us. Most retail market makers, I would imagine also -would have a hate towards scalpers, cause they would not be able to feed prices through to the client fast enough (since they are level 2 brokers - and receive the prices from interbanks then must pass them on to the client - making them a middle, middle man so to speak). This is probably why brokers like IBFX. etc place scalpers on manual execution - cause scalpers would take arbitrage opportunities from the real marketplace and play them against the price the broker is giving them.

The best place for scalpers is with ECN's perhaps. People who guarantee straight through processing.

The myths of brokers, feeding through clients the incorrect market prices in order to trigger stops - is quite preposterous. To be able to do that, would not only put the whole firm in disarray, because regulatory authorities not only from Australia (who are extremely tough), but from all around the world in exchanges we dealt in, would be on your case for fraud, misleading deception, and also theft against the client. ASIC in Australia, who is the main regulatory body, considers it a criminal act of theft, to deceive clients in terms of pricing. And rightly so.

This would damage the bank's name - and i imagine it would be all over the media in a flash. One of the strictest rules in the firm, was to have integrity, especially towards clients.

The foreign exchange market is not regulated to an extent - but if pricing can not be confirmed as being executed at market prices for that time (market prices means that there must be a record of prices from anywhere in the world being at that quote at that time), it cannot be done, legally.

I don't know if brokers elsewhere can toy with that idea - set up phony exchange houses and deal incorrect prices with them for example. But I know we didn't do it. I doubt most large sensible, even the larger retail brokers would do it either.

To the idea of chasing stops - Yes, this did occur, quite often. During news times mostly. We would see where stops were with our clients, we also had a good idea where market depth was, and we would send through volumes of trades to take them out, in order to make money for the bank.

See the bank always came first...profitability for the bank the most important thing overall. Clients would leave eventually, successful or not....but the bank was always there, so it was our main priority.

The idea at the end of the day is that it's every man for themselves in the market. Brokers, traders, hedge funds. etc are all in it for themselves to make a buck and they will do it whatever way they can.

If you are a good trader - and know the ins and outs of the market (not placing in house stop losses. etc), you will not need to worry, cause you can play the game - then you're sweet!

My advice is - pick a respectable and PROFITABLE (profitability in a broker is so important, cause the more clients a broker has, the better level of service they can offer you - and the less chance the broker has of falling to the ground), who has impeccable client service. Aim for the bigger retail brokers (if you're retail)....who have great relationships with interbanks.

When questioning a broker, ask them how many interbanks they deal with. If they have a figure less than 5....than stay well away, cause the flexibility of price they will offer you as a client will be completely crap!

Also, just don't go for brokers just cause they have tighter spreads. etc. Of course you want the best deal at the end of the day...but you also want your orders filled and filled fast and a dealer you can talk to - this is why I'm not really a fan of broker houses without a dealing desk.

For everyone who deals with American brokers go to www.cftc.gov - and then go to 'financial reports for FCM's'. Here you can check out the Capital of all the brokerage houses, try to stick to the retail brokerage houses with the highest amount of capital - cause this ultimately means more clients, a better relationship with more banks in the interbank market, cause they can guarantee volumes, and also a better level of service.

Most importantly....make sure your broker is licensed and registered with regulatory authorities in major financial countries around the world. For example - don't be signing up with brokers who offer you tight spreads and guaranteed fills from Nigeria.

Brokers aren't bad, they aren't there to be against you. But they may not, in terms of co-operation in the market itself, work with you. Most brokers who are large and service respectable numbers of clients will tend to try to help their clients become profitable as much as they can.

But once your order is placed, it's every man for themselves...

I hope I've helped some people who are just starting out create an idea of how the major brokers and institutions work.

Cheers!

Rusty

 

How ECNs Work

ECNs are NOT a deal desk. At all. Remotely.  Your order sits on a server that no one sees and when that order becomes marketable, it hits a bank in the interbank system. An ECN doesn’t take the other side of your trade. Ever. Therefore, they aren’t at the same level of risk that all of these deal desks are on a daily basis. 

An ECN will pass your order through and settle your exchange of currency at the end of the day between themselves and the bank that took the trade at the price that your order executed against the bank.   The ECN charges you a fee for making that transaction possible,either as a visible commission or as an invisible part of the spread.   An ECN typically have so many banks in the system that the EURUSD quote spends much of the day under 1 pip. So does the GBPUSD. Ever heard the phrase “When banks compete, you win”?

So when is an ECN at-risk of having financial troubles? The biggest risk lies in over-seeing the customer accounts. If someone has $1000 in their account and buys 5 GBPUSD and the GBPUSD goes down 180 pips, the account is down to $100. That’s where the customer is at risk, because a news spike could then drop it a quick 40 more pips, and now the customer account has gone negative.

We wish that everyone traded with a stop in the system to prevent this situation from arising, but they don’t. So, we have extensive systems in place that includes human and computer monitoring to make sure that accounts that get near zero are watched appropriately. We don’t want to close out a position for a customer, but when people trade without stops and get themselves into that type of situation, of course we have to. We have to protect ourselves and all of our other customers. Beyond that, our risk is really just our operations, the cost of having a back office that does what we do. That is not significant compared to the risk that most deal desks have to show daily.
 


NFA Regulations
 

There is a maelstrom coming due to the new NFA regulations possibly soon
to be enacted.

 The NFA will be raising the net excess
capital deposit requirements for brokerages from 5 million dollars to 20 million
dollars by June, 2009.

Also, any FCM's that offer 200:1 or 400:1 leverage will be required to have net excess cash deposits of 20 million, or lower the leverage offered to 100:1.

Most of the smaller brokerages won't be able to borrow this
kind of money and unless they are willing and able to find/attract
venture capital, or find a big brother to shelter under, either
by partnering with or becoming IB's with a large better-funded
brokerage, then they will be forced to allow their trader's
accounts to bought out for pennies on the dollar to the largest brokerages like FXCM, or go bankrupt.

If your brokerage is small to mid-sized, meaning their net
excess cash deposit is borderline around 10 million dollars,
give or take a million or so, then I do believe that you should
be ready to move your trading account to a brokerage that has already the
adequate net excess cash deposits.

The NFA has appealed to Congress, and has been granted, thru the CFTC, to raise the net excess cash requirements to 20 million.  Soon to be enacted, only a handful of brokerages will be left for traders to choose between.  My feelings about this:  less choices in the marketplace give extraordinary power to the brokerages, with probably poorer customer service.  More regulation just forces a monopoly and I think that's what we're looking at here.  While I think that some regulation is long over-due, I hate to think of the day when our choices are narrowed down to a handful....but it's here in 2009, whether we like it or not.

Personally, I think that the NFA is in the pockets of some of the larger dealing desk brokers. As far as I can tell, they are not actually a gov't agency but rather a "self regulatory body". As such, they use the CFTC to gain legitimacy. Their fee structure appears to be based on the size of the member brokers. If you make your money skimming off the brokers capital base and there is only so much money available to be held in those reserves, wouldn't it make sense to want to skim this money off of 5-10 large brokers rather than having to watch over hundreds? Same money, less work. By raising the capital requirements, they force smaller brokers to sell off or close their operations until there are only a few big brokers left.

While the NFA does indeed perform a service to retail traders, it also has its own self-interest which may not be in the traders favor. At first, organizations like the NFA appear to act only in the best interests of those it purports to defend. Then, as more and more "issues" real or manufactured appear on the horizon, we are asked to give up more and more of our freedom in exchange for a phony "security". Much like how they now have purportedly come up with a new "non-hedging allowed" bill...for our own good, of course.

 

The NFA is turning this industry upside down. There is no way of knowing who will survive in June 2009. Traders need to beware. These are the firms most vulnerable to these coming 10 million cap increases:

The following firms have net capital below $15 million

Advanced Markets $10,195,000
Hotspot $10,527,000
Easy Forex $10,606,000
GFS Forex $12,861,000
MB Trading $14,664,000
 

MB Trading says it has the 20 milllion and will show it on the books when the time is closer.

AMIFX, HotSpot and Easy Forex are really behind the 8 ball. They are
not even close to the $15 million mark. Sure the CFTC cap report lags
about six weeks behind but time is running out and these firms have
not shown any kind of gradual increase in their cap numbers unlike
their other competitors.

The following firms have net capital below $20 million

IKon Royal $15,013,000
Forex Club $15,823,000
I Trade FX $17,098,000
Alpari-US $18,158,000


The following firms have net capital above $20 million

CMS Forex $26,540,000
FXDD $20,000,000+
 PFG $27,704,000
Interbank FX $42,954,000
FX Solutions $45,125,000
GFT Forex $73,808,000
Gain Capital $102,959,000
FXCM $131,416,000
Oanda $170,799,000

 

Use this link to check up on the financial health of a brokerage:

http://www.cftc.gov/marketreports/financialdataforfcms/

 

To get on the NFA new info list to get news, go to:

http://www.nfa.futures.org/news/subscribe.asp
 

 

Here's another piece of NFA news that you may or may not have
heard:
 

Broker/Dealer Lobbists have been trying to get hedging banned for years and it has finally been passed by the CFTC in 2009.

Folks in the NFA that have no idea what's going on are being paid big bucks to try to get this passed because hedging prevents dealing desk brokers from making money against you since you are also taking their opposite position of the trade.

The CFTC knows how important that hedging is to the trading community because the Futures and Commodity Markets came into existence as a hedge for the farmers, manufactures, etc. to enable them to be able to offset potential losses in the event that prices dropped before a crop, etc. could be brought to market. Hedging within the Futures and Commodity Markets is really big and the Big Dogs hedge all the time. So, it will be doubtful that it will pass.

Also, the US brokers know that it would cost them a ton of money because those traders who normally hedge in the course of every day trading will just take their business to an offshore broker and trade with them....like Dukascopy, SaxoBank, FXPro, Hotspot, MIG Forex, and many, many more.

Brokers like PFG with ECN and STP don't care if you hedge or not because they don't trade against you. The more trades you make, the more money they make. There are a lot of non-dealing desk brokers out there with ECN and STP that would love to have the extra clients and commissions. So, don't look for the US Brokers to cut off their nose to spite their face....it will cost them millions and a lot of them will have to close their doors if this passes.

At least, this is what I've been hearing from a lot of brokers out here.


ALL ABOUT LEVERAGE
 

Leverage is a two-edged sword.  With more leverage, like 400:1, you control more money (margin) and can take a bigger position.

This will allow you to make more money, BUT it also gives you
greater risk (you can lose money faster) if the market fluctuations go
in a different direction than you expect.

There's a reason and not a very nice one, that the worst bucket
shops offer 400:1.  It's because they know that the increased
leverage is sooooo attractive to newbie traders.  It means the
traders are using less equity to get into a trade, so they think
it costs less.  It does, but that's not the point.  Do you really
think the brokerages offering 400:1 are nice guys and are happy
for you that you are using less money to get into a trade?
Heck no!  It's a sucker's offering!  They offer that because
when your trade goes south (or sour, as the case may be), you'll
be losing more money, lots more money, than if you had used
less leverage.
 

With the NFA getting tougher and enforcing it's rules and raising net capital requirements, it is regulating itself better to protect the consumer (trader). Doing so requires raising the amount of money necessary to do business. This keeps the smaller, less-capitalized brokers out, which is good for the consumer.

Why do firms need a net capital in the first place? I find it disturbing the number of people that trade forex and don’t understand how it works. 99% of firms out there are deal desks, including several that are pretending not to be. It doesn’t have anything to do with the size of their spreads or their software. It means ONE thing. They make their income by trading against YOU. You buy, they sell to you. You sell, they buy from you. At the end of the day, it’s very simple. They make money when their customers collectively lose money.

Now, stop and think about it for a second. You’re a firm. You have hundreds or even thousands of customers, and you have to provide them with a quote (which you have complete control to move around REGARDLESS of what the real banks are showing on the interbank system). What happens if all of your customers want to buy the EUR/USD one day? You’re selling it to them.

Forex is a highly leveraged deal. What if the EUR/USD keeps going up? The firm is short and selling more if the customers are buying.

While obviously most deal desks make a ton of money, the RISK of being the platform is huge. If you get caught heavy in the wrong direction and the market goes hard against you, you can eat up everything that your firm is worth quickly.

And, just so we are clear, if a firm has a $25,000,000 capitalization and then all of their customer money, if they lose $28,000,000 on an “event,” meaning a big loss against their customers, they have no capital, and the customer assets are seized next.

That’s the same in any financial business, brokerages and banks included. Whatever capital is required, and then potentially some insurance level for the company or the customers, and then any event that creates a loss that exceeds that and the customer money is at risk. This isn’t just forex. There was a major national stock brokerage firm in the last couple of weeks that went from having millions and millions of dollars to negative $18 million or so due to a bad trade/investment in the bond market. Firm is gone, customers are scrambling. It can happen.

 Regarding ECNs:  because they are not a counterparty to your trade,  they don't run the same financial risk as a dealing desk.

And of course, in reality, just because a firm/brokerage/bank has a huge net capital doesn’t mean that things are safer. They tend to take bigger risks with that money because they need a return on that money. They don’t just leave it sitting in cash. So a firm with a $50,000,000 net capital is probably showing a risk level that is more in line with having that sort of valuation, which means they can get hit just as hard and fast if they don’t know what they are doing as a smaller operation.

We believe that LOWER leverage levels are going to be mandated eventually. No one makes money trading at 400 to 1. They get crushed. 100 to 1 or 50 to 1 as a maximum would be sufficient. The professional traders who make money in this business don’t trade anywhere near that level anyway.  Of course, they are trading HUGE amounts of money and they only need a small move to be in profit.  The small retail trader with small accounts needs the higher leverage just to play the game.

As always conduct your due diligence and make sure the firm you are
trading with will be able to comply with the new $20 million capital
requirement going into effect in the months ahead.

The most current financial statements won't be available until April, 2009, for quarter-ending March, 2009.  So we won't even know the financial status of a brokerage until it's too late --- June 2009 is when the doors of some brokerages may get slammed shut and customers will be scrambling and screaming.
 

The clock is ticking. Are your funds safe??

 

UPDATE:  as of October 18, 2010, leverage has been decreased to 50:1 for majors and 20:1 for exotics.

How low can they go?!  Time will tell....

 

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