Who is and what does a Forex broker do
Let’s suppose you’re ready to take your first step on the Forex market.
Before you decide which particular currency exchange to use for the transaction, before you even decide whether to want to buy or sell, first of all you need two things.
Now, all you need is a capital to start with, but above all you need is a broker (check out our list of the best forex broker for beginners).
What does a forex broker do?
A broker is an intermediary that execute the transaction orders on behalf of his client. They are called intermediaries because their job is to intercede between the market, on one hand, and investors and traders on the other. The tasks performed by the broker are:
- to provide customers the market prices of the various financial instruments (underlying), via trading platforms accessible via web or installed on the PC, or in some cases, by phone (a practice most used some years ago and currently in decline);
- to find a counterparty with which to satisfy the transaction request received from his client:
- to send to the market the trading orders executed by his clients via PC or phone;
- to return information about the order outcome, if it has been executed or rejected, or if it’s in the processing phase, or maybe stuck for some problem;
- some also act as withholding agent, calculating and paying taxes for the trader on the realized capital gains or on the generated capital gains, or by calculating and maintaining the capital losses if the trader has not yet made a profit with his work.
The two major broker families
Brokers can be divided into two large families: Dealing Desk and No Dealing Desk broker.
To tell the truth, nowadays many brokers, especially the larger, have the ability to offer their customers both the account management solutions (dealing desk or no dealing desk), depending on the type of deposit that is made or on the customer’s choice.
Usually the dealing desk option is given to the less consistent deposit, and the no-dealing desk to the more important. The thresholds that define when a deposit is more or less consistent depends on the business plan of the broker.
Obviously these different options have different conditions, in terms of commissions, spreads, orders execution times, and so on. But let’s see together in detail the main features of these two great families.
Dealing desk brokers (market makers)
These intermediaries are usually the smaller, or is the setting that is attributed to smaller accounts in the event that the broker possess multiple solutions.
In the case of dealing desk broker, in addition to performing the simple task of an intermediary, that is to send orders to the market and funding a counterpart, the broker can directly act itself as the counterpart.
Usually brokers, when they receive orders from their customers, they go directly to the market through specific entities that represent the Forex circuit (discussed below), where they find a counterpart, and so the order is then executed. But it may happen that, if a counterparty is not found, or the situation is considered convenient, the broker acts himself as the counterparty for the operation of his client, without going through the market.
Therefore, when then the client will close the transaction, the broker will lose his own money if the operation of the client had been successful, or in the other case he will cash directly into his account the money lost by the customer. In fact, this type of broker make profits in two ways:
- With the spread (as we have seen widening the spread between bid and ask);
- by trading against their clients (playing as counterpart for transactions submitted by customers).
To be clear, there is nothing illegal about this activity (trading against customers), provided the market it’s not modified artificially by disguising prices with some subterfuge.
Given that, statistically, of the customers who decide to make Forex trading personally, the 90% fails (due to the difficulty of retail trading), they act as counterpart to their customers, knowing that in the short to medium term, almost all of off them will be found to be on the wrong side of the market, and will lose money, which instead will be earned by the broker that was the counterpart.
These brokers, also known as ‘market makers’, literally create an artificial market of Forex exchange rates for their customers. Given that the ‘market makers’ control both the supply and demand prices, it follows that for them to define fixed spreads is really not very risky.
An example to understand this better: let’s say you want to put through a dealing desk broker a purchase order on EUR/USD (that is buy euro and sell dollars).
In order to fulfill your request, the broker first of all will seek among its customers a sales order that coincides with your purchase order, or in the other case he will pass the order to his liquidity supplier, ie a large entity capable of quickly buying or selling large financial positions in block. Doing the latter, it minimizes the risk, as he gains from the spread without having the opposite side of the trading operation.
In the event, however, he cannot find orders that meet the other side of the client’s transaction, then the broker will take the opposite position to guarantee the order execution. At that point, if you earn, he lose, vice versa if you lose, he earns.
No Dealing Desk brokers
As the name suggests, a No Dealing Desk broker is a broker that does not pass the orders of their customers through their dealing desk (“brokerage office”).
This means that the broker will never take on charge the opposite side of his clients’ operations, but he will simply connect the two counterparties to each other by sending the order directly to the market. For this intermediation activities, these brokers may charge a small fee, or simply put a little surcharge by increasing the spread as already seen.
The No Dealing Desk brokers can be either STP or STP + ECN.
– Broker Straight-Through Processing (STP)
The Forex broker who has a STP system directs his clients’ orders directly to his liquidity providers, who in turn have access to the interbank market.
The STP Broker usually has a lot of liquidity providers, and each provider determines its own ’ask’ and ‘bid’ values, which are communicated to the broker constantly. For example:
Let’s assume that a STP broker has three different liquidity providers.
In his STP system, the broker will see three different pairs of ’ask’ and ‘bid’ values. The system will sort these pairs of values in descending order, from the best to the worst. In this case, the best ‘bid’ value is 1.3000 (the highest for selling) and the best ‘ask’ value is 1.3001 (the lowest for buying). The best bid/ask couple is thus 1.3000 / 1.3001.
But those are not the quotes you will receive. Usually the broker will add a little fixed surcharge, which will be his gain. If he would add 1 pip, the quotation for you would be 1.2999 / 1.3002. So you’d see a spread of 3 pips, that is the difference between the bid and ask on which the broker will get his profit from.
The spread in this case is not fixed, like it was with the dealing desk, but it’s a variable spread. The broker, since he doesn’t create his own, must report the best prices he receives from its liquidity providers, and the latters, in order to determine their prices, follow specific formulas.
In particular, when the number of trades increased dramatically (in technical terms, “volatility increases”), the spreads can widen, even a lot.
– Broker ECN (Electronic Communication Network)
A true ECN broker allows the orders of his clients to interact directly with the orders of the other participants in the ECN (Electronic Communication Network).
Participants may be banks, individual traders, investment funds, as well as other brokers. In essence, the participants are trading against each other by offering their best bid and ask prices.
The ECN broker enables its customers to see the “Market Depth“. The “Market Depth” shows you where (and at what values) the purchase and sales orders of the other market participants are. The ECN broker is the only broker that can provide such a market book, precisely because it gives direct access to it.
Given the nature of the ECN, it’s very difficult to add an extra fixed cost, then the ECN brokers are usually compensated with a small commission deducted from each transaction, or from a total transactions volume.
Here’s an ECN and STP broker list plus a deepening on the subject if you are interested in how these brokerage firms work.
PROS AND CON
Being the broker itself the counterpart, he might be interested in working against your interest (only incorrect brokers do that, and usually you recognize them because the charts has spikes that other brokers charts are not present).
Orders sent directly to market
Easier and more frequent requotes (the broker cannot or is not willing to accept your quote request for the operation, and then asks you if you want the execution with a different quotation)
Immediate execution of orders
Possible execution of the order at a unfavorable price for the trader
In case of no liquidity (rare but can happen), the orders execution can slow down
Delays in the orders execution, with processing times that increase
View of market depth
High Spread but no commission
Spread usually very tight, but that can enlarge in case of lack of liquidity or volatility explosion
Possibility to enter the market with accounts of modest size
Payment of a commission to the broker
Currency exchange in practice
The financial leverage
Types of traders
Buy long Sell short
Summary and Conclusions