A common complaint, and a vastly misunderstood concept, to which the response should be – so what!?
Let’s examine this scenario. Firstly, all forex brokers are in the business to make money. None are charities. They make a profit … from somewhere.
You might hear on “live chat” that the broker “only” makes money from the spread or the commission they charge. Please do yourself a favour and understand this is nonsense. No broker makes the profits they do and stays in business earning only from spread collection and/or commission per million traded. It’s more likely the goon on the live chat doesn’t understand either.
So, let’s take a step back and understand how a profit is made from a forex trade (or any other CFD type deal).
Firstly, let’s explore the myths surrounding the catchy industry terms, such as “Agency Model”, ”STP”, ”ECN”, ”DMA”, ”NDD” and ”Market Making”.
For the most part, we’re talking about different sides of the same coin.
Many brokers have actually gotten themselves into trouble with the regulator for falsely claiming to be one of these terms, when another more appropriately describes their business model.
The most common model you will find is NDD. This means “no dealing desk”. It actually does not mean there is no dealing desk… obvious right? It means the dealers are not allowed to “interfere” with your trades. That would be illegal of course. A bit like running an advert on your car that says you always obey the road traffic laws. Always. Dealers never artificially widen spreads to cause you to hit your stops or cause price slippage so you miss that big win. Never.
A dealing desk will be very closely watching youtube the trading activities going on. Big trades or growing positions might require the broker to add more of their own capital onto the liquidity provider where your trades are placed, and/or to cover their hedged positions. When markets are buzzing, the NDD brokers’s dealing desks are busy places indeed.
When comparing brokers, and you see STP advertised take note of the legal entities in the group (under the fancy brand). Straight through processing means the broker A-books your trade directly to a liquidity provider. The marketing makes it sounds like a perfect marriage. The broker loves you and only wants you to trade, and never trades against you [coughs].
Usually the liquidity provider is another company within the group. This one is the NDD broker. The Market Maker taking that A book trade onto their B book – or possible A booking to a third LP in the chain.
Sometimes it is a third party LP – but that LP will be profit sharing (your losses) back to the “STP/ethical” broker. Hmm. This can easily be hidden in “marketing contracts” and other methods – but it happens.
What about the ECN crowd you say? Well an Electronic Communication Network in theory is a whole bunch of LPs bidding for your business with VWAP pricing. The broker is just there, providing you with cTrader platform for example, basking in the warm glow of being agnostic to the execution venue and only earning that small sliver of spread. That “ECN” network might only be two or three LPs and at least one of these is another company in the same brand. I refer you back to the above. They are making money from you.
But how are they making money – does it even matter!?
We said “so what” right at the start. Why do you care? At least a broker who claims to be a market maker is open and honest about it. When you lose the whole position you just took a hit on, this amount goes into the pocket of the broker. But, wait a minute. What if your trade was a winner? Now the position is reversed. The broker hands over their cash to you. Bet you’re not complaining now, are you?
So, in addition to you paying the spread (the tiny difference between the Bid and Ask prices) and/or commission, and/or fees for depositing or withdrawing, the broker earns a profit when your trades lose. That’s life. Do you get annoyed with the supermarket when you walk out with your shopping, but minus the cash you had before you went in? Yes, me too – but I accept that the supermarket takes my money in exchange for food. Same with the broker, in exchange for trading, and only if you lose, they get paid. If you win, they pay.
So, really, the question you need to ask yourself is: do I want to deal with the market maker directly or have no contact with them and just the middle-man? Personally, I think it’s better to be able to hold the end market maker to account.
What about regulation? Do you even need a regulated broker? Are each of the companies in this loop regulated? Does it matter to you? Probably should, but depends entirely on your risk appetite.
Finally, one sure-fire way to tell who you’re actually dealing with, aside from the marketing fluff, smoke and mirrors is to check in the brand’s legal documents. I realise this can be akin to finding a needle in a haystack, but under the law, brokers now have to declare the execution venues to you. This means the market maker executing your trade. Here you will find buried in a document normally called something like “Best Execution” the names of the legal entities (companies) involved. I’ll bet most of the time, the brand you trade is or owns at least one of the companies listed here.