Retail forex industry is booming right now. Many people who got their fingers burnt in the recent stock market crash are heading towards the forex markets. Many forex brokers tend to entice new trades by offering high leveraged margin accounts. Leverage as high as 400:1 is offered to new traders who often even don’t know how to trade forex. The result, these forex brokers make a lot of money at the expense of new and inexperienced traders. Anyone can open a forex trading account with a retail forex broker and trade currencies with little money upfront. This makes forex trading very easy for the retail trader.
Market making is what most of the forex brokers are supposed to do. Market makers set the bid and the ask prices themselves. There are basically two types of forex brokers: 1) Market Makers and 2) Electronic Communications Networks (ECNs).
Forex dealers work for the retail forex brokers. If the interbank market is the wholesale and the forex brokers are the middlemen then the dealers are the salesmen. Market making is a lucrative business for banks and brokers and forms the backbone of market liquidity. ECNs consolidate the various bids and ask prices from the different market makers and other participants connected to their platforms and display the best available prices.
In contrast to other forex participants, market makers are only non customers in the market and are there only to provide service to their clients. Market makers are essentially providing liquidity and inviting other qualified parties like banks, hedge funds, corporations and retail investors to deal with them by quoting the bid and ask prices on the screens of electronic brokering platforms or through telephone calls.
Banks are the only one with deep enough pockets to handle the biggest of the forex transactions like the M&A deals. But since not everyone can deal directly with the bank, specialist brokerage houses have long existed to make market for their corporate client base. Most market makers access the Electronic Brokering Platforms like the EBS and the Reuters for pricing. Some market makers establish credit lines with banks that trade on the interbank market. Market makers must always be prepared to buy or sell from other market participants.
Retail forex is not interbank. The prices are not interbank, the size is not interbank, the counterparty is not interbank and the rules are also not interbank. The generous bid/ask spreads paid by the retail trades is the bounty shared by your forex broker, the manager of your account and some large banks. The bid/ask spread is the difference between the price at which the market maker will buy (bid) and the price at which the market maker will sell at (ask) from the customer interested in foreign exchange. Market makers make profit from the difference between the bid/ask spread.
Forex brokers are at liberty to quote their own bid/ask spreads due to the unregulated and decentralized nature of the forex market. Bid/ask spreads of the actively traded currency pairs are usually kept quite narrow like 1-4 pips during the period of high liquidity in which there is a great deal of trading activity.
Forex brokers can widen the bid/ask spread and make the excuse of slippage. Bid/ask spread may widen sometime by a huge margin when the market is quiet with very little trading going on for example prior to New York close on Fridays or during the news releases. Market makers widen the spread when the market activity is low in order to protect themselves against carrying additional risks.
Forex brokers sometimes also trade against their clients. It is possible for the forex brokers to manipulate prices so as to run their client’s stops or not let the client’s trades reach their profit target levels. ECNs are highly popular in stock trading as well as futures trading. ECNs are electronic trading platforms that match the buy and sell orders automatically at the specific prices.
In fact in an ECN, there is a better price discovery as compared to forex brokers who can quote their own prices. In an ECN, the order is routed to the best available bid or ask price for execution in the system. An ECN broker gets its currency pricing from several liquidity providers such as banks, market makers or other traders connected to the system.
ECN brokers are better for you as compared to most of the retail forex brokers. Spreads are often overlooked by the individual traders as the price you pay to play. Tighter spreads means lower trading costs for you as a trader. You can usually get tighter spreads on many currency pairs due to the large liquidity pool available with the ECNs. However, ECN brokers usually charge a small commission. Risk of trade manipulation is also minimized when using a good ECN broker as compared to the brokers that operate dealing desks.
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