3 Types of Forex Brokers
The safest way to trade forex, particularly if you’re a beginner, is to trade through a broker. Before you start jumping into trading and examining broker reviews, you should consider which type of broker you’d prefer to use. The three main types of brokers include market maker (dealing desk), no dealing desk and electronic communications network (ECN). There are pros and cons to working with each type of broker, and it’s important to do a thorough evaluation before selecting your broker.
(1) Market Maker (Dealing Desk) Brokers
A market maker or dealing desk broker creates a mini forex market for you as a client. For example, if you place an order to buy Japanese yen, then a market maker can take your buy order and group it with multiple other buy orders from among his or her clients. Your order can be forwarded to the banks, or your brokerage can keep your order if it thinks that the price of the yen is going down and it can profit from your trade. In that case, your brokerage will place a sell order to compensate you and then take your buy order to the bank for itself when the price increases. Essentially, you’re trading against your broker’s capital instead of sending your money to the interbank market.
Market makers make money by quoting you a slightly smaller spread (the difference between the bid and the ask price) than EBS, Reuters or a big bank quotes to them. If you think you can buy the yen and the value will drop later, and your broker agrees, then he or she will keep your buy order. You get paid the smaller spread, and the market maker keeps the difference between the bank quote and your profit. Alternatively, a few market makers make money by charging commissions for trades.
Many people feel suspicious of trading with their brokerage, but you still either gain or lose just as you would if you traded directly with a bank. On the other hand, if you like to conduct a high volume of scalping trades, a dealing desk may decline to serve you because your style exposes them to too much risk. Also, a market maker’s spreads can also slip considerably when economic news is released. The main issue, however, is that a market maker has an inherent conflict of interest. If you lose, then your brokerage gains. Of course, dealing desk brokers won’t last for long if their customers continuously lose money. Just remember that market makers have some incentive to manipulate prices.
(2) No Dealing Desk
A no dealing desk (NDD) broker sends spreads directly from liquidity providers, such as banks. When you place a buy order, you can look at quotes directly from the liquidity provider instead of looking at a spread set by a market maker. You can also execute trades instantly using straight-through processing (STP), and you can also set up automatic orders. Your order is also executed anonymously so that the liquidity provider doesn’t see your stops, limits and entry orders.
The main disadvantage of NDD is increased volatility. You will also pay a commission for each transaction. However, the increased competition often results in better bid/ask prices. Also, if you enjoy scalping, then you can place more trades on very small spreads.
(3) Electronic Communications Network (ECN)
An ECN broker is a spinoff similar to no dealing desk trading. However, instead of simply sending your order directly through the liquidity provider, your order interacts with many other orders in the ECN. For example, when you place an order, the ECN matches that order up with a contra-order within the system. If it doesn’t find a contra-order, then the broker makes the order visible to other clients while maintaining your personal anonymity.
ECN is great for scalping. However, with ECN trading, keep settlement risk in mind. You have greater exposure to risk because you’re trading with such a large number of liquidity holders. If you go with a market maker, then you know that your brokerage has to pay you. If you go with ECN, then you risk trading with someone who can’t fulfill your order. Also, you may have to keep a large account balance.
A final warning: No matter what type of broker you use, read reviews carefully before making a final choice.
