The foreign exchange (forex) market is a decentralized marketplace that you access via forex brokers which, to say the least, are free to operate the way they want. You must have heard of terms like market makers and straight-through processing if you are familiar with the currency market. Those terms describe how brokers operate.
At the basic level, all brokers appear to offer the same service — fill the clients’ buy and sell orders — but the way they do that and other peculiarities of their services differ. Based on the mode of trade execution, you will encounter three types of forex, and the type of broker you choose may have a great impact on how you trade, as well as your long-term trading success.
With hundreds of forex brokers to choose from, finding the right broker is not an easy job, which is why, in this post, we want to explain the different types of brokers and offer some basic guidelines in choosing the right broker. Here, you will learn the following:
- The different categories of forex brokers
- How to choose the right broker
- Why you need a reliable broker
- What you should know about scam brokers
The different types of forex brokers
There are different ways to classify forex brokers. You can group them based on regulation — regulated and unregulated brokers. Even the regulated ones, there are levels of regulation. A broker that is solely regulated by a tier 3 financial regulator in one of those Island nations can’t be said to be as well regulated as one that is regulated by a tier 1 financial authority like the Financial Conduct Authority (FCA) in England, the Commodity Futures Trading Commission (CFTC) in the US, or the Australian Securities and Investment Commission (ASIC).
With many jurisdictions restricting the access of foreign brokers to their residents, forex brokers can also be classified based on the countries in which they operate. Thus, you can have U.S. forex brokers, U.K. forex brokers, European forex brokers, Canadian forex brokers, Australian forex brokers, offshore brokers, and others.
Forex brokers could also be classified based on their trading platform. Most brokers mainly offer self-directed trading via platforms like the MetaTrader 4, MetaTrader 5, cTrader, and others, with access to trading signals and some copy-trading tools, but a few offer mainly a social trading platform where traders can analyze and copy other trader’s trades.
Based on trading accounts and the allowed trading strategies, some brokers offer Islamic swap-free accounts, while some don’t. Also, some brokers allow scalping and hedging strategies, while others don’t or may allow one and not the other.
However, our discussion today is centered on the different types of forex brokers based on order execution model, and there are two main categories:
- Dealing desk (DD) brokers, also known as market makers
- Non-dealing desk (NDD) brokers
The non-dealing desk brokers are further classified into the following:
- Straight-through processing (STP) brokers
- Electronic Communication Network (ECN) brokers and direct market access (DMA) broker
Forex brokers: Market makers
Market makers or dealing desk brokers directly provide liquidity for their clients. In other words, they create a market for their clients internally by matching clients’ orders with opposite orders from other clients or taking the other side of the trades themselves. In such situations, clients’ losses are their gains, while clients’ gains are their losses.
However, they usually hedge their positions when acting as the direct counterparty to clients’ orders. Moreover, when they get overwhelmed by clients’ orders in one direction, they pass them on to their liquidity providers. The fact that a broker takes the other side of a client’s trade can, in itself, make one think that there is a conflict of interest. While this is possible, there may not be any.
Dealing desk brokers only believe that they have enough liquidity pool from their numerous clients, so they can easily match opposite orders from their huge pool of orders. They simply provide a buy and sell quote and fill orders from buyers with orders from sellers, so they may not really care about what an individual trader’s order fills at.
Nonetheless, they have control over what they display as their price quotes at which traders enter their buy or sell market orders. As a result, they don’t have much risk offering fixed spreads, which most new traders will find easier to deal with than floating spreads. It is from this fixed spread — between the bid and ask prices — that dealing desk brokers make most of their money — though, they can also make money from their clients’ losses when they’re at the other end of the trades.
One thing is clear: clients of market makers don’t have access to the interbank market prices, but with the huge competition between brokers and the advance in trading technology, dealing desk brokers offer rates that are close to, if not the same as, the interbank rates.
Basically, this is how dealing desk order processing model works: If a trader places a trade with a dealing desk broker, the broker will first look for a matching opposite order from their other clients to execute the trades. When there is no matching order, the broker will assume the counterparty role and take the other end of the trade. In this case, if the trader is losing, the broker is making money, but if the trader is gaining, the broker is losing and may pass the trades to their liquidity providers so as to avoid the risk of taking a heavy loss.
There are some pros and cons to using a dealing desk broker, and they are as follows:
Some of the benefits of trading with a market maker include:
- Trade execution is instant: Clients’ trades are executed at the quoted prices, so slippages are almost impossible except during periods of extreme volatility and low liquidity when the broker may increase their spread.
- Spreads are fixed: Traders know the spreads they will pay when placing their trades.
- Dealing desk brokers can allow Nano lots: Trading a cent account can be very useful to beginner traders who want to test the waters with little risk.
- There is a wider range of leverages: Dealing desk brokers can allow up to 500:1 leverage. Some even allow up to 1000:1 leverage.
- There may not be rollover fees: Market makers tend to offer swap-free trading since most orders are offset by counter-orders within the broker’s internal pool.
Here are some of the disadvantages of using a market maker:
- Different rates: It is common for prices quoted by market makers to be a little different from the interbank market.
- Liquidity issues: There are times when the broker may not find enough counterparties to take some orders and are not ready to take the orders themselves.
- Conflict of interest: When the broker is at the other end of a trade, there may be a conflict of interest, leading to manipulating spreads and execution times or enabling negative-only slippages.
- Insolvency: The broker can go bankrupt if their order executions are not well managed.
How to identify a dealing desk broker
Most honest brokers would state it right away on their website the type of trade execution model they offer. But if it is not stated, one of the features that give them away is that they offer different forms of cent accounts. Another import feature they usually offer is fixed spreads.
Forex brokers: STP broker
STP brokers act as agents and pass their clients’ orders to their liquidity providers who are part of the interbank market. They are an intermediary between retail traders and the interbank forex market. So, they operate the agency-only brokerage model and channel their clients’ orders to the liquidity providers.
Generally, STP brokers have access to many liquidity providers, with each offering different bid and ask prices for a particular currency pair. Since traders sell at the bid price and buy at the ask price, the brokers often sort the different price quotes from the liquidity providers into the highest bid prices and the lowest ask prices because traders want to sell high (which is at bid prices) and buy low (which is at ask prices). They would then add a small markup and then quote the marked-up bid and ask prices to their clients.
For instance, say an STP broker has three liquidity providers, each with its own bid and ask quotes for a particular currency pair — EURUSD, for example — the broker would get three different quotes, as follows:
From these quotes, the broker would sort the bid prices to get the best quote (highest quote), and in this case, it would be 1.1889. Similarly, the broker would sort the ask prices and take the best quote (lowest quote), which, in this case, would be 1.1890. So, the best bid/ask quote the broker could get is 1.1889/1.1890, but the broker would need to add their profit as markup to the spread or charge a commission separately from the spread.
If the broker’s policy is to add a 1-pip markup to both the bid and ask quotes, the bid/ask quote the broker will display on their trading platform would be 1.1888/1.1891 — which means a spread of 3 pips, but the broker makes only 1 pip from each executed order in one direction and 2 pips per round trip.
So, if a trader places an order to buy 1 standard lot of EUR/USD at the 1.1891 displayed on the trading platform, the broker would send the order to Liquidity Provider Y, who sells a standard lot of the currency pair to you at 1.1890, while they (the broker) pockets the 1 pip for their services.
On the other hand, a trader that wants to sell 1 standard lot at 1.1888 displayed on the brokers trading platform would have his order sent to Liquidity Provider X or Z who buys it at 1.1889, and the broker earns 1 pip. Alternatively, the broker may use the direct market spread and charge a commission separately.
Because of the fact that the bid and ask quotes from the liquidity providers keep changing with market conditions and the broker adds a markup to the best quotes they can get, many STP brokers tend to have floating spreads. However, some STP brokers do offer both fixed and floating spreads.
There are many pros and cons to using an STP broker, and these are some of them:
The pros include:
- STP brokers offer identical prices with the interbank rates, especially those that charge commissions instead of markups.
- There is no conflict of interest with the brokers, as the more profits the traders make, the more they trade, and the more the broker earns from spreads or commissions.
- There are few trade rejections or re-quotes, except in periods of excessive volatility
- There can be positive slippages
- These brokers often offer negative balance protection
The cons include:
- Floating spreads can widen at any time and present the risk of being stopped out
- There are overnight fees
- There can be negative slippage
How to identify an STP broker
Most genuine brokers will state their order execution model on their website, but in case you don’t find it, here are a few signs that the broker operates the STP model:
- Variable spreads
- Fewer account types
- Negative balance protection
- No re-quotes
- Positive and negative slippage
Forex brokers: ECN brokers
ECN brokers connect their traders’ orders directly with counterparties in the interbank market. They are the gateway through which their clients’ orders are passed to the marketplace where they interact with the orders from other market participants in the Electronic Communication Network. And these participants can be banks, hedge funds, corporations, and retail traders, as well as other brokers.
In other words, in the marketplace, participants trade against each other, and their various buy limit and sell limit orders create the bid and ask prices respectively — at any point in time, the highest-priced buy limit order is the bid price, while the lowest-priced sell limit order is the ask price.
In the marketplace, the only role ECN brokers play in executing trades is to link the buy orders to the available sell orders at that moment. The brokers do not create their own price quotes, rather, they directly display price quotes as they appear in the interbank market. Thus, their clients can see not just the best bid/ask prices (the current price quote) but also the Depth of Market, which can help them to plan where to place their orders.
Depth of Market shows where other market participants have their buy limit and sell limit orders. With that, traders can see the price levels where there are plenty of buy orders and sell orders, which constitute the demand zone and the supply zone respectively. For the price to progress, there should be enough buy market orders to take out all the orders at the supply zone or enough sell market orders to take out all the orders at the demand zone. So, by seeing the size of orders at these price levels, a trader can better plan his trades and also know where to expect difficult price movements.
ECN brokers hardly use markup spreads because that would no longer show the actual market quotes in the interbank market. Generally, ECN brokers charge a certain amount as a commission on each trade. Since the interbank market bid/ask spread changes based on the orders in the market, ECN brokers always offer floating/variable spreads.
It is important to note that ECN brokers usually require higher initial deposits than other types of brokers because most of the participants in the interbank market only trade in large lot sizes. One more thing, since order execution depends on finding a matching order in the market at the time it’s placed, there may be order execution delays, rejections, or re-quotes.
The brokerage model has some pros and cons, including the following:
The pros include:
- It offers interbank price quotes
- It offers tighter spreads
- There is no conflict of interest as the broker does not trade against the clients
- Traders can implement any strategy they want
The cons include:
- The spread can change widely depending on market liquidity and volatility at the time
- There can be many order rejections or re-quotes
- Traders pay commission in addition to the spread
- There are overnight swap charges
How to identify an ECN broker
Any genuine ECN broker will proudly state it on its website. However, if you can’t find the information, these are a few ways to spot:
- Interbank price quotes
- Floating spreads
- Fewer account types
- Negative balance protection
- Positive and negative slippage
Choosing the right type forex broker model for your style
Choosing the right type of forex broker that suits your trading needs will depend on a number of things, such as:
- The amount of your trading capital
- Your trading strategy
- Your trading frequency
Generally, traders want to avoid dealing desk brokers because of the non-transparent pricing model and potential conflict of interest that may lead to all sorts of order manipulations.
ECN brokers generally require $1,000 and above as initial deposit, so traders with lower trading capital may not have this option. But certain trading strategies, such as scalping, require tighter interbank spread offered by ECN brokers.
While a swing trader or a position trader may not bother about the spread, scalpers and day trader would. So, if you have the required capital, an ECN broker may be the best for you, but if you are a beginner trader with little capital, an STP broker is good.
Ensure that you use a reliable forex broker
Your forex broker is your link to the forex market, and it is also the one to keep your money until your next trade, record your trades, and more importantly, pay you when you want to take your profits or your entire money. So, it is absolutely necessary that you take your time to choose a reliable broker that is not just suitable for your trading strategy but also can be trusted with your money.
It does not matter whether your trading strategy has a great edge in the market, if you trade with the wrong broker that is not suitable for your strategy, you will not have the best trading experience. In addition, you need to check the broker’s trading platform to be sure that you are cool with it.
Moreover, some brokers are not only poorly regulated or even unregulated but can be outrightly dishonest and should be avoided. With such brokers, it is very difficult to make profits, and when you do, you may not be able to withdraw the profit, let alone get your deposit back if you want to. That is why you need to check some of the reviews on any forex broker you want to trade with.
You need to know about scam forex brokers
There are many scam brokers out there, so you need to be careful not to fall a victim to any of them. The most unfortunate thing about these dishonest brokers is that they run the most captivating adverts — with a handsome young guy riding the latest sports cars or a hot chick enjoying a cozy environment in one of the best beaches in the world. They often portray forex trading as a get-rich-quick scheme.
How to spot scam forex brokers
Here are some telltale signs that should raise red flags when checking out a forex broker:
- Outrageous bonuses: welcome bonus, no deposit bonus, first deposit bonus, and other similar bonuses
- Location: they mostly operate from those small Island nations, such as Marshall Islands, Seychelles, Belize, Vanuatu, and others
- Regulation: They are never regulated by any tier 1 financial authorities like the FCA, ASIC, CFTC, or ESMA. They are either unregulated or poorly regulated by tier 3 financial bodies in those Island nations where they operate from
- Multiple account types and sub-account types with different spreads and trading conditions
- Random bonuses, rewards, and prizes, such as offering laptops, cars, apartments, vacations for trading a certain amount of lot size over a certain period — mostly conditions that are impossible to meet
There are different ways to classify forex brokers, but here, we focused mainly on the order execution model, which puts brokers into three types: dealing desk (market makers), STP, and ECN brokers. Each of them has its pros and cons, but experienced traders tend to go for STP or ECN brokers.