In the foreign exchange market, traders and speculators buy and sell various currencies based on whether they think the currency will appreciate or lose value. The foreign exchange, or forex market is high risk and sees more than $5 trillion dollars traded daily. Traders have to go through an intermediary such as a forex broker to execute trades. No matter the gains or losses sustained by individual traders, forex brokers make money on commissions and fees, some of them hidden. Understanding how forex brokers make money can help you in choosing the right broker. (For related reading see: 5 Tips For Selecting a Forex Broker.)
Role of the Foreign Exchange Broker
A foreign-exchange broker takes orders to buy or sell currencies and executes them. Forex brokers typically operate on the over-the-counter, or OTC, market. This is a market that is not subject to the same regulations as other financial exchanges, and the forex broker may not be subject to many of the rules that govern securities transactions. There is also no centralized clearing mechanism in this market which means you will have to be careful that your counterparty does not default. Make sure that you investigate the counterparty and his capitalization before you proceed. Be vigilant in choosing a reliable forex broker. (For related reading, see: Market Makers Vs. Electronic Communications Networks.)
Forex Broker Fees
In return for executing buy or sell orders, the forex broker will charge a commission per trade or a spread. That is how forex brokers make their money. A spread is a difference between the bid price and the ask price for the trade. The bid price is the price you will receive for selling a currency, while the ask price is the price you will have to pay for buying a currency. The difference between the bid and ask price is the broker’s spread. A broker could also charge both a commission and a spread on a trade. Some brokers may claim to offer commission-free trades. Actually, these brokers probably make a commission by widening the spread on trades.
The spread could also be either fixed or variable. In the case of a variable spread, the spread will vary depending on how the market moves. A major market event, such as a change in interest rates, could cause the spread to change. This could either be favorable or unfavorable to you. If the market gets volatile, you could end up paying much more than you expected. Another aspect to note is that a forex broker could have a different spread for buying a currency and for selling the same currency. Thus you have to pay close attention to pricing.
In general, the brokers who are well capitalized and work with a number of large foreign exchange dealers to get competitive quotes typically offer competitive pricing.
Risks of Foreign Exchange Trading
It is possible to trade on margin by depositing a small amount as a margin requirement. This introduces a lot of risk in the foreign exchange market for both the trader and the broker. For example, in January 2015, the Swiss National Bank stopped supporting the euro peg, causing the Swiss franc to appreciate considerably versus the euro. (For related reading, see: Why Switzerland Scrapped the Euro.) Traders caught on the wrong side of this trade lost their money and were not able to make good on the margin requirements, resulting in some brokers suffering catastrophic losses and even going into bankruptcy. Inexperienced traders could also get caught up in a fat finger error, such as the one that was blamed for the 6% dip of the British pound in 2016.
The Bottom Line
Those contemplating trading in the forex market will have to proceed cautiously—many foreign-exchange traders have lost money as a result of fraudulent get-rich schemes that promise great returns in this thinly regulated market. The forex market is not one in which prices are transparent and each broker has his own quoting method. It is up to those who are transacting in this market to investigate their broker pricing to ensure that they are getting a good deal.