Know your broker

Dear Traders,

You can often gain insight into a profession, from understanding its history. In 1999, retail or individual Forex trading essentially did not exist. Trading the foreign exchange markets was pretty much restricted to big banks, hedge funds and high net-worth individuals as a result of the capital prerequisites for trading. Namely, a minimum trading size of around 1 million USD.

Now, thanks to advancements in technology and the internet, traders can freely participate in the Forex market. This has also removed barriers between interbank markets and the retail clients themselves, because they can connect to Forex brokers via the internet.

So what's the insight? Forex brokers were born from market need and serve to bridge the gap between everyday traders and the financial market's big players. Choosing the right Forex broker is essential to your trading success and one of first things you need to consider is whether you want a dealer's desk involved.

A-books, B-books and the hybrid model

Electronic Communications Networks (ECN) and Straight Through Processing (STP) brokers act as mediators that send their clients trades directly to liquidity providers. These NDD or no-dealing-desk brokers use the A-book system.

If a broker chooses to trade against their clients, which most dealing-desk market makers do, we call it a B-book system.

However, most brokers use a combination or hybrid model that consists of A-book for profitable clients and B-book for losing traders. The hybrid model allows both additional profitability and solidity to Forex brokers.

As a trader you have nothing to concern yourself with regarding what system your broker uses for you. Quite the opposite in fact. The book systems are simply how brokerage firms manage their risks. Basically, brokers use software that analyses their customers' orders and develop risk management strategies (e.g. internal hedging and spread variations) based on the results. Applying a hybrid system for example, allows brokers to manage their profitability and this is a good thing for you as the trader. Why? Well as long as the broker is profitable, your money is safe and large withdrawals are easily handled.

Another advantage of the hybrid system for the trader, is that the profits made from B-book traders enable hybrid brokers to provide you with competitive spreads.

The A, B, Hybrid book systems also influence your money's security behind the scenes, so it's important to choose an experienced broker (i.e. one with at least 12 years experience). The danger lies in mismanagement of so called B-book risk. Experience will inform a reputable broker to apply considerable resources to closely managing B-book risk, while less reputable brokers may aim for quick returns and inevitably endanger their solvency i.e. go bust before you get paid out.

Dealing desk broker

Dealing desk (DD) brokers are called market makers because they create a market for their clients. They usually provide traders with a buy-sell quote on a fixed spread and their main profit comes through this spread plus providing liquidity to their clients.

DD broker's don't show customers the real interbank rates, but heavy competition means their offers are usually very close anyway. However, you should forget about very low spreads and no commission offers with these brokers because a trader doesn't see the real market quotes and in turn that allows DD brokers to manipulate with quotes, usually providing the infamous "requote message". For example, let's say you place a buy for GBP/USD for 1 full lot. In order to fill that order, a broker needs to find a matching sell order (1 lot) from its customers. If it doesn't find this matching order, you are passed on to its liquidity provider who then takes the opposite side of your trade (internal hedging). This is clearly negative for you because the liquidity pool from liquidity providers can raise the prices and pull the orders refusing to give you the desired price. You will usually get a much worse will than you wanted initially. If you ever find out that your Forex broker gets you requoted frequently that means it is suffering from the lack of liquidity. The only way you can protect yourself is by placing limit orders which should be executed at the same price you wanted. However, I advise you to stay away from trading with such a broker.

No dealing desk brokers

There are 2 types of no-dealing-desk (NDD) brokers - ECN and STP - who as the name suggests, don't pass their clients orders through a dealing desk. Their execution is instant and they charge a very small commission for trading, or use a small markup by slightly increasing the spread.

ECNs are generally deemed more exclusive than STP, because they need larger deposits to get started. But ECN can provide more direct access to the interbank market too. ECN:

• gives the connection between your orders and other ECN participants (banks, hedge funds, other brokers, institutions, retail traders, etc)
• allows for Depth of Market (DOM) information, so traders can use ECN to see exactly where liquidity lies
• makes most of it's profit from commissions, so the results of a trade are not important i.e. it's in the ECN broker's best interest for you to make money.

STP brokers are not liquidity providers, so all trades placed with this broker are passed immediately to liquidity providers. The main profit for an STP broker comes from the difference between the spread they charge their customer and the spread they get from their liquidity providers. Again, it's in the STPs best interest that traders succeed and keep on trading.

This video illustrates how DD, ECN and STP brokers work.

If you have any comments or questions don't hesitate to comment or ask us.

Cheers and safe trading,

Nenad

Admiral Markets offers you ECN on your trading account through it's Trade.MT4 and ECN+ accounts.