Why market-making can corrupt your broker so easily

Whenever you trade your broker has a Hamletian dilemma: to hedge or not to hedge. If they decide to hedge, they take the same exposure towards their prime broker as you did towards your broker: if you buy they buy too, if you sell they sell too. From risk point of view, they are just a risk-free intermediary between you and their prime broker.

If they do this, they are considered as an STP provider and a clean and respected member of the forex industry.

If they choose not to hedge, it means whenever you trade they take a bet too: your loss is their win and if you make money, they are the ones who lose that amount. They are not risk-free anymore, they act pretty much like you or any other gambler in the forex casino. In this case, they follow a “market-maker” or “dealing desk” business model and they are one of the most suspicious species of the world.

For good reasons. If they are market-maker, they play a 0-sum game with you. According to a not-that-recent study, 70% of traders lose on average, so their chances to win are already better than what a Las Vegas casino could ever dream about. That should be enough for a decent profit, in case they can spot and alienate profitable traders in time. But they also got a broad arsenal of tools to further “enhance” their chances. Let’s take a look at just the major ones:

• Requote: If they see an incoming client order closing a too profitable position, they can requote the bid/ask so the trade will be filled at a less favorable price. They can always blame sudden and unlucky market movements.
• Stop-hunting: They  know well where their clients’ stop-losses are, right? When the night comes, nobody’s looking and spreads are broader anyway, these stops can get within arm’s reach. Since stop-loss activations usually close loss-making positions, touching these levels causes an instant flow of monies from client accounts to broker’s account. It really tries your broker not to harvest these low-hanging fruits. Of course they can blame sudden and unlucky market movements, yet again.
• Slippage:  Filling a market order is rather a subjective art, not exact science. They can always slip-a-bip here and there, nobody will tell it was them or their price feed. If a client still complains about it, I hope you know by now what will be blamed.
• Execution review/cancellation: No matter which competitor’s Terms&Condition they copied in the beginning, there must be a clause stating their right to modify or cancel trade executions at any time at their own discretion. It’s more for the lames, since it is always visible, they have to inform the clients etc. They can take client complaint zunami for granted. That’s the reason why this weapon is used as last resort.

As you might realize, requote, stop-hunting and slippage are hard to detect and even harder to prove since traders usually don’t have trading accounts with several brokers to compare their price feeds and trade executions. That’s why we started TradeProofer.com, a self-defense community for forex traders. We benchmark traders’ trade executions against other members’ price feed and spot price/quote discrepancies. Brokers hate it.

As you see, market-making is not inherently evil, but as a market-maker you got just too many easy ways to make profit by harming your clients. As cops say, 4 factors influence criminal acts’ probability: motivation, mean, opportunity and chance to get off. All these factors work against an honest market-maker.

Disclaimers:

The frontier between market-making and STP is not that sharp. It’s very common to follow a market-making business model in general, but to put professional (ie: profit-making)  traders into a special STP bucket and hedge their trades. I am also not convinced that all STP brokers are really that clean STPs.

I didn’t want to dwell on the legal side for long since it wouldn’t add to the story, but in case of STP/ECN, from legal point of view, your broker might not even hedge and “stand between” you and the prime broker, they might just facilitate trade execution between you and their prime broker. It’s really up to their fine print.

Market-making can have good effects too. I have heard a story from credible source when a client pushed the big red “close all @market” button accidentally, the dealing desk spotted the unusual activity, called the client instantly and make him revert the order over phone. It’s not something an STP broker could provide.