Brokers: can’t live with them, can’t live without them. Ultimately, they are a financial services corporation providing access for traders to speculate in the currencies market. They are essentially the middleman between the client and the interbank, where digital forex transactions occur daily.
An excellent broker has licenses with some of the industry’s leading regulators like the FCA (Financial Conduct Authority), CySEC (Cyprus Securities and Exchange Commission), etc.
Regulation ensures, for the most part, a broker acts ethically to their clients and aligns with periodic reporting standards.
Well before internet usage exploded, the forex market was primarily reserved for wealthy institutional traders where few retail brokers existed. This exclusion created a high barrier to entry because one needed a special relationship with the banks.
What brokers have allowed is access and other services to trading currencies with significantly smaller capital than if one was to access the interbank market directly.
Although their role may seem under-valued, brokers play a critical role in making forex speculation as efficient as possible.
The main roles of a forex broker
The roles of a forex broker are multi-faceted but generally include the following.
The chief reason why millions of forex transactions can occur within seconds is due to the inexhaustible liquidity that exists, which is why forex boasts the largest trading volume of all markets.
In simple terms, liquidity refers to the rate at which traders can buy and sell currencies without affecting the price in any way. Since forex is always quoted in pairs, every time someone buys, a broker must ensure a seller of that market (and vice versa).
For example, when buying USD/JPY, technically, there needs to be a party in the market willing to sell US dollars to the trader. All this exchange activity is possible because a broker must connect to as many liquidity providers as possible, becoming a price aggregator of sorts.
Alternatively, many brokers themselves are market makers since they have millions worth of currencies to buy and sell at a moment’s notice rather than always relying on the banks.
Running the trading platforms
By trading platforms, we refer not only to the front-facing software clients are using but also to the back-end.
On the front end, a broker must maintain any licenses to the program developers, ensure the software connects to several global servers with minimal latency, establish trade execution as quickly as possible, etc. With the back end, similar processes are also running.
Facilitating deposits and withdrawals
A broker is supposed to ensure they meet the clearing times for all the various deposits they’ve offered to their clients. Most brokers should have some form of the insurance scheme in the rare case of liquidation and keep customers’ money in segregated accounts separate from their own.
Perhaps one of the essential features of any broker is processing withdrawals without excuses regardless of how large they are. Assuming a trader has all their registration complete and has not breached any of their Ts & Cs, the broker will process the withdrawal to the original funding methods.
If the withdrawal exceeds the total deposited through these channels, then it usually goes via bank wire. Overall, a good broker should process this within 24 hours, and clients should expect clearing in about two to three business days afterward.
The two main brokerage models
The general premise with forex brokers is they fall in two strands regarding how they deal with trading orders: straight-through processing (STP) or dealing desk (also referred to as being a ‘market maker,’ although banks themselves are effectively performing the same role).
STP merely means the broker sends orders ‘straight through’ to the interbank without intervention. On the other hand, a dealing desk broker creates its own market by clearing its client’s orders internally.
The perceptions with a broker’s execution system
Most assume the STP model is more transparent since the pricing accurately reflects the real forex market of the banks. Although there is some truth to this statement, it doesn’t paint the entire picture.
Dealing desks are typically frowned upon because of the perceived conflict of interest (when the clients make a profit, it comes directly from their broker’s pocket, and vice versa.)
The type of execution used by forex brokers is often a contentious issue because it’s almost impossible to verify conclusively. Many of them may likely be utilizing both on some occasions.
Forex is an entirely decentralized or over-the-counter financial security where there is no central exchange like in the stock market. Every forex broker is not offering the exact same prices to traders (although there is minimal variance) because of this structure.
So, although many brokers will take pride in marketing themselves as STP or Direct Market Access, it may not always be the case. A better approach to judging a broker’s authenticity is via their customer service, international presence, trading conditions, and regulation.
How do brokers make money?
The business model of all brokers relies on small fees compounding themselves the greater the client base becomes. Primarily, these companies make money on a ‘mark-up’ they put on every pair.
The broker’s fundamental job is to buy and sell currencies from the interbank market on behalf of their clients. The difference between the bid (buying) and ask (selling) prices is the spread.
Some brokers may also add their own commissions above this. While it is not illegal, it’s generally not favorable for traders unless the broker offers fixed spreads that are usually lower than variable ones for the convenience of having more consistent fees.
Another way brokers are compensated is through swaps incurred by traders for having positions overnight. A swap is simply interest that one pays or receives depending on the interest rate differentials of the two currencies they are holding.
Like any business, brokers have increased their product lines and offer other services like VPS (virtual private servers), signals, etc., that all provide additional revenue.
This article provides the main things to know about forex brokers, helpful information, especially for new traders.
Ultimately, although most brokers are not immune from negative reviews, like any service provider, they are a necessary bridge between clients and the forex markets.