Business Models of Currency Trading Brokers
Most online forex brokers act as a market maker for your trade, which means that the broker is on the other side of every trade – when you buy, you buy from the broker; When you sell, you are selling to the broker. Usually, brokerage firms from market makers provide liquidity and consistent execution, allowing you to trade the amount you want at all times.
Market makers usually offer either fixed spreads or floating spreads:
1. Fixed spreads remain constant all the time, no matter what is happening in the market. Since the broker has to take on the additional market risk of pricing a fixed spread throughout the day (including in thinly traded or volatile markets, when interbank spreads tend to widen), fixed spreads tend to be slightly wider than variable spreads.
2. Variable spreads that fluctuate according to market interest. In highly liquid periods – such as the overlap between the London and New York sessions – the variable spreads will be the narrowest (up to 1 or 2 pips in EUR/USD and other heavily traded currency pairs). On slower periods (such as 6 PM ET [Eastern Time], when New York is closed and Asia is not fully online), the spreads tend to be wider.
Whether you should choose fixed spreads or variable spreads largely depends on your trading style. If you are a short term trader and are looking to make just a few pips on each trade, you will probably be better off with variable spreads, which are tight in liquid markets. If you are trading around the news, fixed spreads will allow you to avoid the inevitable widening of spreads (sometimes by a large amount) that usually occurs around the primary announcements.
Another model that is being promoted by a few brokers is the loose office model. The term is intended to distinguish between these market-making brokers and brokers—who have trading desks or trading desks—that manage the company’s exposure to the market.
Non-desk brokers will tell you that the price you are trading comes directly from the interbank market and that they route all your trades directly to the banks. But if this is the case, why is even a non-trading desk broker needed?
Online forex brokers appeared precisely because the large institutional players did not have the ability to process tens of thousands of individual trades.
More importantly, if the no-dealing desk is commission-free and funnels every deal to a bank, how does it make any money? A legitimate desk firm will offer very tight bid/offer spreads and commissions for each trade.
Commission-free forex brokers are compensated by the spread between bid and offer. If you buy from a broker at a price of 15, for example, and another trader simultaneously sells the broker at a price of 14, 13 or 12, the broker makes a profit on the spread.
The reality with the no-desk approach is that these trading platforms may display wider prices and sharper price gaps during periods of volatility, while claiming no control over the displayed prices. Be careful about promises of dealing in the interbank market – if it sounds too good to be true, it usually is.