By Steve W.
The sell side of the retail Forex industry can be as opaque as the market itself, and few individual traders actually have a clue about how they are being quoted, if their trade is going out to market, and a slew of other concerns that escapes common knowledge. Today we are going to cover retail broker models, common terminology and essentially everything that many brokers don’t want you to know. Most of the articles found on the internet, well, most retail traders won’t even look at. That is why I’m posting it here, to hopefully better educate the masses and shed some light on a typically dark subject matter. To some of you, this is nothing new, but to others, I hope to better inform.
Transaction costs are a huge concern for us because it is essentially money down the tubes and most of the time, for no reason whatsoever. This is the main reason we largely abandoned a major ECN and went with another that does not attempt to add costs on top of our preexisting PB fees.
The bottom line is that no trader should be paying anything more than around a pip on a EUR/USD during any standard trading session. And yes, on ECN platforms, that includes commission. If this is the case on your platform, then you are essentially donating money to your broker. Again, this is your hard-earned money simply being handed over to someone else, one little trade at a time. This cost can of course be justified if you are getting some serious analysis or tools in return, but most of the time this is not the case and these tools can be acquired elsewhere for much less.
Standard Retail Broker Models and Why Everyone Hates Them
Retail brokers typically fall into several “model” categories, with the larger ones using a combination of these in order to cater to more sophisticated clients. An example would be 70% B-Model, 20% A-Model and 10% C-Model being used within one firm. These are all industry terms and nothing new. Again, I am simply just bringing these into the light. So let’s talk about these models one by one:
A-Model: In an A-Model, a broker profits from spread only. Trades are passed out to market via straight through processing to a bank or an ECN through a bank. You will never hear me recommend trading through any platform that does not strictly follow an A-Model. Trade matching technology is simply too good and accessible these days to have to deal with anything less. In addition to better execution (which is an understatement), as a client, you don’t have to deal with any of the more common trading restrictions seen elsewhere.
B-Model: The most common, for a reason. One look at a retail broker’s client book and the profitability results are astoundingly clear: it makes much more sense to “hedge”, or trade against your client’s positions as opposed to simply passing them out to market and capturing spread. Additionally, a lot more “flexibility” is given to the broker which in most cases, is a conflict of interest with the client (more on this below). Recent CFTC reports indicate that approximately 70-80% of retail client volume is unprofitable. Most retail brokers follow a B-Model simply because it is so lucrative to do so. The largest brokers here in the US have historically followed a B-Model with “good” results (understatement of the century). For clients, B-Models are generally frowned upon, yet encouraged by brokers with the argument that better flexibility is afforded to them. The major cause of concern is of course the conflict of interest and now long history of unethical practices exercised by brokers under this model.
C-Model: More obscure and essentially anything that does not fall into the first 2 categories. C-Models consist of a range of strategies designed to typically balance extracted profit for a broker and client satisfaction.
Retail brokers will pull liquidity from any number of major destinations. In the early days of retail FX, the only route to go was to set up a relationship with a bank, or several banks, and pool that liquidity onto their platforms. The broker could then take their route of choice, which usually entailed market making. Today, a number of different methods may be used including turnkey solutions with established sources of liquidity or connecting directly with an institutional ECN. Regardless, a bank’s services are still needed in order to hold the account and facilitate a number of operational functions.
Liquidity aggregation is getting more and more accessible these days, with a number of market participants (funds, brokers, you name it) using platforms such as MarketFactory to direct multiple trading venues into one platform on the client side. These technology improvements allow further flexibility for brokers to expand their horizons and offer better conditions for traders of all sizes. Ultimately, the market is improving, transparency gaining traction, and retail traders have more options than ever.
As it stands today, retail brokers will access liquidity by any number of different means:
Direct bank relationships: Single bank platforms or other pass through systems that allow retail FX brokers access to a wider pool of liquidity.
ECNs: A relationship with a larger bank is usually required as well due to the broker’s lack of size, thus credit.
3rd party aggregators or all in one solutions: These businesses essentially act as a turnkey solution for everything when it comes to starting an FX brokerage business. Leverate is a prime example. Companies go to these types of businesses for simplicity and negotiation muscle when it comes to acquiring liquidity for their shop.
And Now for Some Badly Needed Explanation of Terms:
ECN: Electronic Communication Network. ECN’s have risen in volume substantially over the years and will likely continue to do so, as they have several major benefits:
- Direct access to liquidity: It is you and the bank / another trader / institution, whoever wants to make a price.
- Deep liquidity: Prices are abundant on the majors and can generally serve most of the more demanding clients.
- Limit Book Access: Orders are out in the open. Conventions do indeed vary from ECN to ECN.
- Superior execution: Due mainly to the above. Note that some platforms will still allow for “last look”, giving the counterparty the upper advantage on your trade.
Retail brokers commonly advertise ECN platforms, but this does not mean that they are a “true” ECN. A “true” ECN allows direct access to the interbank market, where the broker charges you a commission on top of your spread, which even can commonly be inverted. Many “ECNs” labeled in the retail world still pose risk to the client. These are not “true” ECNs but usually a bridge of some sort where spreads are marked up and inventory risk for the broker is still a concern. Major institutional ECN’s include Currenex, FXAll, Hotspot, LMAX, etc.
An ECN broker will allow you to trade directly with other participants in the marketplace. You are literally trading on the ECN with the rest of the world, consisting of banks, hedge funds, other individual traders like you, etc. Be aware that some ECNs are only as good as the platform you are using, so ensure you picky in terms of what software you choose to use.
Market Maker: A market maker typically does several things:
Creates a price for you, the client. These prices are most oftentimes “representative” of a true market price and in some cases, your trade will never even leave the retail firm. The market maker will take the other side of your position, sometimes determining whether or not you are an A or B client. If you are an A client, in some cases your trade will be routed out to market, essentially making you someone else’s “problem”. This can still cause major issues in execution, however, as your trade is jumping a few servers and usually old technology to make it happen. If you are a B-client, the broker essentially has confidence that at some point, you will wipe yourself out and fork over your money to them.
The vast majority of retail forex brokers follow some sort of market making model. It is still very dominant and allows them the pure flexibility of doing any number of different things, which most people with half an ounce of common sense would consider unethical. Delaying execution, utilizing trading restrictions and popping spreads around stop losses so they are executed are just a few examples of some of the horrendous things these firms are capable of doing. And yes, some of the largest shops will do this. Plainly speaking, it is difficult for some regulatory agencies to detect some of this behavior, such as “spread popping”. If you want to avoid any of these things then simply stay away from this model. Regulatory agencies will only catch so much, but they are getting better at doing so.
Much of the above described activity is simply illegal in most jurisdictions, but that has not stopped many brokers from doing it. Those who have been caught are usually done by a well-organized regulatory entity, such as the NFA.
The much, much greater majority of brokers who find themselves in trouble do so because they are playing around with the market making model. Granted, not all market makers are “bad”, but the possibility for them to be is much, much greater than those following an A-Model.
Retail traders are becoming more savvy to these tactics, of course, and opting against these types of subpar trading conditions. So it is no surprise that a slew of other services are offered by brokers in order to entice newer traders to come on board.
DMA: Direct Market Access. Just as the name implies. You, the trader, has direct access to the interbank market. This entails you accepting, or if allowed, making a price with any number of counterparties available on the platform. The term is commonly used in conjunction with an ECN model.
STP Straight Through Processing. – Another term that gets tossed around quite a bit, which gives some indication, but not all, as to what model your broker is following. Straight through processing implies that your trade is passed through the broker, direct to their liquidity provider(s). The most common way of distinguishing an STP broker from an ECN broker is that an STP broker passes your trade directly to banks in which they have a relationship. An ECN broker will pass your trades to a true ECN, where you have complete access to a range of participants.
The broker will inflate the spread in order to profit from your transaction turnover and “make up” for the lack of B-Model being employed on your account. They want you to be profitable so that you continue to rack in commissions, but make it extremely hard to do with such high costs. Some of these markups are extraordinary, however, and the concept is laughable. Essentially you are being charged for the “courtesy” of the broker not messing with your trade execution.
Some STP’s are certainly more reasonable and offer better markups, or lack thereof. To my knowledge not one “reasonable” STP exists here in the United States that will offer fair costs and pure execution without restrictions, such as severely inflating spreads, etc. STP is still limited, however, in the sense that someone essentially has an upper advantage over you, to state it in general terms.
No Dealing Desk: An “overused” term that gives vague indication as to what the broker is actually doing with your trade, though generally refers to some form of STP. This is thought to imply that the broker is directly following a pass through system, though manipulation with conditions is certainly still possible.
Signs of a Market Maker or “Fake” or “Quasi” ECN aka STP
- Requotes on any trade. On a true ECN you get a price and take it or leave it.
- Prohibit any type of trading such as “scalping”.
- Asymmetrical slippage. This an illegal practice here in the US (and abroad I am sure) where the broker does not give you the benefit of the doubt should slippage be in your favor, yet make you suffer the loss if slippage is against the intended direction of your trade.
- Hide depth of book. Trade volumes should be visible across the platform.
- Set freeze levels. Freeze levels are minimum distances for stop loss or take profit orders.
This list is primarily geared towards market makers, many of which have conducted themselves in manners which, well, let’s say I highly disapprove of from an ethical standpoint.
“Fake” ECN’s or other forms of STP I do not consider always bad, but I don’t consider them the best, either. For most retail traders, they will do the job yet be aware that you are still likely to face restrictions not seen by those trading on a true ECN platform.
Some people prefer STP over ECNs in terms of execution speed, as I have heard it is claimed to be better. The bottom line is that when you are getting this technical you have entered a world where much of our discussion here becomes irrelevant.
As previously stated, most brokers offer some form of direct market access, yet they require you to be a “Pro” client, or whatever naming convention they use, in order to get this kind of access. This typically refers to large deposits or large turnover. As this market continues to evolve, more and more brokers are popping up and filling the void in order to grant such access at a very basic level.
The problem tends to arise with white label solutions, usually delivered by firms like Integral or Currenex, which can demand higher requirements. Others have brokered deals where the aggregate volume gets routed in order to compensate. Currenex Standard and Viking, and platforms like it, are being offered to retail clients with large deposits through many brokers.
LMAX is a prime example of a new kind of ECN designed to squash the old retail market making model. For anyone based outside of the US, accounts can be funded with as little as $1,000 through an introducing broker.
For the rest, an ECN is an ECN. Institutional or retail, you still need someone to hold your money and do your paperwork/settlement. That’s where your broker steps in, and things tend to get a little murky. Most brokers will charge a simple commission based on some form of tiered volume schedule in order to make money on your trades. Others like to fiddle with the volume. Personally, I don’t mind paying a commission for the lack of conflict of interest.
As usual, US clients have somewhat of an anvil tied around their necks due to the indirect effects of recent regulatory actions. Like the largest banks after the financial crisis, most of the smaller FCMs ended up consolidating with certain houses in order to meet a number of regulatory requirements. Additionally, costs vs. profit became exceedingly slim, forcing many UK-based firms to hand over their U.S. books to these other U.S.-based brokers with already larger ones.
Unfortunately, most of these larger brokers historically utilize unwavering B-Models unless you walk in the door with $10,000-$20,000 and access a “Pro” account, or face an uphill battle against inflated spreads on an STP model. As a result, setting up a penny practice account on an institutional grade execution platform is far from the easiest bet. If you are able to do this, then no questions asked, pay the commission and get the dirt cheap spread. Also, I recommend going with a company that has a leg in the institutional world (the real one, not wannabes) as opposed to what is stated on their website.
Transaction cost comes first. Save your money. Those little, incremental amounts add up substantially over time. Experienced traders know this, newer traders see it more of a non-issue. It is a HUGE issue.Do your homework. Sites like http://www.fxintel.com/ can help steer you in the right direction. And no, demo spreads can be very different from live spreads.
Do a due diligence/background check to ensure that no massive red flags have risen in history. For clients based in the US, http://www.nfa.futures.org/basicnet/ is the place to go. Australia, this way please: http://www.asic.gov.au/asic/asic.nsf/byheadline/Introduction+to+ASIC+Connect?openDocument and the UK, right here: https://www.fsa.gov.uk/register/home.do . For firms based in any other countries, I simply don’t have enough experience dealing, but I can say that these 3 have some of the higher regulatory standards in the world.
For the NFA, simply type in the name of the firm, hit “GO”, and look in the “Regulatory Actions” box. Have fun.
Also, if you can’t find dirt on a firm in one country, they might be registered in another as well. Stay clean. That’s my best advice.
Find out what kind of model your broker is using. Again, many larger brokers now offer A-Models in addition to their traditional B-Models. You want to get as close to the market as possible and with as little interference necessary, and at a reasonable cost. If they refuse to tell you, then 99% of time they are B-Model. An A-Model broker would have zero problem disclosing information about what happens to your trades.
Most people slip when they call a broker, ask if they trade against client positions, and are given the ring-a-round to the no dealing desk “model” where they end up being eaten alive by either poor technology or inflated costs. So be careful. Just because a regulatory agency is watching your broker does not mean they are up to no good. Just a couple weeks ago, the FSA went after one of the largest retail brokers in the world because of asymmetrical price slippage. This broker has been in business for years and yet such conduct is still prevalent. So do your homework. The landscape is changing and people are becoming wiser. There is no need to settle for less.
Other Final Considerations
Stay away from any form of fixed spreads. These simply don’t help. The broker is either a market maker or using an STP that will work against you when you need it the most.
No platform is perfect, whether they be a market maker, STP or ECN. Again, research.
Find the biggest pool of liquidity you can. A whole world opens up to you. Want to trade spikes? No problem. Want a fill in a few milliseconds? No problem. More liquidity typically translates to lower spreads and while the flexibility might not be needed today, it likely will in the long run.
If you intend on investing anything greater than 10-20k, your options open up substantially. Use them.
Be smart. Choosing a proper broker should not be a rush decision or one based on tools, signals, or any other type of vanity that is essentially the FX world’s version of a free buffet at a casino. It’s your money. Keep it safe.
Please post any comments below but all I ask is that you take it easy with the names. This article is meant to inform, not bash others. Thank you.
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Category: Trading Strategy