What is a Forex Broker?

Forex brokers are firms that provide traders with access to a platform that allows them to buy and sell foreign currencies. Transactions in this market are always between a pair of two different currencies, so forex traders either buy or sell the particular pair they want to trade.

Forex brokers may also known be as a retail forex broker, or currency trading brokers. Most forex broker firms handle only a very small portion of the volume of the overall foreign exchange market. Retail currency traders use these brokers to gain access to the 24-hour currency market for purposes of speculation. Forex broker services are also provided for institutional clients by larger firms such as investment banks.

Key Takeaways

  • Forex brokers allow traders access to the foreign exchange market for currencies.
  • Most brokers service retail clients, though larger banking firms service institutional clients as well.
  • Forex brokers allow clients to trade with very substantial leverage.
  • Forex brokers make money primarily on the bid-ask spread, but may have other ways to do so as well.

Understanding the Role of a Forex Broker

Forex brokers provide access to trading on all major currency pairs; EUR/USD, GBP/USD, USD/JPY, and USD/CHF as well as the remaining g10 currencies and all the exchange rates between them. Additionally, most brokers will allow customers to trade emerging market currencies. (Further reading: What are the most common currency pairs traded in the forex market?)

A forex broker makes it possible for a trader to open a trade by buying a currency pair, and close the trade by selling that same pair. For example, if traders want to exchange Euros for U.S. dollars, they buy the EUR/USD pair. This amounts to buying Euros using U.S. Dollars for the purchase. When they close the trade they would sell the pair, which would be equivalent to buying U.S. Dollars and using Euros for the purchase. If the exchange rates were higher when the traders closed the trade, the traders would keep the profit, otherwise the traders would realize a loss.

Forex brokers have improved their client services over the years. Opening a forex trading account is usually quite simple and can be done online. Before trading, a forex broker will require customers to deposit money into their account as collateral. However, the broker also provides leverage to customers so they can trade larger amounts than what is deposited in their account. Depending on the country the traders are trading from, that leverage can be 30 to 400 times the amount available in the trading account. High leverage makes forex trading very risky and most traders lose money attempting to trade in this way.

How Forex Brokers Make Money

Forex brokers are compensated two ways; firstly through the bid-ask spread of a currency pair. For example, when the Euro-U.S. Dollar pair is priced as 1.20010 bid and 1.20022 ask, the spread between these two prices is .00012, or 1.2 pips. When a retail client opens a position at the ask price, and then later closes the position at the bid price, the forex broker will have collected that spread amount. Secondly, brokers may charge additional fees. Some may charge a fee per transaction or a monthly fee for access to a particular software interface, or fees for access to special trading products such as exotic options. However, competition among forex brokers is very intense and the majority of firms servicing retail clients find they must attract customers by eliminating as many fees as possible. This has led many to offer free or very small transaction costs beyond the spread.

Some forex brokers also make money through their own trading operations. This can be problematic if their trading creates a conflict of interest with their customers, but regulation in this area has helped to significantly reduce this practice.

Regulation Among Forex Brokers

Two entities serve regulation functions among forex brokers in an attempt to discourage and eliminate fraudulent practices: the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA). These organizations publicize lawsuits they may pursue against any whose practices are deemed fraudulent or intentionally harmful to their customers.

It is valuable to do some research to find out whether a broker has an excellent reputation and has the functionality that you are looking for in a broker. This research can be conducted by checking out the NFA's homepage, and looking over Investopedia's broker reviews.

Most major forex brokers will allow prospective clients to use a practice account so that they can get a good understanding of what the system is like. It is a wise idea to test out as many platforms as possible before deciding on which broker to use.

Furthermore, because the forex market is a 24-hour market, most quality forex brokers will provide 24-hour customer service. (Further reading: 5 Tips For Selecting A Forex Broker)