One of the unique features of the Forex market is that it is an over-the-counter market. This means that unlike the stock or commodities markets, there is no official price for currencies at any given moment.
Now as the various interbank liquidity providers (i.e. banks) offer the same currency at different prices to Forex brokers, these brokers will in turn offer different currency prices to the retail traders they serve.
This is why, as a Forex trader, your choice of broker is an especially important decision. If you trade with the wrong type of broker, you could spend your entire career trading at sub-par prices without knowing it.
To be able to select the right type of broker, you will first need to understand the 3 types of retail Forex brokers, and the pros and cons of each.
Dealing Desk, STP, or ECN brokers?
There are 3 types of brokers in the retail Forex industry: dealing desk brokers, STP brokers and ECN brokers. These broker types differ in the currency prices they offer to trades, and in the way they operate and charge brokerage fees.
Dealing Desk brokers
Dealing desk brokers are also known as “market makers”, as they are the ones who absorb your buy and sell orders.
In other words, dealing desk brokers take the opposite position of your trades. When you buy, they are the ones who sell to you. When you sell, they are the ones who buy from you. They are thus called market markers because they literally “make” a market for you to trade in.
The main characteristic of dealing desk brokers is that they do not route your trade orders to the real market. The prices you see on the trading chart are completely provided by the broker, and they are able to manipulate those prices as little or as much as they want.
As you might imagine, there exists a serious conflict of interest here, since dealing desk brokers make money when you lose, and lose money when you profit.
But of course, not all dealing desk brokers partake in intentionally pushing prices to hit your stop loss orders, and there are still a number of reputable and honest ones out there. However, this doesn’t change the fact that there is a serious conflict of interest, and that they have the capability to artificially push market prices in their favour, at your expense.
All this being said, there are a few upsides to trading with dealing desk brokers. For one, since they are essentially “the market” to their customers, they can offer quick trade executions with little to no instances of re-quotes. Also, they are typically in a position to offer fixed spreads so traders don’t get hit with sudden spikes of the bid-ask spread.
For dealing desk brokers, the best type of trader is one that breaks even. This ensures that they don’t end up losing a lot of money (when the trader wins), while at the same time being able to keep charging trading fees that are embedded in the bid-ask spread.
STP brokers
STP stands for “straight through processing”, which apparently describes the process of routing the trader’s orders straight to the interbank market. In many instances however, this is a mostly a deceptive term used for marketing purposes.
In reality, many so-called STP brokers adopt a hybrid of both the dealing desk and STP model. When they claim not to have a dealing desk, what they mean is that they do not have human dealers taking the opposite side of your trades”¦ but they fail to mention that the process is now fully automated. This means that the broker is still the counter-party to your trades, and that the conflict of interest still exists.
The way many STP brokers operate is such that when a trader loses, they absorb his trades and profit from his loss. But when a trader wins, they either match his order with another losing trader’s order, or route his trades to the interbank market. Thus, the benefit of STP brokers (if it can be called a benefit) is that there is a smaller incentive to artificially manipulate chart prices because the broker will make money either way.
A simple way to identify an STP broker is to find out how they charge brokerage fees. If they don’t charge trading commissions and only charge a fee embedded in the spread, it’s likely that they are a STP broker.
ECN brokers
ECN stands for “electronic communications network”. ECN brokers offer what many traders would consider to be the only legitimate type of brokerage service, which is to route trade orders directly to the interbank market.
The price data provided by ECN brokers is the closest one can get to real market price conditions. There is no conflict of interest here because the counter-party to your trades is not the broker, but other traders and financial institutions that are trading in the same market.
Real ECN brokers don’t mark up the spread, and instead charge a commission for each trade taken. Because of this, the bid-ask spread is very low, often at half a pip or less.
The interests of these brokers are aligned with yours, because the more successful you are and the larger you trade, the more commissions you will be paying to trade. In my opinion, this is completely fair.
The downside of trading with ECN brokers is that your trade orders are not guaranteed to be filled. Since your trade orders are merely routed to the liquidity providers, they are subject to real market conditions which means that you might not get your orders filled at the price you want, or even at all. This being said, the market is typically liquid enough to accommodate 99% of your trades.
Which broker should you trade with?
My opinion is to go with an ECN broker.
Many years ago when liquidity was an issue, dealing desk brokers performed the valuable service of guaranteeing liquidity for their traders, even if there was a conflict of interest. These days however, there is little reason for retail Forex traders to pick a dealing desk broker or even an STP broker for that matter.
If you have a choice, always go with an ECN broker.
Guest post by Jai Patel of Forex System Profits (http://forexsystemprofits.com)
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