A broker-dealer firm or Market Maker that accepts the risk of holding a certain number of investments or trades in a particular security or currency, in order to enable trading in that security or currency. Each market maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of “lots”. Once an order is received, the market maker immediately sells/Buys from its own inventory or seeks an offsetting order in the market to Hedge its Exposure to the market.
There are two main types of brokers: Dealing Desks (DD) and No Dealing Desks. Dealing Desk (NDD) brokers are also called Market Makers, while No Dealing Desks can be further subdivided into Straight Through Processing (STP) and Electronic Communication Network + Straight Through Processing (ECN+STP). It is important to remember that Broker/Market makers can be combinations of any of these catagories.
Dealing Desk Broker (Market Maker MM)
Forex brokers that operate through Dealing Desk (DD) brokers make money through spreads and by filling the opposite side of the positions taken by their clients (for every BID there has to be an ASK, to complete the order. Also called market makers, Dealing Desk brokers actually create a market and artificial Forex exchange rates for their clients. It may appear that there is a conflict of interest between the client and MM however, there really isn’t. Imagine you were trading fiscal stocks if there was nobody to buy/sell the stocks no transaction could take place. Market makers provide both a sell and buy quote, which implies that they are indifferent to the decision of the trader, they will simply fill the opposite side of the trade to allow the transaction to take place.
Since market makers control prices, it also follows that there is very little risk for them to set FIXED spreads. Also, clients of dealing desk brokers do not see the True interbank market rates. Don’t be too concerned though, the competition among brokers is very high so the rates offered by Dealing Desks brokers are almost identical, to the interbank rate.
Let’s say you place a buy order for EUR/USD for 100,000 units (1Lot) with your Dealing Desk broker. To complete the order, your broker will first try to find a matching sell order from its other clients, (clients that have done exactly the opposite to you, sell 1Lot 100,000 units) if they are unable to do this, they will pass your trades on to its liquidity provider, i.e. a Bank or financial Institution that readily buys or sells a financial asset. By doing this, they minimize their exposure, as they earn from the spread without taking the opposite side of your trade.
The company will Hedge on aggregate, meaning they will counter act the buy orders with sell orders if there is any exposure remaining they can choose to pass the exposure to the liquidity provider OR if the dealing desk decides not to do this, they can maximize their profits by doing nothing, if the market moves in the right direction.
In the event that there are no matching orders, they will have to take the opposite side of your trade and manage the exposure.
No Dealing Desk (NDD) Broker
A No Dealing Desk (NDD) brokers do NOT pass their clients’ orders through a Dealing Desk. This means that they do not Fill the other side of their clients’ trade, instead they act as a middleman by simply linking the Buy & Sell parties together.
NDDs can either charge a very small commission for trading, but usually they simply increase the spread “slightly”.
No Dealing Desk brokers can either be Straight Through Processing (STP) or (STP+ECN).
Some brokers ‘claim” that they are true Electronic Communications Networks (ECN) brokers, but in reality, they merely have a Straight Through Processing system.
Forex brokers that have an STP system, route the orders of their clients directly to their liquidity providers, who have access to the interbank market. NDD, STP brokers usually have more than one liquidity provider, with each provider quoting its own bid and ask price.
Let’s say your NDD STP broker has three different liquidity providers. In their system, they will see three different pairs of bid and ask quotes from each provider.
Their system then arranges these bid and ask quotes from best to worst. In this case, the best price in the bid side is 1.5000 (you want to sell high) and the best price on the ask side is 1.5001 (you want to buy low). The bid/ask is now 1.5000/1.5001.
This will NOT be the quote that you will see on your trading platform
Your Broker has to make its profit.
To enable them to make money, your broker will add a small, usually fixed, mark-up on the spread. If their policy is to add a 1-pip mark-up, the quote you will see on your platform would be 1.4999/1.5002. So in your prices, you will see a 3-pip spread. The 1-pip spread for your broker becomes a 3-pip spread for you the trader.
So when you decide to buy 100,000 units of EUR/USD at 1.5002, your order is sent through your broker and then routed to either Liquidity Provider 1,2.
If your order is acknowledged, Liquidity Provider 1 or 2 will have a short position of 100,000 units of EUR/USD 1.5001, and you will have a long position of 100,000 units of EUR/USD at 1.5002. Your broker will earn 1 pip in revenue.
The constantly changing bid/ask quote from the liquidity providers is the reason why most STP type brokers have variable spreads (spreads that change). If the spreads of their liquidity providers widen, they have no choice but to widen their spreads too.
Electronic Communications Networks ECN Broker
“True” Electronic Communications Networks (ECN) brokers, enable the Buy/Sell orders of their clients to interact directly with the orders of other participants in the ECN.
Participants could be banks, retail traders, hedge funds, and even other brokers. In essence, participants trade against each other by offering their best bid and ask prices.
ECNs also allow their clients to see the “Depth of Market.” Depth of Market displays where the buy and sell orders of other market participants are. Because of the nature ECN, it is very difficult to slap on a fixed mark-up so ECN brokers usually get compensated through a small COMMISSION on the transactions.
It does not matter who you trade through, Everyone is in this industry to make money somehow, none of these services are for free so you will PAY one way OR another.