Online brokers may be categorized into "Market Makers", "ECN" or Electronics Communication Network Brokers, or "NDD" or No Dealing Desk Brokers. For a neophyte trader, it will be hard to distinguish one from the other. Besides, very few of these online brokers describe their services in detail and more often than not, they make themselves appear as if they are all market makers.
What is a market maker?
A market maker provides pricing and liquidity for a particular currency pair and stands ready to buy or sell that currency at the quoted price. The market maker has the volume and the liquidity to take the opposite side of your trade. He has the option of either holding that position or partially or fully offsetting it with other market participants, managing their aggregate exposure to their clients.
Each market maker has a "dealing desk," which is the traditional method that most banks and financial institutions use. Market makers provide two-way pricing to customers throughout the day. These prices sometimes are quoted on a "fixed" basis, meaning that they do not move throughout the day, while other firms use a dynamic spread system, which means the prices change as the liquidity in certain pairs change. The market maker interacts with other market makers banks to manage their global FX positions/risk. Each market maker offers a slightly different price in a particular currency pair based on their global FX book. Banks, investments banks, broker/dealers, and FCMs make up the majority of this category. Market makers are compensated by their ability to manage their global FX risk. This may include spread revenue, netting revenue, and revenue on swaps and conversions of residual profits or losses.
A market maker may choose to keep the trader's position without offsetting it in the market. This will mean that the trader's profit is the market maker's loss and vice versa, and may lead to a possible conflict of interest between the trader and his market maker. A market maker earns their commission from the spread between the bid and offer price and because of this, the trader may at times be at the mercy of the market maker who has the power to increase the spread to minimize his own loss or shave off profits from the traders' position.
What is an NDD broker?
A no-dealing desk broker does not have a dealing desk but instead uses external liquidity providers to provide pricing and liquidity for its clients. The liquidity providers may include banks and other brokers they have networked with. Usually, they have their own proprietary trading platforms which connect to participating banks and brokers (liquidity providers) in their own network. The liquidity providers send in competing bids and offers into the platform, resulting in the best bid and offer being displayed to the client. A no-dealing desk broker may increase the spread to earn its commission.
An NDD broker acts as a conduit between a customer and a market maker. The broker sends the customer's order to another party to be executed by the dealing desk of the market maker. The spreads that the customer receives are dependant on the market maker or dealer that the broker routes the customer's transactions through, and either a fixed or dynamic system can be used. Brokers generally charge fees for this service and/or are compensated by the market maker for the transactions that they route to the market maker/dealing desk.
What is an ECN broker?
A Forex ECN broker does not have a dealing desk but instead provides a subscription to a trading platform where multiple market makers, banks and traders can enter in competing bids and offers into the platform either inside or outside the spread, allowing traders to be market makers and have their trades filled by multiple liquidity providers. A trader might have their buy order filled by liquidity provider "A", and close the same order against liquidity provider "B", or have their trade matched internally by the bid or offer of another trader. The best bid and offer is displayed to the trader along with the market book depth and combined available volume at each price. The ECN broker has a wider base of marketplace participants providing pricing which results to smaller spreads. An ECN earns by charging a small fee for each transaction.
The ECN is not responsible for execution, only the transmission of the order to the dealing desk from which the price was taken. In this system, spreads are determined by the difference between the best bid and the best offer at a particular point in time on the ECN. In this model, the ECN is compensated by fees charged to the customer plus a "kick-back" or "rebate" from the dealing desk based on the amount of volume or order flow that it is given from the ECN.
Offhand, it will really be hard to distinguish which broker is of what type since practically everyone is electronically linked with each other one way or the other. A market maker may have one or two clients who are NDD brokers who in turn provide services to other ECN brokers.
What we need to distinguish is who is a legitimate broker and who is not? On this matter, it is always important to know if the broker you are dealing with is regulated by an acceptable regulatory body. By an acceptable regulatory body, it must be one which is internationally recognized and not just a made up regulatory organization from some obscure country.
As part of Samurai Daddy's commitment to help weed out the scammers among the lot of online brokers, this blog will be regularly featuring its choice of online forex brokers.
Samurai Daddy's First Five Choice of Online Brokers