A Forex Broker (foreign exchange broker) is a financial services company that allows retail traders to trade the Forex market to buy and sell currency pairs, typically with the use of leverage, by holding your money in their account.
Generally, there are three specific types of Forex brokers catering to the retail Forex market. Not all Forex brokers are created equal so we will take a look at some of the various types of Forex brokers and how they make money. This will help give you an understanding of what is really going on behind the scenes when you are placing trades in the Forex Market.
After learning about how Forex brokers make their money you might think that certain types of brokers take on a lot of risks but the reality is that most Forex brokers will be a combination of the following types.
Types of Forex Brokers
Market Makers
The term market making means just that; these brokers make a market. Market-making brokers create their own Forex market environment for traders to trade within using the pricing information from their liquidity providers.
The advantage of doing this is that they can take larger contracts and cut them into smaller pieces so that less capitalized traders can buy and sell in a quantity that is best suited for the size of their trading account. The downside for the retail trader is that you are never really trading the true market. Also, the costs are generally higher because of the greater degree of involvement that those brokers have when creating this market for you to trade in.
Market makers can also engage in a practice known as B-Booking which we will look at more later in this article. Not many retail traders are aware of how their trades are booked or cleared by their broker. Many traders might be surprised to learn that the broker is counting on the trader to lose money so that the broker can make money.
The statistics are overwhelmingly against retail traders generating consistent profits over time. Market makers use these statistics to their own benefit and make a lot of money on the back of retail traders’ losses. They know that traders who deposit small sums of money have a difficult chance of profiting over the long run and as such they simply let the retail client lose their money to their B-Book rather than hedging the client trades in the open market.
You may think this is unfair or scandalous but it’s actually smart from a business standpoint. The broker creates a fair pricing environment for you to trade within and it’s up to you to make money in that environment. As long as the broker gives the trader fair pricing and allows for withdrawals then it doesn't really matter how they make money. However, the statistics are that 95% of retail traders depositing less than $5,000 will eventually close their accounts with a loss, and many traders lose the majority of their deposits.
There are many reasons that undercapitalized traders tend to lose money. For example, taking excessive risks with leverage to try and make more money faster, lack of experience and proper knowledge, and the idea that getting rich is easy with enough leverage.
This practice of B-booking can be a good or a bad thing depending on who you are talking to. No one wants a broker to make money if they have just taken a loss. However, if someone is looking to place a large order that may have the potential to move the market then a market-making broker may allow this trader to make the trade without penalty. If you get to a point where your trades are so large that you are moving the market then maybe spreading some of your risk across a market-making broker is not a bad idea. They always have the option of passing your trades along to the market or hedging out your trades.
ECN Brokers
ECN stands for Electronic Communications Network. These brokers work by automatically matching all the buyers and sellers together within their own network. The traders being matched can be anyone from banks to individual retail traders. The volumes of orders are aggregated together and trade executions happen within milliseconds. If there is not enough liquidity to match orders at any point then the ECN broker will then act as an STP broker and pass the additional risk on to the Interbank market. We will talk about STP brokers in a moment.
ECN brokers make their money by matching buyers and sellers quickly at the best possible price. For this matchmaking, they take a very small commission or in the form of marking up the spread slightly from the quotes they receive from their liquidity provider. These brokers are generally considered to be more transparent because all they do is match orders. They do not make a market or B-Book which many traders prefer.
STP Brokers
STP stands for Straight-Through Processing and many people make the mistake of using STP interchangeably with ECN brokers. This is a mistake because all an STP broker does is sends their client order flow to another broker that is typically a market-making broker or a prime broker that has access to the Interbank market. This prime broker might decide tp market-make the order flow on behalf of the STP broker, but you likely will never know. If the prime broker did decide to market-make on behalf of the STP broker they would normally share in the revenue generated from the market-making and client losses with the STP broker.
Basically, an STP broker passes all the risk associated with market-making to another broker but still gets to participate in the profits generated on the back of client losses. However, just because they pass the market making risks off to another broker, this does not mean that the STP broker is free from risk. STP brokers will typically have counterparty risk with the prime broker that is managing the market making of their client order flow because the market maker could lose money or go out of business. This would obviously be really bad news for STP brokers. So STP brokers have risks to their businesses just like any other type of broker.
Broker Type Example
In reality, larger well-known retail brokers are using a combination of market making, ECN, and STP broking to conduct their business. It would be very difficult for anyone not on the inside to determine exactly what the individual broker is up to regardless of what they advertise. Just because a broker advertises that they have interbank liquidity does not actually mean that they do.
As an example of the trickery that brokers use to dupe clients into believing they are something that they are not is that of FXCM. If you have been around the Forex market for any length of time then you are sure to have heard of FXCM. FXCM claimed and advertised that they were a true STP broker and that they have no dealing desk or do any market-making. This is true in a sense, but what they actually did is STP all of their client trades to a different liquidity provider. This sounds fine at first glance but it turns out that this liquidity provider is a pure B-Booking broker and that FXCM actually owns this other company. The profits that this company generated made up the vast majority of FXCM’s earnings at the time of this writing. That is just a cheeky way of making money on the back of traders’ losses but trying to look like they don’t to the retail public. So they are not exactly telling the truth when they say they are a true STP broker or that they have no dealing desk.
This story was true as of the time of this writing but could obviously change over time because FXCM may decide to change how they do business. However, you can be sure that many other brokers are doing the exact same thing because it just makes so much money to let the retail traders lose their money in the Forex market.
How Forex Brokers Make Money
There are generally 3 ways in which Forex brokers book or clear client trades:
A-Book
This is where a broker passes the client trade flow through to the Interbank market or another currency dealer who has access to the Interbank market. The profit is made from marking up the raw spread, by adding a commission to each trade, or a combination of both.
B-Book
This is where the broker doesn’t send the client trade flow to the Interbank market. Instead, they choose to manage the client trades through their own internal market-making efforts. This would normally involve making money on the back of client losses by using the individual client profile and trading activity history. If they know a particular client loses all the time then they will not hedge them.
C-Book
If a broker is lucky enough to have a client that has a proven track record and a high probability of success based on certain risk metrics then the broker may feel inclined to trade with the successful client. If you have great traders in your network then why not make some extra money by following along with the client’s trades? This is one of the benefits that a broker enjoys because they get to see all of the client order flow and can choose to do whatever they want with that information in the backend. This is of course, as long as they are being fair in the front-end platform to the client.
This is quite literally the opposite of B-Booking but it’s still a market-making effort and does involve a level of risk as well because those profitable traders could go on losing streaks.
Market Making Risk
With both B and C booking, there is a potential for the market maker to lose money. To combat this brokers have come up with extremely sophisticated risk management systems so that they don’t blow up overnight if something goes wrong. It’s possible for retail clients to go on a long winning streak on aggregate which would make B-Booking unprofitable. It’s also possible for C-Book clients to have losing streaks as well so there is no certainty that the broker will make money. This is why the management by the market maker is so tightly controlled and the methods that they use are a closely guarded secret from the public.
Many traders prefer to trade through an ECN broker because the pricing and execution are considered the most transparent. However, their main goal is to execute our trades in a timely and cost-effective manner in an environment that is stable and secure. In this case, picking a broker that has a license with a strong regulator may be the best option. No matter what the broker does with your trades, as long as the regulation is strong then you should be able to get your money whenever you need it.