What Is a Forex Market Maker?
Ever wondered what happens when you place a trade?
Market makers play a key role in the Forex market, providing liquidity and helping the market run smoothly. But what is a Forex market maker? How do they work? And why should you care? Keep reading to find out!
The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.
What Is a Forex Market Maker?
Market makers are market participants that buy and sell large volumes of a security, or securities, in order to ensure the financial markets run smoothly.
Market markers continuously quote both buy (bid) and sell (ask) prices for securities and are ready, and obligated, to accept any trades at these prices. They are responsible for providing liquidity to the markets, hence why they’re also commonly referred to as liquidity providers.
Forex market makers, therefore, are market makers which offer quotes on one or more currency pairs, thereby creating a market for that pair.
How Do Market Makers Work?
We can summarise a Forex market maker’s activity into three points:
- Sets bid and ask prices for a certain currency pair, or pairs.
- Stands ready to accept deals at these prices.
- Takes the resulting exposure onto their own book.
Rather than matching buyers and sellers, market makers act as a counterparty to any transaction which it accepts.
In other words, if a trader buys a currency pair via a market maker, the market maker is the one selling that currency pair from their inventory. By doing so, they facilitate an instant transaction at their quoted price, allowing the market to run smoothly.
Unlike traders, rather than try to predict movements in price, a liquidity provider accepts transactions from both sides of the market, generating their profit from the difference between the bid and ask prices, known as the spread.
When the flow of trades they receive is mostly balanced, it allows Forex market makers to offset opposing trades against one another, reducing their exposure. This is sometimes referred to as internalisation.
However, when the flow of trades is more one-sided, a liquidity provider will typically choose to offset risk by hedging its exposure with an external provider.
Internalisation vs External Hedging
To illustrate this in simplified terms, imagine the following scenario:
- Client A buys 1 lot of GBPUSD
- Client B sells 1 lot of GBPUSD
The market maker is the counterparty to both trades; however, because the trades are the same size in the same instrument, they effectively offset each other.
Now, imagine the following:
- Client A buys 5 lots of GBPUSD
- Client B sells 1 lot of GBPUSD
As the counterparty to both trades, our market maker is now left with significant exposure to Client A’s trade. In this instance, the market maker may be required to offset this risk by hedging the position externally.
Market Makers vs ECN/STP Brokers
Many retail Forex brokers operate as market makers, acting as the counterparty to the trades made by their retail clients.
In this instance, the broker/market maker acts as a bridge between retail clients and the interbank market, buying up large positions from liquidity providers and reselling them in smaller packages suitable for retail traders.
However, not all brokers operate in this way. Straight Through Processing (STP) and Electronic Communications Network (ECN) brokers do not act as a counterparty to transactions. Instead, they both route client orders directly to external liquidity providers.
The manner in which STP and ECN brokers operate is slightly different. STP brokers route orders to their pool of liquidity providers, using algorithms to determine the best provider to match clients with.
On the other hand, ECN brokers provide clients with direct access to the interbank market, where trades are automatically matched with a counterparty. Because of this, ECN brokers typically have higher deposit requirements and higher minimum lot sizes per trade, making them more suitable for experienced traders.
Find out more about the differences between STP and ECN brokers in our article: STP Broker vs ECN Broker Explained
Advantages and Disadvantages of Trading with Market Makers
The table below highlights some of the main advantages and disadvantages of trading with Forex market makers:
Final Thoughts
Whilst Forex market makers form an essential part of the market, providing much needed liquidity, trading with them may not be suitable for all traders.
Their low minimum deposits and flexible position sizes may make them an attractive option for less experienced traders, trading on a lower budget. However, the potential for conflict of interest, wide spreads and limited transparency are certainly factors to bear in mind.
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Frequently Asked Questions
What do market makers do?
Market makers provide liquidity in the financial markets by continuously quoting buy and sell prices for assets, and accepting trades received at these prices.
How do market makers make money?
Market makers primarily generate profit from the bid-ask spread – which is the difference between the price they are willing to pay for an asset and the price they are willing to sell it for.
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