It is not possible to participate in any market directly, even your local stock exchange, you need someone to act as the go-between. It was important to put this law in place because, otherwise, there would be huge delays in processing orders. Imagine if every trader interested in the NYSE worldwide traded directly with the exchange? That would be millions of orders at any time, so instead, the brokers reduce the number of simultaneous orders while speeding up the process.
Types of Forex brokers
The same is true with the Forex market, where the Forex broker is simply a company that connects their clients to the Forex market. By definition, a broker is not supposed to ‘create’ trades but rather to link you to the interbank market so you can make the trades. These kinds of brokers are out there, and they are known as ECN Forex brokers because they provide an electronic communications network to the interbank Forex market.
However, not all brokers follow the traditional role of a broker, and instead act as the market maker themselves. You can find some of these brokers on our STP Forex brokers list, and while they act like the market itself, all their quotes are similar to the actual interbank market rates. However, for a broker to act as a market maker, they require a lot of capital to cover all their clients’ trades, and this means a huge financial backing, say, from a bank.
It would seem easy for a bank to become a Forex broker, but it is not possible, since a bank is not allowed to do so by law. Yet we know that there are several banks offering Forex trading, so how do they do it? Simple, just create a subsidiary which specializes in Forex exchange, then provide this service to clients. Most banks do not do this because they deal with huge amounts of money, we’re talking billions of dollars per trade, so they don’t have time for chump change like $1,000 dollars, which is unfortunately where most retail Forex traders are.
For those banks with a Forex subsidiary, they are able to provide the service to clients just like a regular Forex broker after being licences by the necessary Forex regulators. With the backing of the bank’s financial resources, this kind of broker would act as a market maker and become a dealing desk.
When you’re choosing a Forex broker, you will have to decide whether you want to deal with the traditional broker, or a bank offering Forex services. In this article, we’re going to look at the features of a Forex bank that make it unique, and also the disadvantages of such a system.
Security of funds
When you deposit your money with a Forex broker, the security of your funds is of utmost important, especially if you’re trading as a form of long-term investment. You want to be assured that your money will be available for withdrawal whenever you need it.
Some of the best Forex brokers are also market makers, meaning that they don’t connect you to a liquidity provider and they are a dealing desk; so, in essence, you’re trading against the broker. While this kind of system may have its downsides but it ensures the client’s funds remain secure despite any volatile market situations.
Take the ‘black Thursday’ event that occurred on the 15th of January 2015, companies that were most hurt by this event, including Alpari UK and FXCM, were using a non-dealing desk model. This meant that all their clients’ trades were transferred to a liquidity provider, and when the clients lost money due to the sudden strengthening of the Swiss Franc, the broker lost a lot more since they had provided leverage to the clients. For example, a trade worth $1,000 made by a client with a leverage of 1:100 meant that the broker lost $100,000 to the liquidity provider compared to the trader’s $1,000 investment.
After this event occurred, some non-dealing desk brokers filed for bankruptcy, locking up all of their clients’ funds regardless of whether they had made a loss or not, even though it was the broker’s fault. For brokers operating a dealing desk model or acting as market makers, the leverage offered to the client was only virtual since you were trading against the broker, and the broker would not lose a lot of money. For this reason, their losses would only be minimal and their clients’ funds would remain secure since there was no 3rd party claiming money from the broker.
Faster execution of trades
When traders initiate orders from their Forex trading platforms, that order essentially asks that a commodity be bought or sold at the current market price. In the case of an ECN broker, the order is transferred to the liquidity provider who then places the order and sends a confirmation back to the broker who then notifies the trader. As you can see, this is a longer process compared to an STP broker who can process the order themselves.
Now, internet speeds have become very fast, and even an order through an ECN broker only takes a few milliseconds longer, but sometimes these milliseconds become crucial. Financial announcements create high volatility in the market, and the value of financial instruments changes very rapidly as millions of traders around the world are reacting. This causes prices to shift very rapidly, and this is referred to as slippage.
When slippage occurs, the dealer executes the trades at the next best price, meaning that the price of execution could be higher or lesser than the trader anticipated. With a dealing desk, chances of slippage are low and even when it occurs, it usually isn’t as significant as with a non-dealing desk. Besides the execution price, slippage also renders stop loss orders ineffective, so when a trade goes bad, there is no stopping it even with a stop loss. The few milliseconds saved in execution through a dealing desk can help limit this situation too.
Brokers make money either through spreads or commissions – if you’re trading with a broker who uses spreads, you want the tightest spreads available. With a dealing desk broker, they have the tightest spreads since they are the once creating the market. Non-dealing desks, on the other hand, receive quotes from the liquidity provider already with a spread on it, and then they add their own spreads in order to make money. This makes their spreads wider, and can seriously affect a day trader especially considering how scalpers make money.
While banking Forex may be advantageous, it still has its own downsides that you need to consider:
Self-preservation by the broker
With a dealing desk, you’re basically trading against the broker, so any profit you make comes out of their pocket. Obviously, you can see that the broker has an incentive to mess with your trades especially if you’re very profitable, and this can be a risk. A broker won’t do this all the time, of course, otherwise traders would tarnish their name on real Forex broker reviews websites, losing the broker potential clients. Nevertheless, it has been known to happen, and this can be a huge deterrent to trading with Forex banks.
It rarely happens, but there have been several cases of manipulation of market data even by FCA regulated Forex brokers and other highly regulated brokers. Since the Forex bank is the market maker, they can easily manipulate the price of financial instruments, presenting the trader with false data that loses them money. The conflict of interest has led to some Forex banks being termed as bucket shops, because the broker can alter market prices at will, effectively swindling their clients’ money and even complaining against the broker may be futile.
Risks to the Forex bank
To be fair, it’s not just the traders who experience the risky side of banking Forex, but the broker can occasionally suffer the short end of the stick. Again, I’ll refer to the ‘black Thursday’ event since it depicts the worst case scenario, but lesser financial crises occur every day when critical financial announcements are made.
Before the Swiss National Bank (SNB) de-pegged the Swiss Franc from the Euro, brokers reported that less than 10% of all Swiss crosses were long on the Swiss Franc, and the rest were short. This meant that more than 90% of their clients who had positions with the Swiss Franc lost money, but the profits gained by the less than 10% on the other side were still more than the losses since it was such a huge change. As the market maker, the Forex bank had to pay out to the winners more than they earned from the losing trades, causing them a loss.
However, when compared to ECN brokers, the Forex banks did not suffer as much as the ECN brokers.
What this means to banking Forex
Are you still asking how to choose a Forex broker? I realize that I didn’t really nudge you towards or away from banking Forex, but that’s because there are always 2 sides of a coin, and it’s better that you know them both before making your choice. I also believe that you would appreciate the free will to make your own conscious decision and incorporate this insight into your trading strategy.
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