The foreign exchange market (forex or FX) is an unregulated global market in which trading does not occur on an exchange and does not have a physical address of doing business. Unlike equities, which are traded through exchanges worldwide, such as the New York Stock Exchange or the London Stock Exchange, foreign exchange transactions take place over-the-counter (OTC) between agreeable buyers and sellers from all over the world. This network of market participants is not centralized, therefore, the exchange rate of any currency pair at any one time can vary from one broker to another. (To get a complete overview of forex, see Introduction to The Forex Market and A Primer On The Forex Market.)
Tutorial: Electronic Trading
The main market players are the largest banks in the world, and they form the exclusive club in which most trading activities take place.This club is known as the interbank market. Retail traders are unable to access the interbank market because they do not have credit connections with these large players. This does not mean that retail traders are barred from trading forex; they are able to do so mainly through two types of brokers: markets makers and electronic communications networks (ECNs). In this article, we'll cover the differences between these two brokers and provide insight into how these differences can affect forex traders. (To continue reading on this subject, see The Foreign Exchange Interbank Market, and The Global Electronic Stock Market.)
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. The spread is 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. 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 that 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.
- The trading platform usually comes with free charting software and news feeds. (For related reading, see Forex: 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.
- Market makers can present a clear conflict of interest in order execution, because they may trade against you.
- 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 customers' stops or not let customers' trades reach profit objectives. Market makers may also move their currency quotes 10 to 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.
How ECNs Work
ECNs pass on prices from multiple market participants, such as banks and market makers, as well as other traders connected to the ECN, and display the best bid/ask quotes on their trading platforms based on these prices. ECN-type brokers also serve as counterparties to forex transactions, but they operate on a settlement, rather than pricing basis. Unlike fixed spreads, which are offered by some market makers, spreads of currency pairs vary on ECNs, depending on the pair's trading activities. During very active trading periods, you can sometimes get no ECN spread at all, particularly in very liquid currency pairs such as the majors (EUR/USD, USD/JPY, GBP/USD and USD/CHF) and some currency crosses.
Electronic networks make money by charging customers a fixed commission for each transaction. Authentic ECNs do not play any role in making or setting prices, therefore, the risks of price manipulation are reduced for retail traders. (For more insight, see Direct Access Trading Systems.)
Just like with market makers, there are also two main types of ECNs: retail and institutional. Institutional ECNs relay the best bid/ask from many institutional market makers such as banks, to other banks and institutions such as hedge funds or large corporations. Retail ECNs, on the other hand, offer quotes from a few banks and other traders on the ECN to the retail trader.
- You can usually get better bid/ask prices because they are derived from several sources.
- It is possible to trade on prices that have very little or no spread at certain times.
- Genuine ECN brokers will not trade against you, as they will pass on your orders to a bank or another customer on the opposite side of the transaction.
- Prices may be more volatile, which will be better for scalping purposes.
- Since you are able to offer a price between the bid and ask, you can take on the role as a market maker to other traders on the ECN.
- Many of them do not offer integrated charting and news feeds.
- Their trading platforms tend to be less user-friendly.
- It may be more difficult to calculate stop-loss and breakeven points in pips in advance, because of variable spreads between the bid and the ask prices.
- Traders have to pay commissions for each transaction.
The Bottom Line
The type of broker that you use can significantly impact your trading performance. If a broker does not execute your trades in a timely fashion at the price you want, what could have been a good trading opportunity can quickly turn into an unexpected loss; therefore, it is important that you carefully weigh the pros and cons of each broker before deciding which one to trade through.