By Grace Cheng
As you may already know, foreign exchange (Forex/FX) is an unregulated market that is not traded on an exchange, which means that prices you see and get from one broker could vary from those of another broker. There are mainly two types of brokers. One type is an ECN (Electronic Communications Network) and another a Market-Maker.
Market-makers "make" or set the prices on their systems based on what they think is best for themselves as the counter-party. This is because every time you sell, they must buy, and when you buy, they must sell to you. This is why they can give you a fixed spread since they are setting both the bid and the ask price. Many of them will then try to "hedge" or "cover" your order by passing it on to someone else; however, some may decide to hold your order, and thus trade against you. This can result in a conflict of interest between the retail trader (you) and the market-maker.
ECNs, on the other hand, pass on prices from several banks and market-makers, as well as from the other traders in the ECN, and display the best bid/ask prices based on these input. This is why sometimes you can get no spread on ECNs, especially in very liquid currency pairs. How do ECNs make money then? They do so by charging you a fixed commission for each transaction.
Here are some of the pros and cons of ECNs and market-makers:
- Usually give free charting software and news feed
- Prices can be "smoother" and less volatile than ECN prices (this can be a con if you are scalping or trading very short term)
- Often have a more user-friendly trading and analysis interface
- They may trade against you. In that case, there will be a conflict of interest between you and them
- The price they offer you may be worse than what you could get on an ECN
- It is possible that they may trigger stops or not let your trade reach your profit target levels by manipulating prices
- During news, there will usually be a large amount of slippage; their systems may also lock up or not allow order placing during times of high volatility
- Many of them discourage scalping and put scalpers on "manual execution" which means their orders may not get filled at the price they want
Examples of some market-makers:
- You can usually get better bid/ask prices since they come from several sources
- Variable spreads between bid and ask may give no spread or tiny spreads at times
- If they are a true ECN, they will not be trading against you but will pass on your orders to a bank or another customer on the other end of the transaction.
- You will be able to offer a price between the bid and ask with a chance of it getting filled
- If they support Stop-Limit orders, you can prevent slippage during news by making sure that your order either gets filled at the price you want or not at all
- Prices may be more volatile which will be better for scalping
- Many do not offer integrated charting
- Many do not offer integrated news
- Many of the trading platforms are less user-friendly
- Because of variable spreads (between bid and ask,) it may be more difficult to calculate stop loss and profit target in pips beforehand.
Examples of some ECNs:
It is important that you carefully look into the pros and cons of each broker before choosing the one which best suits your needs. You may also wish to have several broker accounts to mitigate the risks, and so that you can compare bid/ask prices and trade on the broker with the best prices for the direction you wish to trade. Because of the unregulated nature of forex, US brokers are not required to keep your money in an untouchable account that only you can have access to if they were to collapse. As customers of Refco (was one of the world's largest brokers) found out, their unprotected accounts made them unsecured creditors, and thus are less likely to get their money back than those who had given secured loans to Refco. What this means is that the customers' money was used to pay other creditors.
The moral of the story is this:
Deposit as little money with your broker as you need for trading, and withdraw your profits when they exceed a certain amount. Keep the rest of your trading capital in your own bank accounts which are probably government-insured.
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Risk Disclosure: Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.